MARKET FAILURE - 1 1. Explain the meaning of market failure in terms of inefficient allocation allocation of resources.
Market failure is a situation that occurs when allocation of resources is not performed in a way that would satisfy the consumers to the greatest extent. It is the case where quantit y demanded by the consumers is not the same as quantity supplied by producer is – excess excess demand or supply, therefore there is no market equilibrium in such situation. There are no directions imposed by the government. 2. Define externalities! externalities!
Externalities are common in virtually every area of economic activity. They are defined as third party (or spill-over) effects arising from the production and/or consumption of goods and services for which no appropriate compensation is paid. Externalities can cause market failure if the price mechanism does not take into account the fullsocial costs and social benefits of production and consumption. 3. Destinguish between positive and negative externalities. Give one example for each!
A negative externality is an action of a product p roduct on consumers that imposes a negative side effect on a third party which is not directly involved in the economy. It is called social cost as well. An example could be river pollution caused by the factories – this this is harmful for environment, animals and people. Water from the river is poured in the underwater that people use for drinking – drinking – it it may cause different diseases. A positive externality is a benefit for the third party which is not directly involved in the economy. Because it presents a benefit for the society it is called social benefit. An example may be increased education increased education of individuals which can lead to broader society benefits in the form of greater economic productivity, economic productivity, lower lower unemployment rate, greater household mobility and higher rates of political participation 4. Examine negative production externalities. externalities. Illustrate!
Negative production externalities are spillover costs created by producers. With their production, they harm the society involved involved as a third party. An example may be a cement factory. Beside all the cost that t hat they have with the production, they produce external cost for the society by producing the gasses which pollute air and water. The marginal social cost is thus greater than solely the production costs.
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Figure 1: MSC P MPC
P1
Spillover cost
MPB Q opt
Q
Qm
5. Identify the appropriate government policies intended to correct negative production externalities. Illustrate!
The goal of policies to achieve Q opt thus that allocative efficiency is achieved. There are many options to do that. Legislation and regulations can be used to prevent or reduce the effects of production externalities. In the case of polluting firm, legislation can be used to completely forbid the dumping of certain toxic substance in the environment. Imposing a tax on the fi rm is one of the options. The government could impose a tax of a unit of the good produced. This would produce an upward shift in the supply curve. Both of these solutions lead to reducing or completely preventing the marginal s ocial cost. In example of taxes, the taxes imposed should be as high as the social cost, to completely reduce the social cost. Thus, the welfare loss is minimized or there is no welfare lost at all. Figure 2: MSC P MPC
P2
P1
Spillover cost
MPB Q opt
Qm
Q
2
6. Examine negative consumption externalities. Illustrate!
These are spillover cost produced by the consumers. Although private benefits are produced, there is a cost for the society. A great and the clearest example is smoking. If there is a smoker indoors, smoking brings benefit to that particular person, but if all the people around him are non-smokers, his smoke presents a cost for them. Allocative efficiency is not achieved because too much of a good is produces regarding the social optimum. Figure 3: MPC P P1
Spillover
MPB
cost MSB Qopt
Qm
7. Identify the appropriate government policies intended to correct negative consumption externalities. Illustrate
There are many options that the government can use to pursue the people to lower the demand. Advertising and campaigns are one of the most common options used to pursue people against use of a certain product, like anti-smoking campaigns for example. Objective is to decrease the demand so that MPB shifts towards the MSB. Legislation can be used to prevent consumer activities to impose a cost on third parties. Such legislations are again used in smoking – prohibited in public places (indoor), restriction of playing the loud music, discarding the trash at public places…this again produces a downward shift of the MPB curve. Imposing a tax on a firm producing a good that causes a negative consumption externality can cause the decrease in supply of a certain good and thus the upward shift of the supply curve.
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Figure 4: MPC P P1
MPB
Spillover
P2
cost MSB = MPB 2 Qopt
Qm MPC + tax
Figure 5:
MPC P P1
MPB
P2
Spillover cost MSB = MPB 2 Qopt
8.
Qm
Explain the relationship between environmental externalities and sustainable
development.
If there is an externality it influences the market and, of course, economic system. In case of the environmental externality it is obvious that it involves either the damage to property or resources of the third party or the externalizing of cleanup costs onto those who did not do the damage (third parties). Obviously, if people were allowed to do either of those things on a very large scale, the pollution will be high and eventually people would destroy most of the usable land, water, forest, etc. Environmental externalities would prove the economic system and its development to be unsustainable. Thus, in the case of any externality government always intervenes in order to make the difference smaller and reach the equilibrium.
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9. Examine positive production externalities. Illustrate!
Positive production externalities occur when the production of a good or service creates external benefits that are good for other, third parties. In the case of positive production externalities the marginal private cost of the firm is greater than the marginal social cost.
Figure 6: MPC P
MSC
Spillover benefit
MPB Qopt
Q
Qm
10. Identify the appropriate government policies intended to correct positive production externalities. Illustrate!
A positive production externality gives rise to a marginal socia l cost curve which lies below the marginal private cost – the difference is spillover benefit. If a government imposes a subsidy per a unit of good that is spillover benefit, t hen the private marginal cost curve will shift downwards.
Figure 7: MPC P
MSC
P1 P
Spillover benefit
MPB Qm
Q Qopt
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11.
Examine positive consumption externalities. Illustrate!
There are some goods and services that can provide external benefits to third parties. The example would be the health care. When people consume health care they create benefits for society as well. In a free market of health care the efficient level of consumption would be in a point where the marginal social benefit is equal to the marginal social cost. There would also be a potential welfare gain, as the marginal social benefit is greater than the marginal private benefit.
Figure 8: MPC P
MSB Spillover
P1
benefit MPB Qm
Qopt
12. Identify the appropriate government policies intended to correct positive production externalities.
Legislation can be used to promote greater consumption of goods with positive externalities, like in many countries education is compulsory to a certain age. In this case the demand for education is getting higher and the MPB curve shifts to the right. One of the options for the government is to use the advertising to pursue the consumers to buy more goods with + ext. For example, government can encourage people to use more sport facilities, regarding this is good for their health and there is right shift of the MPB curve. One of the options is subsidiz ing. If producers get subsidies they are willing the supply more goods for lower price. Thus the purchasing power of consumers is bigger and the demand increases, pulling the MPB to the right as well.
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MPC
Figure 9:
P P2
MSB = MPB 2 Spillover
P1
benefit MPB Qm
Qopt
Figure 10: MPC MPC + subsidy P P1
MSB Subsidy –
P2
spillover benefit MPB
Qopt
Qm
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