market failure.
when the price mechanism leads to a misallocation of resources
types of market failure:
– negative externalities
– positive externalities
– public goods
– information gaps
negative externalities:
costs which affect third parties outside of the price mechanism.
negative consumption externalities: when the consumption of a good/service leads to a cost
which affects third parties outside of the price mechanism (society)
-> examples:
● smoking affects other peoples lungs.
● too much alcohol intake leading to vomiting on roads or antisocial behaviour.
● cars burn fossil fuels, damaging environment, and accidents which injure other people.
NO DIAGRAM FOR NEGATIVE CONSUMPTION EXTERNALITY
negative production externalities: when the production of a good/service leads to a cost which
affects third parties outside of the price mechanism (society)
-> examples:
● construction, noise that disturbs residents, trucks delivering materials block roads,
burning of fossil fuels contribute to global warming.
in negative production externalities there are private costs and private benefits inside the price
mechanism, and only external costs outside the price mechanism. NO EXTERNAL BENEFITS.
, welfare = MSB - MSC
– amount of welfare decreases with an increase in quantity.
– moving closer to socially efficient equlibrium (MSB = MSC) means welfare is getting
closer to 0.
– going past the socially efficient equilibrium (MSB = MSC) shows a welfare loss up to the
market equilibrium (MPC = MPB).
– gap between socially efficient equilibrium (MSB = MSC) and market equilibrium (MPC =
MPB) shows the overproduction.
– vertical distance between MPC and MSC represents external cost
the external cost is not reflected in the market equilibrium, because firms do not face the full
social cost of production. this leads to overproduction compared to the socially optimal level.
EVALUATION:
● difficult to quantify external costs. estimating the exact cost of pollution or noise is
subjective and varies by context.
● value judgment involved. what is considered a ‘cost’ differs between individuals.
● information gaps may exaggerate of downplay the externality. people may not be fully
aware of the consequences or might ignore them.
● externalities often vary over time and space. for example, the external costs of congestion
differs during rush hour vs late at night.
positive externalities:
benefits which affect third parties outside the price mechanism.
positive production externalities: when the production of a good / service leads to a benefit
when the price mechanism leads to a misallocation of resources
types of market failure:
– negative externalities
– positive externalities
– public goods
– information gaps
negative externalities:
costs which affect third parties outside of the price mechanism.
negative consumption externalities: when the consumption of a good/service leads to a cost
which affects third parties outside of the price mechanism (society)
-> examples:
● smoking affects other peoples lungs.
● too much alcohol intake leading to vomiting on roads or antisocial behaviour.
● cars burn fossil fuels, damaging environment, and accidents which injure other people.
NO DIAGRAM FOR NEGATIVE CONSUMPTION EXTERNALITY
negative production externalities: when the production of a good/service leads to a cost which
affects third parties outside of the price mechanism (society)
-> examples:
● construction, noise that disturbs residents, trucks delivering materials block roads,
burning of fossil fuels contribute to global warming.
in negative production externalities there are private costs and private benefits inside the price
mechanism, and only external costs outside the price mechanism. NO EXTERNAL BENEFITS.
, welfare = MSB - MSC
– amount of welfare decreases with an increase in quantity.
– moving closer to socially efficient equlibrium (MSB = MSC) means welfare is getting
closer to 0.
– going past the socially efficient equilibrium (MSB = MSC) shows a welfare loss up to the
market equilibrium (MPC = MPB).
– gap between socially efficient equilibrium (MSB = MSC) and market equilibrium (MPC =
MPB) shows the overproduction.
– vertical distance between MPC and MSC represents external cost
the external cost is not reflected in the market equilibrium, because firms do not face the full
social cost of production. this leads to overproduction compared to the socially optimal level.
EVALUATION:
● difficult to quantify external costs. estimating the exact cost of pollution or noise is
subjective and varies by context.
● value judgment involved. what is considered a ‘cost’ differs between individuals.
● information gaps may exaggerate of downplay the externality. people may not be fully
aware of the consequences or might ignore them.
● externalities often vary over time and space. for example, the external costs of congestion
differs during rush hour vs late at night.
positive externalities:
benefits which affect third parties outside the price mechanism.
positive production externalities: when the production of a good / service leads to a benefit
