Market failure occurs when the market system is unable to achieve an efficient allocation of resources
Definition of Positive Externality.
This occurs when the consumption or production of a good causes a benefit to a third party. •For example, when you consume education you get a private benefit. But there are also benefits to the rest of society. E.g you are able to educate other people and therefore they benefit as a result of your education. A farmer who grows apple trees, provides a benefit to a beekeeper. The beekeeper gets a good source of nectar to help make more honey. Therefore with positive externalities the benefit to society is greater than your personal benefit. Therefore with a positive externality the Social Benefit > Private Benefit •
Remember Social Benefit = private benefit + external benefit. Diagram of Positive Externality
In a free market consumption will be at Q1 because Demand = Supply (private benefit = private cost ) •
However this is socially inefficient because Social Cost < Social Benefit. Therefore there is under consumption of the positive externality •
Social Efficiency would occur at Q2 where Social Cost = Social Benefit For example In the real world without govt intervention there would be too little education and public transport.
Negative externalities occur when the consumption or production of a good causes a harmful effect to a third party. •
For Example, if you play loud music at night your neighbour may not be able to sleep. •
If you produce chemicals, but cause pollution, then local fishermen will not be able to catch fish. This loss of income will be the negative externality. •
Therefore with a negative externality Social Cost > Private Cost Diagram of Negative Externality with Deadweight welfare loss
In a free Market people ignore the external costs to others therefore output will be at Q1 (where Demand = Supply). •
This is socially inefficient because at Q1 Social Cost > Social Benefit. •
Social Efficiency occurs at Q2 where Social Cost = Social Benefit The red triangle is the area of dead weight welfare loss. It indicates the area of overconsumption (where MSC is greater than MPC) Merit and Demerit Goods
Definition of Merit Good: A merit good has two characteristic: •
People do not realise the true benefit. For example, people underestimate the benefit of education or vaccinations. •
Usually these goods have positive externalities.
Therefore in a free market there will be under consumption of merit goods. Examples of Merit Goods:
Definition: A demerit goods has two characteristics:
A good which harms the consumer. For example, people don’t realise or ignore the costs of doing something e.g. smoking, drugs. 2.
Usually these goods also have negative externalities.
Therefore in a free market there will be over consumption of these goods. the govt should intervene to reduce demand. Examples of Demerit Goods include:
Demerit Good Definition
A demerit good is defined as a good which can harm or damage the consumer of the good. It is a good with negative utility or at least lower utility than consumer believes. Examples of Demerit Goods
alcohol, cigarettes, drugs.
The classification of demerit goods is a normative judgement. In defining demerit goods we may assume that people are irrational and make poor choices - often consuming goods which are harmful. This may be due to poor information or poor decision making. In other words people may under-estimate the private costs and over-estimate the private benefits. Demerit Goods are often defined as having two characteristics: •
1) Harmful to individual consumer
2) Also have negative externalities. (Costs imposed on third parties) For example,
Consuming alcohol can cause personal health problems.
Consuming alcohol can also...
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