4.3 Market Failure across the economy

• when does market failure occur

  free market fails to allocate resources to the socially optimal level of output
• equation for total social cost

  social cost = private costs + external costs
• how would you calculate the external costs from a graph

  measure the vertical distance between the Marginal social cost line and margin private cost line
• do the mpc and msc lines move parallel to each other

  no, both lines diverge from each other, as external costs increase disproportionately to output
• draw a graph showing external costs of production in a market, labelling the area of welfare loss

  When negative externalities are present, MSC > MPC, which results in welfare loss

  
• draw a graph showing external benefits of production in a market, labelling the area of welfare gain

  When positive externalities are present, MSB > MPB, which results in welfare gain. The goods are underbought by Q1 - Qe

  
• externality


  cost or benefit to a third party member outside the market transaction
• where on a graph is the socially optimal point in a market

  where MSC = MSB
• difference between public and private goods

  public goods: non excludable and non rival

  private goods: excludable and rival
• why are public goods underprovided in a free market

  people who do not pay for the good receive the same benefits from it compared to the ones who do pay. Therefore it is underprovide by the private sector as there is no room for profit
• link between market failure and perfect information

  rarely do both parties of a market transaction have perfect information, and so there is usually a misallocation of resources, hence market failure
• why do governments often intervene in free markets

  intervene to correct market failure
• 3 examples of government intervention

  • regulation
  • indirect tax
  • subsidies
• 2 different types of indirect tax

  • ad valorem tax
  • specific tax
• which type of indirect tax is represented on this graph

  ad valorem tax

  
• How do indirect taxes reduce the quantity of demerit goods consumed

  firms that have to pay the taxes pass them onto consumers in the form of higher prices, thus reducing the quantity demanded
• subsidy

  grant from government to firms in order to lower costs of production and encourage production
• would the government subsidise alcohol products or education, and why

  education, because this is a merit good and so subsidising it would encourage learning and improve quality of labour force
• which way would a subsidy shift the supply curve

  to the right ( reduces the cost of production which encourages firms to produce more)
• how could a subsidy potentially become a source of government failure

  distorting price signals by distorting the free market mechanism
• example of unintended consequence when implementing government policies

  policy could be expensive to implement