Fundamental concepts of economics -2

Governments Can Sometimes Improve Market Outcomes. Market failure occurs when the market fails to allocate resources efficiently. When the market fails (breaks down) government can intervene to promote efficiency and equity.

Market failure may be caused by an externality, which is the impact of one person or firm’s actions on the well-being of a bystander. market power, which is the ability of a single person or firm to unduly influence market prices. An externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander. Externalities cause markets to be inefficient, and thus fail to maximize total surplus.

When the impact on the bystander is adverse, the externality is called a negative externality. When the impact on the bystander is beneficial, the externality is called a positive externality.

Negative Externalities Air pollution from road and traffic congestion Smokers ignore the harmful impact of toxic passive smoking on non-smokers External costs of scraping the seabed Barking dogs (loud pets) Loud stereos in an apartment building

Positive Externalities Immunizations Restored historic buildings Research into new technologies

Pollution and the Social Optimum Price of This graph shows the effect of a negative externality. The red line represents society's supply curve/marginal cost curve while the black line represents the marginal cost curve that the firm or industry with the negative externality faces. The optimal production quantity is Q', but the negative externality results in production of Q*. The deadweight welfare loss is shown in gray. Social cost Aluminum Cost of pollution Demand (private value) Supply (private cost) Optimum QOPTIMUM Equilibrium QMARKET Quantity of Aluminum

Negative Externalities The intersection of the demand curve and the social-cost curve determines the optimal output level. The socially optimal output level is less than the market equilibrium quantity. Internalizing an externality involves altering incentives so that people take account of the external effects of their actions.

Positive Externalities A technology spillover is a type of positive externality that exists when a firm’s innovation or design not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole.

Education and the Social Optimum Price of Education Supply (private cost) Demand (private value) QOPTIMUM QMARKET Social value Quantity of Education

The Standard of Living Depends on a Country’s Production. Almost all variations in living standards are explained by differences in countries’ productivities. Productivity is the amount of goods and services produced from each hour of a worker’s time.

The Standard of Living Depends on a Country’s Production. Standard of living may be measured in different ways: By comparing personal incomes. By comparing the total market value of a nation’s production.