5: Market failure (externalities)

Question 1

Define market failure:

Answer 1

Market failure refers to the failure of the market to allocate resources efficiently, resulting in allocative inefficiency.

Question 2

Define externalities:

Answer 2

An externality occurs when the actions of consumers or producers give rise to negative or positive side-effects on a third party, whose interests are not taken into consideration.

Question 3

What is a positive/negative externality?

Answer 3

If the side effects on third parties involves benefits, it is a positive externality. If the side effects on third parties involves costs, then arises a negative externality.

Question 4

What do the supply and demand curves represent?

Answer 4

The demand curve represents marginal benefit for consumers whilst the supply curve represents marginal costs for producers.

Question 5

Who does the demand curve benefit though? So?

Answer 5

The demand curve benefits private consumers, so it can also be referred to as marginal private benefits (MPB).

Question 6

Who does the supply curve affect though? So?

Answer 6

The supply curve reflects firms’ costs of production, so the supply curve can be referred to as marginal private cost (MPC).

Question 7

If externalities are present, how does the graph change?

Answer 7

Marginal social benefits (MSB) and marginal social costs (MSC) are present.

Question 8

How is the Pe determined when there are externalities?

Answer 8

The equilibrium price and quantity are determined by wherever MPB and MPC meet, although this indicates allocative inefficiency.

Question 9

Define marginal private/social costs/benefits:

Answer 9

Refers to the costs/benefits of producers/consumers/society producing/consuming one more unit of the good.

Question 10

When is allocative efficiency achieved with externalities?

Answer 10

When MSB = MSC

Question 11

When there is no externality when is allocative efficiency achieved?

Answer 11

When MPB = MPC = MSB = MSC

Question 12

What are negative externalities of production? Examples?

Answer 12

External costs created by producers such as environmental pollution. The MPC of the producer are lower than the MSC of society.

Question 13

Draw the graph for negative externalities of production:

Answer 13

MSC is more left than MPC (because left means less production and with negative externalities of production society wants less) = S
D = MPB = MSB
P opt is where MSC and D intercept.
Pm (market price) is where MPC and D intercept.
The vertical difference between them is external cost.
The welfare loss is the triangle above D, vertical line from Qm until MSC. It lies at the Qopt level of output (I think this means this is where the point is).

Question 14

What are methods of correcting negative production externalities?

Answer 14

1. Government regulations

2. Market based policies

Question 15

Describe government regulations as a method of correcting negative production externalities:

Answer 15

The government can use its authority to enact legislations and regulations in the public’s interest. For example, in the case of the polluting firm, regulations can forbid the dumbing of certain toxic substances into the environment. Regulations rarely ban production of pollutants completely, as there is still social benefit, instead they may set maximum levels, or require firms to install technology aimed at reducing emissions. This shifts the MPC to the left, towards the MSC curve. The objective is to make the two curves coincide, so that Qopt is produced.

Question 16

Evaluate government regulations as a method of correcting negative production externalities:

Answer 16

Advantages:
•They are more simple than market based and can be implemented more easily.
•Firms are more likely to comply.

Disadvantages:
• They do not allow the externality to be internalised and create no market based incentives. They also do not incentivise firms to use less polluting resources. Pollution is reduced, but at a higher overall cost. Enforcement is also difficult so policies can only ever partially decrease pollution.

Question 17

Describe market based policies as a method of correcting negative production externalities (tax):

Answer 17

There are two main methods of market based policies to decrease negative externalities: taxes and tradable permits.
Tax:
The government could impose a tax per unit produced or tax per pollutant emitted, such as a carbon tax. The tax results in an upwards shift of the MPC curve to MSC. Ideally, the tax would be exactly equal to the external cost. If this is the case, Qopt will be produced at a higher, but optimum price (Popt). The incidence will be shared between consumers and producers.

Question 18

How is a tax on output different to a tax on pollutants?

Answer 18

A tax on output simply shifts the MPC curve to the left, ideally the tax will equal to external cost and the MPC will become the MSC.
A tax on pollutants however, such as the carbon tax, can also shift the MPC to the MSC, should the firm continue to use the pollutants despite the tax. If the firm looks for substitutes, such as solar power or other renewables, this will shift MPC to the left as they are more expensive than carbon prior to the tax, as well as shifting MSC to the right as there are less externalities with renewable energy. This creates a Qopt2, higher than the original Qopt but lower than Qm.

