Market Failure - Negative Ext

Negative externalities are negative spillover effects on third parties who are neither consumers nor producers due to only production of goods and services.

• True

• False

Answer explanation

Consumption could also result in external cost and not production only.

Free market equilibrium is where MSB = MSC.

• True

• False

Answer explanation

Free market equilibrium is MPB=MPC in which producers and consumers only take their own costs and benefits into consideration. MSB=MSC is the condition for the socially efficient equilibrium which include costs and benefits to 3rd parties.

Due to the presence of external cost, MSC shifts up from MPC.

• True

• False

Answer explanation

MSC=MPC+MEC so MSC is ABOVE MPC and not shifts up from MPC as they are different.

Taxation in which tax = MEC at Qs will make the producers and consumers to internalise the external cost.

• True

• False

Answer explanation

When tax=MEC at Qs, MPC will increase and quantity will fall from Qm to Qs.

In a situation shown in the diagram, the government should not ban the production of the good as it will result in a net welfare loss if production is zero.

• True

• False

Answer explanation

Ban will result giving up area B which is the net social benefit from production of 0Qs and remove the external cost of area A due to over production of Qs-Qm. But since area B > area A, the society will be at a net welfare loss if ban is imposed. So government should not ban the product.

'Cap and Trade' system comprises elements of government command and control and price mechanism.

• True

• False

Answer explanation

'Cap' is the part that is command and control as the government estimates the amount of pollutants is allowed and issued a quota of permits. 'Trade' is where price mechanism kicks in as producers are free to buy and sell the permits they require.

Regulations to reduce external cost will result in a higher MPC.

• True

• False

Answer explanation

Having a lower MEC will shift MSC down since MSC'=MPC+MEC' where MEC'<MEC and not MPC up.

Economists generally advocate taxation to correct negative externality as it allows price mechanism to work and punishes the culprit while regulations are deemed as blunt instruments.

• True

• False

Answer explanation

Producers and consumers can continue to have the good as long as they are willing to pay and they bear the higher costs but a ban does not discriminate culprits and non-culprits and punishes everyone even those who do not contribute to the negative externality.