Market Failure: Externalities
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Market Failure: Externalities

Learn about externalities, a type of market failure that occurs when a transaction affects a third party. Understand the different types of externalities and their examples.

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Questions and Answers

What is the term for a beneficial effect on a third party who is not directly involved in a transaction?

Positive externality

Which of the following is a characteristic of a public good?

Non-rivalry and non-excludability

What is a consequence of market failure due to externalities?

Inefficient allocation of resources

Which of the following is an example of a public good?

<p>National defense</p> Signup and view all the answers

What is a consequence of market failure due to public goods?

<p>Underproduction or lack of provision</p> Signup and view all the answers

Why do public goods often suffer from underproduction or lack of provision?

<p>Because of the free-rider problem</p> Signup and view all the answers

Which of the following types of inflation is caused by an increase in production costs?

<p>Cost-Push Inflation</p> Signup and view all the answers

What is the primary objective of inflation targeting by central banks?

<p>To control inflation</p> Signup and view all the answers

What is the primary cause of hyperinflation?

<p>All of the above</p> Signup and view all the answers

What is a characteristic of deflation?

<p>A sustained decrease in the general price level</p> Signup and view all the answers

What is an effect of inflation on fixed-income earners?

<p>Redistributive effect from fixed-income earners to borrowers</p> Signup and view all the answers

What is a fiscal policy tool used to combat inflation?

<p>Taxation increase</p> Signup and view all the answers

What is an effect of hyperinflation?

<p>Currency devaluation</p> Signup and view all the answers

What is a characteristic of monetary policy in controlling inflation?

<p>Using monetary policy tools, such as interest rates and quantitative easing</p> Signup and view all the answers

Study Notes

Market Failure

Externalities

  • Definition: Externalities occur when a transaction between two parties affects a third party who is not directly involved in the transaction.
  • Types:
    • Positive externality: A beneficial effect on a third party, e.g., a beekeeper's bees pollinate nearby crops.
    • Negative externality: A harmful effect on a third party, e.g., pollution from a factory affecting neighboring residents.
  • Examples:
    • Environmental pollution (air, water, noise)
    • Second-hand smoke
    • Noise pollution from airports
  • Consequences:
    • Overproduction or underproduction of goods and services
    • Inefficient allocation of resources
    • Social welfare loss

Public Goods

  • Definition: Goods and services that are non-rivalrous (can be consumed by multiple people without reducing their quantity) and non-excludable (difficult or impossible to exclude people from consuming).
  • Characteristics:
    • Non-rivalry: Multiple people can consume without reducing the quantity.
    • Non-excludability: Difficult or impossible to exclude people from consuming.
  • Examples:
    • National defense
    • Public parks
    • Street lighting
  • Consequences:
    • Underproduction or lack of provision due to free-rider problem
    • Inefficient allocation of resources
    • Social welfare loss

Consequences of Market Failure

  • Inefficient allocation of resources
  • Social welfare loss
  • Overproduction or underproduction of goods and services
  • Inequitable distribution of goods and services
  • Reduced economic efficiency
  • Potential for government intervention to correct the market failure

Market Failure

Externalities

  • Externalities occur when a transaction affects a third party who is not directly involved in the transaction.
  • There are two types of externalities:
    • Positive externality: a beneficial effect on a third party, e.g., a beekeeper's bees pollinate nearby crops.
    • Negative externality: a harmful effect on a third party, e.g., pollution from a factory affecting neighboring residents.
  • Examples of externalities include:
    • Environmental pollution (air, water, noise)
    • Second-hand smoke
    • Noise pollution from airports
  • Consequences of externalities include:
    • Overproduction or underproduction of goods and services
    • Inefficient allocation of resources
    • Social welfare loss

Public Goods

  • Public goods are non-rivalrous and non-excludable.
  • Non-rivalry means multiple people can consume without reducing the quantity.
  • Non-excludability means it's difficult or impossible to exclude people from consuming.
  • Examples of public goods include:
    • National defense
    • Public parks
    • Street lighting
  • Consequences of public goods include:
    • Underproduction or lack of provision due to the free-rider problem
    • Inefficient allocation of resources
    • Social welfare loss

Consequences of Market Failure

  • Market failure leads to:
    • Inefficient allocation of resources
    • Social welfare loss
    • Overproduction or underproduction of goods and services
    • Inequitable distribution of goods and services
    • Reduced economic efficiency
  • Government intervention may be necessary to correct market failure.

Inflation

Causes of Inflation

  • Excessive aggregate demand leads to higher prices due to demand-pull inflation
  • Increase in production costs, such as higher wages or raw materials, leads to cost-push inflation
  • Excessive growth in money supply leads to inflation through monetary policy
  • Supply shocks, like natural disasters or global pandemics, disrupt supply chains and lead to higher prices

Effects of Inflation

  • Inflation redistributes wealth from fixed-income earners to borrowers
  • Inflation creates uncertainty, making it difficult for businesses to make long-term plans
  • Inflation exacerbates income inequality, benefiting those who own assets that increase in value

Monetary Policy and Inflation

  • Central banks use monetary policy tools to control inflation
  • Inflation targeting involves setting an inflation target and adjusting monetary policy to achieve it

Hyperinflation

  • Extreme inflation rates exceed 50% per month, rendering the currency nearly worthless
  • Causes of hyperinflation include excessive money printing, fiscal policy mistakes, and supply shocks
  • Hyperinflation leads to currency devaluation, economic collapse, and loss of savings

Deflation

  • Deflation is a sustained decrease in the general price level of goods and services over time
  • Causes of deflation include decreased aggregate demand, improvement in productivity, and increased productivity
  • Effects of deflation include increased debt burden, reduced spending and investment, and potential for deflationary spiral

Fiscal Policy and Inflation

  • Increased government spending can stimulate economic growth but may lead to inflation if excessive
  • Taxation can reduce aggregate demand, helping to combat inflation
  • Fiscal discipline helps maintain low and stable inflation through a sustainable fiscal stance

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