1.5.1 market failure and externalities

What are private costs?

Costs incurred by producers, e.g., rent, machinery, labour, insurance, transport, and raw materials

What do private costs determine?

How much a producer will supply

What can private costs also refer to?

The market price paid by consumers

What are social costs?

Private costs plus external costs

How are external costs shown on a diagram?

Vertical distance between MSC and MPC

What happens to external costs as output increases?

They increase disproportionately

What are private benefits?

Benefits to consumers or firms, e.g., utility or revenue from selling a good

What determines private benefit for consumers?

The price they are willing to pay

What determines private benefit for firms?

Revenue from selling the product

What are social benefits?

Private benefits plus external benefits

How are external benefits shown on a diagram?

Vertical distance between MSB and MPB

How do external benefits change as output increases?

They increase disproportionately

What are external costs of production?

Costs like pollution not reflected in the market price

What happens at market equilibrium with negative externalities?

MSC > MPC; over-provision and under-pricing occur

What is deadweight welfare loss?

Area where social costs > private benefits, representing lost welfare

What are external benefits of production?

Positive spillover effects not accounted for by the market, e.g., vaccinations

What happens in a free market with positive externalities?

MSB > MPB; goods are underprovided and underconsumed

What is the area of welfare gain?

Excess of social benefits over costs

When does the market economy work well?

When private and social benefits are equal to or exceed private and social costs

What is the social optimum position?

MSC = MSB; point of maximum welfare

What is market failure?

When the free market fails to allocate resources efficiently, reducing economic and social welfare

Why does market failure occur?

External costs, under/over production or consumption, and misallocation of resources

What are externalities?

Costs or benefits to a third party from a transaction outside the market mechanism

What are public goods?

Non-excludable and non-rival goods, underprovided in a free market

Examples of public goods

Street lights, flood control systems

What is the free-rider problem?

People benefit from public goods without paying, reducing private sector incentive to provide them

Why are public goods underprovided?

Difficult to measure value and consumers undervalue benefits

What are private goods?

Rival and excludable goods, e.g., a chocolate bar

How are private property rights related to private goods?

They prevent others from consuming the good

What are information gaps?

When consumers or producers lack perfect information

What is the effect of imperfect information?

Misallocation of resources