Question 19

Describe market based policies as a method of correcting negative production externalities (tradable permits):

Answer 19

Tradable permits are policy involving permits to pollute, issued to firms by a government or international body. These permits to pollute can be bought and sold in a market. The price of the permits are determined by supply and demand. If a firm can produce its product by emitting a lower level of pollutants than the one set by its permit, it can sell its extra permits in the market. If a firm needs to emit more pollutants, it can buy permits.

Question 20

Describe the graph for tradable permits:

Answer 20

The supply graph is completely inelastic (vertical) because there are only so many permits available in the market, chosen by the government or international body. The demand-for-permits curve determines the equilibrium price. As an economy grows, the demand for permits is expected to increase, so the demand curve shifts to the right from D1 to D2. They incentivise companies to switch to non polluting resources that do not require permits. It can then sell its permits for profit. This will shift the MSC curve down to the MPC since firms are looking for alternatives.

Question 21

Evaluate advantages of market based policies as a method of correcting negative production externalities:

Answer 21

Advantages:
Both taxes and tradable permits have the effect of internalising the externality, meaning that the costs that were previously external are made internal, because now they are paid for by producers and consumers involved in the transaction rather than by third parties (consumers are also affected by a tax as they share the incidence).
Taxes on emissions are better than taxes on output as they incentivise the use of less polluting resources, shifting MSC to the right, meaning output does not have to decrease largely, as with a tax which only shifts MPC to the left.
Tradable permits also reduce emissions at a lower cost.

Question 22

Evaluate disadvantages of market based policies as a method of correcting negative production externalities:

Answer 22

Taxes:
It is difficult to identify what production methods create which pollutants. There is also much controversy amongst scientists as to which pollutant is most harmful. Then the government must attribute a monetary value to this harm. Many firms may also continue to produce without paying the tax.
Tradable permits:
Similar technical limitations as taxes. In addition, they require the government to set a maximum acceptable level for each type of pollutant, called a ‘cap’. If it is too high, firms will continue to pollute. If it is too low, firms could be damaged, as well as the overall economy. Distribution of permits may involve political favouritism.
Carbon taxes must be adjusted for inflation, and are regressive.

Question 23

What is an example of a negative externality of consumption?

Answer 23

Cigarettes due to second hand smoke and if the country has universal health care, smokers are more likely to have health issues which is costly to the country and negatively affects tax payers.

Question 24

How are negative externalities of consumption illustrated graphically?

Answer 24

The S curve = MPC = MSC
The D curve = MPB
Then there is a MSB curve to the left of the D curve. The vertical distance between the MPB and MSB curve is the external cost.
Qm and Pm are where S meets D (MPB).
Qopt and Popt are where S meets MSB.
The welfare loss is the triangle with the point at Popt and Qopt.

Question 25

Describe why society is better off at Qopt and Popt.

Answer 25

Consumer surplus at Pm is a + b (everything above the line)
Producer surplus at Pm is c + d + f (everything below the line)
But to calculate social benefits you must add these and subtract external costs which is everything in the diagonal area, e + a + d
Therefore social benefits = b + c + f

Without external cost it is just b + c + f

If you don’t understand, check page 109.

Question 26

Methods of correcting negative externalities:

Answer 26

1. Government regulations
2. Negative advertising
3. Market based policies

Question 27

Describe government regulation as a method of correcting negative externalities of consumption:

Answer 27

Legal restrictions or complete bans could be installed, such as preventing smoking in public places. This shifts the MPB curve to the left towards the MSB curve, so that the quantity consumed is closer to Qopt.

Question 28

Describe negative advertising as a method of correcting negative externalities of consumption:

Answer 28

Anti-smoking campaigns for example, in an attempt to deter people from using the good, thereby decreasing demand, shifting the MPB curve to the left towards the MSB curve so that the quantity consumed is closer to Qopt.

Question 29

Describe market based policies as a method of correcting negative externalities of consumption:

Answer 29

This involves indirect taxes imposed on the good which would shift the supply curve to the left from MPC to MPC + tax.

