Introduction to Market Failure and Externalities (Pack 9)

• What is the definition of 'market failure'?

  When the allocation of resources is inefficient in the free market
• What is the definition of 'externality'?

  Cost or benefit affecting third parties
• What is the definition of 'third party'?

  Individuals not directly involved in a transaction
• What are examples of private costs, private benefits, external costs, and external benefits for a product of your choice?

  • Private Cost: Price of university tuition
  • Private Benefit: Specialist knowledge
  • External Cost: May take someone’s place
  • External Benefit: Increased productivity in society e.g. More doctors
• How are marginal social costs calculated?

  Sum of marginal private costs and marginal external costs
• How are marginal social benefits calculated?

  Sum of marginal private benefits and marginal external benefits
• What does a diagram showing negative production externalities illustrate?

  • Negative production externalities lead to welfare loss
  • Shifts left from marginal private costs to the marginal social costs (Supply curve)
• Give an example of a product associated with negative externalities.

  Polluting factories
• Why are negative externalities a cause of market failure?

  They impose costs on third parties in the free market
• What does a diagram showing positive consumption externalities illustrate?

  • Positive consumption externalities lead to welfare gain
  • Shifts right from marginal private benefits to the marginal social benefits (Demand curve)
• Give an example of a product associated with positive externalities.

  Education services
• Why are positive externalities a cause of market failure?

  They provide benefits to third parties
• Why can external costs and benefits be difficult to quantify?

  They involve subjective valuations and estimates