What is market failure?
Market failure occurs when goods and services in the free market are not allocated in a way that maximises social welfare.
How are externalities a type of market failure?
Externalities are effects on those that were not originally part of the initial transaction. Negative externalities are the negative effects on those not originally involved in a transaction. These negative effects on society are not factored into the market price, leading to goods and services that produce negative externalities being overproduced, resulting in market failure. Positive externalities are the positive effects on those not originally involved in a transaction. These positive effects on society are not factored into the market price, leading to goods and services that produce positive externalities being underproduced, resulting in market failure.
How is the under-provision of public goods a type of market failure?
In the free market, public goods are often under-provided. This is because public goods often suffer from the free rider problem, where those who benefit from a good or service may not pay for its use. As a result, firms are not incentivised to produce these public goods in the free market, as they may not receive revenue from these public goods when someone uses them. This results in public goods being under-provided, resulting in market failure.
How are information gaps a type of market failure?
Information gaps occur when economic agents may not make informed decisions as a result of having insufficient information or knowledge, potentially resulting in resources being misallocated, resulting in market failure.
What is the distinction between private costs, external costs and social costs?
Private costs are costs to those originally involved in a transaction such as the costs to the firm which produces the good or service and the cost to the consumer that purchases the good or service. External costs are also known as negative externalities and are the negative effects on those not originally involved in a transaction. Demerit goods and services are goods and services that produce external costs. Social costs show the total cost to society of a transaction and incorporate both the private costs and external costs of a transaction. Thus social costs = private costs + external costs.
What is the distinction between private benefits, external benefits and social benefits?
Private benefits are benefits to those individuals originally involved in a transaction such as the benefits to the firm which produces the good or service and the benefits to the consumer that purchases the good or service. External benefits are also known as positive externalities and are the positive effects on those not originally involved in a transaction. Merit goods and services are goods and services that produce external benefits. Social benefits show the total benefit to society of a transaction and incorporate both the private benefits and external benefits of a transaction. Thus social benefits = private benefits + external benefits.
How can a diagram be used to illustrate the external costs of production using marginal analysis?
MSC (Marginal Social Cost) is the additional cost to society of producing an extra unit of a good or service.
MSB (Marginal Social Benefit) is the additional benefit to society of producing an extra unit of a good or service.
MPC (Marginal Private Cost) is the additional private cost of producing an extra unit of a good or service.
MPB (Marginal Private Benefit) is the additional private benefit of producing an extra unit of a good or service.
The MSC, MSB, MPC and MPB curves are drawn in the diagram below. The MSC and MPC curves are diverging. This is because, the external cost rises as output rises, increasing the social cost at higher outputs.
In the diagram above, the external cost of production at the market equilibrium (MPC = MPB) is represented by the distance between Y and Z, where the market equilibrium price is Pe and the market equilibrium quantity is Qe. At a given level of output, the size of the external cost of production is found by the distance between the MPC curve and the MSC curve.
How can a diagram be used to illustrate the distinction between the market equilibrium and social optimum position regarding a product that creates negative externalities in production?
In the above diagram, the market equilibrium is where MPB = MPC at the market equilibrium price of Pe and the market equilibrium quantity of Qe. The social optimum position is where MSB = MSC at the social optimum price of P1 (which is higher than the market equilibrium price of Pe) and the social optimum quantity of Q1 (which is lower than the market equilibrium quantity of Qe). There is overproduction under market conditions between Q1 and Qe.
How can a diagram be used to illustrate the welfare loss area of a product that produces negative externalities in production?
In the above diagram, the welfare loss area is represented by the triangle XYZ.
How can a diagram be used to illustrate the external benefits of consumption using marginal analysis?
The MPB and MSB curves are diverging as at higher outputs, there is a greater external benefit, meaning that the social benefit is much greater than the private benefit at higher outputs.
In the diagram above, the external benefit of consumption at the market equilibrium (MPC = MPB) is represented by the distance between Y and X, where the market equilibrium price is Pe and the market equilibrium quantity is Qe. At a given level of output, the size of the external benefit of consumption is found by the distance between the MPB curve and the MSB curve.
How can a diagram be used to illustrate the distinction between the market equilibrium and social optimum position regarding a product that creates positive externalities in consumption?
In the above diagram, the market equilibrium is where MPB = MPC at the market equilibrium price of Pe and the market equilibrium quantity of Qe. The social optimum position is where MSB = MSC at the social optimum price of P1 (which is higher than the market equilibrium price of Pe) and the social optimum quantity of Q1 (which is greater than the market equilibrium quantity of Qe). There is underconsumption under market conditions between Qe and Q1.
How can a diagram be used to illustrate the welfare gain area of a product that produces positive externalities in consumption?
The welfare gain area in the diagram above is represented by the triangle XYZ.
What is the impact on economic agents of externalities and government intervention in various markets?
Goods and services that create positive externalities are likely to create positive effects for most economic agents, whilst goods and services that create negative externalities are likely to create negative effects for most economic agents. Within markets that produce goods or services with negative externalities, the government is likely to impose an indirect tax and increase regulation on these goods or services in order to reduce the quantity of these goods or services, helping to reduce external costs and likely leading to the market producing a quantity of these goods or services closer to the socially optimum level. Within markets that produce a good or service with positive externalities, the government is likely to subsidise this good or service and reduce regulation on this good or service in order to help increase external benefits and increase the quantity of this good or service towards the socially optimum level.
What is the distinction between public and private goods (using the concepts of non-rivalry and non-excludability)?
A public good is a good that is non-rivalrous and non-excludable. Non-rivalrous means that the use of the good by someone does not affect someone else's use of this good. Non-excludable means that it is not possible to prevent someone from using this good. Whereas, a private good is rivalrous and excludable, so someone's use stops someone else from using the good, and it is possible to prevent someone from using this good.
Why may public goods not be provided by the private sector (using the concept of the free rider problem)?
Public goods often suffer from the free rider problem, where those who benefit from the use of a good do not pay for it. As a result, in the private sector, firms are not incentivised to produce these public goods as firms may not receive payment for the good when someone uses their good. As a result, some public goods may not be provided by the private sector.
What is the distinction between symmetric and asymmetric information?
Symmetric information occurs when all parties that are involved in a transaction have the same level of information. Whereas, asymmetric information is where one party in a transaction may have more information than another party in a transaction, which may result in the party with more information exploiting the other party.
How may imperfect market information result in a misallocation of resources?
Imperfect information may result in economic agents not knowing the potential benefits or costs of a good or service, resulting in resources being misallocated as economic agents may not purchase resources that help to improve overall welfare.