Question 30

What are demerit goos?

Answer 30

Goods that are considered to be undesirable for consumers, but which are overprovided by the market. Such as gambling, smoking or drinking alcohol.

Question 31

Why do taxes shift the supply curve to the left and not the demand curve to the left? (supplementary)

Answer 31

These two shifts produce identical market outcomes. In both Qopt should be achieved and consumers will pay Pc and producers will receive Pp (Pc - tax). The only difference involves who pays the tax to the government.

Question 32

Evaluate the use of market based policies to reduce externalities of consumption:

Answer 32

Indirect taxes create incentives for the consumers to reduce their consumption by changing relative prices. However, it is difficult to measure the value of the external costs. It is difficult to assess who is affected and by how much. In addition many of these goods have an inelastic demand, whether because they are necessities as with petrol or due to addiction as with smoking. Whilst this would increase government revenue, it would not necessarily decrease the quantity demanded of these goods. Thus, to decrease demand it is likely a very high tax would need to be implemented, which would be politically unacceptable.

Question 33

Evaluate the use of negative advertising to reduce externalities of consumption:

Answer 33

Advertising is simpler but it costs the government money for the campaigns. This means there are less available tax funds for other sections of the economy. With cigarettes, negative advertising may have limited affect as they are an addictive substance. People already know their affects but their addiction means they do it anyway. Campaigns may be effective for future generations of smokers. A tax may be more beneficial however as it provides revenue, which can then be spent on negative advertisement campaigns.
Overall, no method of reducing negative externalities will achieve the exact optimum quantity. Taxes are probably best though.

Question 34

Examples of positive externalities of production:

Answer 34

Research and development by firms to decrease their price. Widespread adoption of this technology may benefit society. Since society did not pay for the research, the MSC are lower than the MPC.

Question 35

How are positive externalities of production illustrated graphically?

Answer 35

MPC is greater than MSC, so the MPC curve is more to the left. MPC = S.
The vertical line between them is the external benefits.
D = MPB = MSB curve.
Where MPC = D is Pm. Where MSC = D is Popt and Qopt.
Welfare loss triangle point where Popt and Qopt meet.

Question 36

Why is there welfare loss with positive externalities of production?

Answer 36

Because there is an under-allocation of resources. The best thing for society would be to produce at the marginal social cost level.

Question 37

How do you calculate welfare loss with positive externalities of production?

Answer 37

Calculate GTS at market price:
Calculate the consumer surplus (area above Pm until D curve)
Calculate the producer surplus (Area below Pm until S = MPC curve)
Calculate external benefits (the difference between the MPC and MSC curve until the point of production, Qm.

Calculate GTS at the optimum price (where D meets MSC):
Calculate consumer surplus (the area above Popt until D)
Calculate producer surplus (the area below Popt until MSC)

The difference between these areas is d and g, or whatever you label it. This is the rightward pointing triangle. The point should be where Qopt and Popt meet.

Question 38

Methods of correcting production externalities:

Answer 38

To correct positive externalities of production the government must try to shift the MPC curve downwards to the right. This can be done in two ways, by:

1. Direct government provision
2. Subsidies

Question 39

Describe how direct government provision works as a method of correcting production externalities:

Answer 39

Governments often engage in research and development for new technology, pharmaceuticals, and many other areas. In addition, they could provide universal health care, as with the NHS in Britain. Governments afford such activities using taxes. Ideally, the MPC curve would shift to the right, the exact amount of the external costs, such that the market price was the optimum price.

Question 40

Describe how direct subsidies work as a method of correcting production externalities:

Answer 40

If the government provides a subsidy to a firm per unit of the good produced, that is equal to the external benefit, then the marginal private cost (MPC = supply) curve will shift downward and rightward until it coincides with the MSC curve. This means you can draw an arrow on the diagram, and where “external benefits” were labelled can now be called that and subsidy. This has the same market outcome as direct government provision.

Question 41

Define merit good:

Answer 41

Goods that are deemed desirable for consumers, but are underprovided in the economy.

Question 42

Example of positive externalities of consumption?

Answer 42

Education as the person who received the education receives benefits, but society also gains external benefits given the increase in productivity in the work force, lower unemployment, higher rate of growth, economic development etc.
In addition, the NHS in the UK leads to a healthier, more productive workforce, leading to a higher rat of economic growth.

