HL Economics

Chapter 6: Market Failure

1 (a) Using an appropriate diagram, explain how negative externalities are a type of market failure.

(From Presentation)

Market failure is any situation where the allocation of resources by a free market is not efficient. (p.123) The markets are also likely to fail to provide goods that are beneficial to society or to stop production and consumption of harmful goods. Negative externalities have an impact on the third parties who had no part in the transactions, but not for the consumers or producers. Examples include second hand smoking from the consumption of tobacco or pollution caused from production of goods. There is a negative consumption and production externality in which in this case the consumption is of tobacco causes second-hand smoking effects and the production causes pollution.

(b) Evaluate the measures that a government might adopt to correct market failure arising from negative externalities.

The measures that a government might adopt to correct market failure arising from negative externalities which include legislation, regulation, taxation and advertisement. Taxation is placed on the products which produce negative effects on the third party as it would increase the price of the product and decrease demand. The decrease in the demand by consumers of, for example cigarettes, will most likely have a decline in the consumption. Yet, there are anomalies of people who still consume these products even due to the taxation. Placing taxes or by increasing the tax, may continue to maintain the revenue of the cigarette as there is always a group of people who are addictive to these inelastic goods. Also, the rich will be willing and able to buy the high priced products, which would maintain the income of producers, yet could decrease the consumption.  By correcting these market failure arising from the negative externalities, it would enable the government to increase their health of the country as well as the environment. With a improvement in both the health and environment of the country, governments could be beneficial economically as they could gain wealth as health care will decrease.

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