Market failure and externalities

What is market failure?

A situation in which the market allocation of resources is not economically efficient

Which statement best defines an externality?

A cost or benefit affecting a third party that is not reflected fully in the market price

For production that creates pollution, how do marginal social cost and marginal private cost usually compare?

Marginal social cost is greater than marginal private cost

What output level will an unregulated competitive market tend to produce when production creates a negative externality?

More than the socially efficient output

When consumption creates a positive externality, which relationship generally holds?

Marginal social benefit exceeds marginal private benefit

Why may a good such as education be underconsumed in a free market?

Consumers may ignore benefits received by other people

At the socially efficient output, which condition should hold?

Marginal social benefit equals marginal social cost

How is marginal social cost calculated when an activity creates an external cost?

Marginal private cost plus marginal external cost

How is marginal social benefit calculated when an activity creates an external benefit?

Marginal private benefit plus marginal external benefit

What is the main purpose of a Pigouvian tax on an activity that creates a negative externality?

To make decision-makers face the external cost they impose

For a Pigouvian tax to achieve the socially efficient output, its ideal rate per unit is equal to what?

Marginal external cost at the socially efficient output

A subsidy can help correct a positive externality by doing what?

Encouraging consumption or production toward the socially efficient level

How does a cap-and-trade system control pollution?

It sets a total emissions limit and allows permits to be traded

Why can tradable pollution permits reduce emissions at lower total cost than identical limits for every firm?

They allow firms with lower abatement costs to make more of the reductions

Under which conditions is private bargaining most likely to resolve an externality, according to the Coase theorem?

When property rights are clear and transaction costs are low

What makes property rights relevant to externalities?

They clarify who may use a resource and who can negotiate over its use

For units produced beyond the socially efficient quantity when there is a negative production externality, which statement is correct?

Marginal social cost exceeds marginal social benefit

What is a major practical difficulty in using taxes or subsidies to correct externalities precisely?

Estimating the marginal external costs or benefits