Question 43

Describe the positive externalities of consumption graph:

Draw it

Answer 43

MSB curve to the right, MPB = D to the left of it.
S = MSC = MPC curve.
Where MSB meets S is Popt and Qopt.
Where MPB meets S is Pm and Qm.
Welfare loss triangle with point where Popt meets Qopt, between Qm and Qopt.
Draw parallel lines.

Question 44

Why is there welfare loss with positive externalities of consumption?

Answer 44

There is welfare loss because there is underproduction of the good. If production were at Qopt, there would not be welfare loss.

Question 45

Describe welfare loss graphically with positive externalities of consumption?

Answer 45

Calculate GTS at market price:
Calculate the consumer surplus (area above Pm until D =MPB curve)
Calculate the producer surplus (Area below Pm until S curve)
Calculate external benefits (the difference between the MPB and MSB curve until the point of production, Qm.

Calculate GTS at the optimum price (where D meets MSB):
Calculate consumer surplus (the area above Popt until D)
Calculate producer surplus (the area below Popt until MSB)

Question 46

Why might merit goods be under-provided?

Answer 46

1. The good may have positive externalities.
2. Low level of income and poverty. People may be willing but unable to buy the goods. For example healthcare is desired, but many people cannot afford to go to the doctor.
3. Consumer ignorance. Consumers may ignore the benefits of certain goods, such as vaccinations.

Question 47

Methods of correcting positive externalities of consumption:

Answer 47

1. Legislation
2. Positive advertising
3. Direct government provision
4. Subsidies

Question 48

Describe legislation as a method of correcting positive externalities of consumption:

Answer 48

Legislation can make certain goods required. For example, many countries have legislation that makes education compulsory up to a certain age, as education is a merit good. (If you haven’t done so before, define a merit good). This causes the demand for education to decrease, causing the demand curve to shift upward to the right.

Question 49

Describe advertising as a method of correcting positive externalities of consumption:

Answer 49

Advertising can be used to persuade customers to buy more goods with positive externalities. For example, if the government tries to encourage the use of sports facilities to improve health. Thus, the demand for such facilities should increase and the demand curve will shift upward and to the right.

Question 50

Describe direct government provision as a method of correcting positive externalities of consumption:

Answer 50

For example, the provision of education and healthcare by virtually all governments in the world. Education and health care are merit goods with external benefits so large that it is believed they should not be left solely to public organisations. Unlike the others, this shifts supply to the right rather than demand to the right, to S + government provision. This causes price to fall and quantity to increase, to Pc and Qopt.

Question 51

Describe direct government provision as a method of correcting positive externalities of consumption:

Answer 51

This increases the supply rightward. The subsidy should be equal to the external benefit. If so, Qopt should be produced at Pc, which is lower than Popt as there is a subsidy.

Question 52

Evaluate government provision and subsidies as a method to correct positive production and consumption externalities:

Answer 52

Both direct government provision are effective at attaining a higher quantity produced of the good and a lower price for consumers, although Popt is not achieved. However they both involve the use of government funds that rely on tax revenues, which have opportunity costs. It is not possible for the government to subsidise all goods and services with positive externalities. For example in the UK there is universal healthcare with the NHS, but students must still pay for university, despite it being subsidised, and many people still cannot afford to go. It is practically difficult to measure the exact amount of social benefit provided by certain services. Both direct government provision and subsidies are also highly political in nature, as different groups compete as to who reaps benefits. Unfortunately, governments are susceptible to political pressures as they want to get reelected. They can only really get a step in the right direction therefore.

Question 53

Evaluate legislation and advertising as a method to correct positive production and consumption externalities:

Answer 53

They can only help shift the MPB curve in the right direction, rather than achieve a demand increase that will bring the economy to Qopt level of output. Legislation may be a plausible solution to education, but it is difficult to legislate consumption of health care services. In addition, the optimum level of education may be university, but it is not realistic to require everyone to go to university. It may also raise the price for consumers, so legislation and advertising may be more effective when implemented together with direct provision and subsidies. For example education in the UK is compulsory until 16, yet their are public schools provided by the government.