Definitions

• externalities


  when the actions of consumers or producers give rise to negative or positive effects on people who are not part of the actions
• Private Cost (PC)


  a cost incurred by those involved in an economic transaction
• External Cost (EC) 


  a cost incurred by 3rd parties, those not involved in an economic transaction
• Social Costs (SC)


  the total costs to the whole community/society (SC = PC + EC)
• Private Benefit (PB)


  a benefit gained by those involved in the economic transaction
• External Benefit (EB) 


  a benefit gained by 3rd parties who were not involved in the economic transaction
• Social Benefits (SB)


  the total benefits gain by the whole community/society (SB = PB + EB)
• third parties


  those that did not produce, purchase, or consume the product and are still affected by the production
• spillover costs/benefits 


  the positive or negative effects that impact 3rd parties
• negative production externality


  when uncompensated spillover costs happen during the production of a product
• positive production externality 


  when spillover benefits happen during the production of a product
• negative consumption externality


  when uncompensated spillover costs happen during the consumption of a product
• positive consumption externality


  when spillover benefits happen during the consumption of a product
• merit goods


  goods or services that are underproduced and underconsumed by the market, and produce strong positive externalities, e.g. education, healthcare
• demerit goods


  goods that are considered to be undesirable for consumers, are overproduced and overconsumed by the market, and produce negative externalities, e.g. cigarettes, alcohol, gambling, fast food, factories
• common pool resources 


  resources that aren’t owned by anyone, do not have a price, and are able to be used without payment or any other restriction (e.g. clean air, lakes, rivers, forests)
• Common pool goods are:

  • Non-rivalrous - when one person buys them, they have the same availability for someone else
  • Non-excludable - it is impossible to exclude people from using the good, if someone is unwilling or unable to pay the price of a good, they would still have the benefit of using it
• Why are merit goods underproduced?

  • No profit incentive - no reason to start a business, no money in it
  • Lack of demand (only in some cases)
  • Funding problems - because there is no profit incentive, it is hard to find money to start the business
• Why are demerit goods overconsumed?

  • Profit incentive - prioritise financial gains over social welfare
  • Lack of information - producers and consumers don’t know the extent of the negative impacts that arise from their activities
  • Low prices - most demerit goods are relatively cheap in the free market
• net welfare loss 


  when the free market provision point is less or more than the socially optimal level
• free rider problem 


  when too many people are benefiting from goods, resources, or services that they are not paying for
• government failure


  when the government’s attempt to correct market failure leads to a further misallocation of resources, generally due to lack of appropriate information, expertise, and potential spill-over effects
• Reasons for government failure:

  • Inadequate information - may make wrong decisions based on unreliable information
  • Lack of expertise - may not have an understanding of how a particular market works
  • Moral hazard - firms may behave in a different way if the government is always intervening in the market; any failures from the firm would fall on the government