ECONOMICS: market failure

hallo!

could someone explain to me what +ve and -ve externalities are? and how they along with public, merit and demerit goods contribute to market failure? or basically all of 3.1.4 and beyond on the AQA specification? struggling so much! d:

thank chuuu :3

Reply 1

L'Etudiant

1. Negative Externalities
2. Positive Externalities

Reply 2

Exceptional

Market failure occurs when the market fails to provide a particular service/good in the economy because the benefits aren't recognised by a free market economy. For instance, a merit good might be under-supplied in a market due to inadequate information - i.e. its benefits aren't recognised by the market mechanism (something coined by classical economist Adam Smith).

At the start of a micro essay on market failure/government intervention, you should identify where the market failure is coming from. Accordingly, you draw one of two diagrams (there are 4 but you don't need to worry about the other 2):

If you can identify a positive externality (where MSB > MPB), draw the diagram below at the start of an essay after defining key terms. Say that the benefits to society aren't taken into account in a free market, so the government might need to intervene to correct the market failure and address the positive externality. The positive externality is essentially a free rider problem - like someone not involved in the transaction who benefits without paying. Then, introduce policies (2/3) that the government could use to correct the market failure (e.g. subsidy) and evaluate them.

If in the context you identify a negative externality (something bad on a third party not involved in the transaction, such as pollution), use the diagram below instead (MSC > MPC). Then, do the same thing - government policies to correct this followed by evaluation (e.g. a max price on demerit goods).

Think of positive externalities as good things and negative externalities as bad things. This means associating merit/public goods (which are good) with positive externalities, and demerit goods, which are generally bad for society, in terms of negative externalities. Government is going to want to subsidise merit goods so more people can access them, whereas they're going to want to tax or put a max price on demerit goods so less people use them.

In the diagrams above, there's a welfare loss (pos. externality) in the first diagram because markets aren't operating at Q1, where it's socially efficient to do so. There's a welfare loss (external cost) (neg. externality) in diagram 2 because by providing the bad demerit goods, society is losing welfare (e.g. alcohol causing yobs to smash in your windows or something).