Market Failure Essay Q3

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Market Failure Essay Q3

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    According to The World Bank, 16 of the 20 most polluted cities

    in the world are in China. A plan to lift Beijings shroud of

    pollution ahead of the Olympic Games includes stopping half

    of Beijings 3.3 million vehicles and shutting down chemical

    plants, power stations and foundries to cut emissions by 30%.

    (a) Using appropriate examples, explain and illustrate theterms externality and public goods. [10]

    (b) Assess whether the measures stated above is the best way

    to curb pollution in China. [15]

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    (a) Using appropriate examples, explain and illustrate

    the terms externality and public goods. [10]

    INTRODUCTION

    Define market failure Failure of unregulated free market to achieve efficient

    allocation of resources and/or othersocial goals Two examples of sources of market failure:

    externalities and public goods

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    DEVELOPMENT

    Externalities Definition: third-party effects arising from production

    or consumption of a good or service, for which thethird-party neither pays nor receives anycompensation

    There can be negativeor positiveexternalities

    (a) Using appropriate examples, explain and illustrate

    the terms externality and public goods. [10]

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    (a) Using appropriate examples, explain and illustrate

    the terms externality and public goods. [10]

    DEVELOPMENT

    Negative externalities An example of negative externalities is ___.

    In the pursuit of self-interest, producers of ___ will onlyconsider their own private costs,

    ignoring external cost imposed on society, such as ___.

    As shown in the diagram, this creates a divergencebetween MSC and MPC of the distance of the MEC

    You may want to assume

    constant or increasing MEC

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    (a) Using appropriate examples, explain and illustrate

    the terms externality and public goods. [10]

    DEVELOPMENT

    Negative externalities Assuming that that MSB = MPB,

    the free market results in an overproductionof ___, above the socially optimal level of output(___) whereMSB = MSC.

    The resulting deadweight lossof area ___ indicates an

    inefficient allocation of resourcesin the free market.

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    6

    A

    E

    E1

    Quantity

    Price

    0

    MPB = MSB

    MPC

    QR

    Socially ideal

    output = 0R

    Actual output = 0Q

    Overproduction

    Welfare Loss

    to Society

    (DWL)

    MSC = MPC + MEC

    MEC

    What you need to know

    Deadweight loss

    is the decrease in

    total society

    surplus that

    results from an

    inefficient level of

    production

    Introduction to Negative Externalities

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    7

    A

    E

    E1

    Quantity

    Price

    0

    MPB = MSB

    MPC

    QR

    Welfare Loss

    to Society

    (DWL)

    MSC = MPC + MEC

    MEC

    How to draw the diagram

    Introduction to Negative Externalities

    1. Draw MPC and

    MPB diagram

    2. Indicate Qty(free market)

    3. Draw MSC

    4. Indicate MEC

    5. Indicate Qty

    (socially optm)

    6. Highlight DWL

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    8

    Practice time: Activity -Smoking

    Introduction to Negative Externalities

    1. Identify good / service as one with negative externalities

    The consumption of cigarettes; smoking creates negativeexternalities which are costs spilled over to 3rdparties not

    involved in the consumption of the good.

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    Practice time: Activity -Smoking

    Introduction to Negative Externalities

    2. Identify MEC such that MSC > MPC

    In such an activity, there incurs external cost on 3rdparties and

    this external cost is not taken into account by private consumers

    of cigarettes. This causes the marginal social cost of smoking to

    be greater than the marginal private cost due to the marginal

    external cost burdened on 3rdparties.

    This marginal external cost comes in the form of 2ndhandsmoke which non-smokers inhale, possibly leading to health

    problems such as lung cancer.

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    Practice time: Activity -Smoking

    Introduction to Negative Externalities

    3. Explain that when left to a free market, production

    (consumption) will be at MPB=MPC

    When left to the free market, a smoker will choose to consume

    cigarettes to the point where his marginal private benefit is

    equal to his marginal private cost.

    In this case, his satisfaction and happiness will determine his

    marginal private benefit and the cost of the cigarettes as well asthe health damage to himself makes up his marginal private

    cost.

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    Practice time: Activity -Smoking

    Introduction to Negative Externalities

    4. Explain that societys welfare will instead be at MSB=MSC

    However, societys welfare is not maximised in this case as thesocially optimum level of consumption should be where

    marginal social benefit to society is equal to the marginal social

    cost. Because the external cost to 3rdparties are not considered

    in a smokers consumption of cigarettes, marginal social cost is

    thus greater than marginal private cost.

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    Practice time: Activity -Smoking

    Introduction to Negative Externalities

    5. Identify over production of good

    Thus, an over-consumption of cigarettes occur, whereby qtywhen left to the free market is higher than where it is allocatively

    efficient for society.

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    Practice time: Activity -Smoking

    Introduction to Negative Externalities

    6. Explain dead weight loss is observed and thus society is not at

    allocative efficient point.

    This overconsumption of cigarettes that causes society to be

    allocatively inefficient thus result in a dead weight loss to

    society, thus explaining market failure in smoking.

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    (a) Using appropriate examples, explain and illustrate

    the terms externality and public goods. [10]

    DEVELOPMENT

    Positive externalities Example (e.g., vaccination)

    Self-interest External benefit

    Diagram

    Divergence between MSB and MPB

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    (a) Using appropriate examples, explain and illustrate

    the terms externality and public goods. [10]

    DEVELOPMENT

    Positive externalities Assuming MSC = MPC

    Underconsumption Socially optimal level of output where MSB = MSC

    Deadweight loss

    Inefficient allocation of resources

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    (a) Using appropriate examples, explain and illustrate

    the terms externality and public goods. [10]

    DEVELOPMENT

    Public Goods 2 key features: non-rivalry and non-excludability

    Non-rivalry: consumption of a good or service by one person

    does not reduce amount available to others Non-excludability: not possible or very costly to exclude a

    non-payer from consuming the good or service

    An example is ___.

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    (a) Using appropriate examples, explain and illustrate

    the terms externality and public goods. [10]

    DEVELOPMENT

    Public Goods It is non-rivalrous because ___. Once produced, the marginal

    cost of providing___to the additional user is zero,

    meaning that the price has to be zero for allocative efficiency. It is non-excludable because ___. This leads to the free riderproblem, where no one has the incentive to pay for ___.

    Typically, a public good will not be provided by the freemarket, even though people want to consume it.

    This represents an inefficient allocation of resources.

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    (a) Using appropriate examples, explain and illustrate

    the terms externality and public goods. [10]

    CONCLUSION(an example)

    As a result of sources of market failure such asexternalities and public goods, the unregulated

    free market will be unable to achieve an efficientallocation of resources. Hence, governmentintervention may be required to correct themarket failure, and this will be discussed in (b).

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    (b) Assess whether the measures stated above is the

    best way to curb pollution in China. [15]

    INTRODUCTION

    Clarify that pollution is a form of externality

    Clarify measures Stopping vehicles in Beijing

    Shutting down chemical plants, etc

    Clarify objective specified in question Curbing pollution in China

    Criteria for best Effectiveness

    Desirability

    FeasibilityNote:best, most effective, only

    must consider alternatives!

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    (b) Assess whether the measures stated above is the

    best way to curb pollution in China. [15]

    DEVELOPMENT

    Briefly explain the stated measures Stopping vehicles in Beijing

    A form of quotalimit m