Transcript
10th Tutorial
Welfare and Market Failures
Solutions
True or False
1. Externalities are always bad. False. Negative externalities are bad for society, but positive externalities are not. See section 8.6 of Begg and Ward. True/False
2. A positive benefit externality occurs when the marginal social benefit is greater than the marginal private benefit. True. If the benefits to society are greater than to the individual, then a positive externality exists. See section 8.6 of Begg and Ward. True/False
3. Pareto efficiency will hold under monopoly. False. Under monopoly, products are not necessarily produced at lowest cost and they are not priced at marginal cost. So, Pareto efficiency will not hold. See Section 8.5. True/False
4. If there were not market failures, marginal social costs and marginal private costs would be equal. True. If markets were perfect MSC=MPC. See Section 8.6. True/False
5. Taxation is a mean to achieve Pareto efficiency. False. Taxation is a mean to deal with externality and not to achieve Pareto efficiency. See Section 8.7. True/False
Question 1
Describe the concept of Pareto efficiency.
An allocation is Pareto efficient if there is no other allocation in which some other individual is better off and no individual is worse off.
Explain why a monopoly is not Pareto efficient.
Under monopoly, products are not necessarily produced at lowest cost and they are not priced at marginal cost. So, Pareto efficiency will not hold. Also, think that when we move from perfect competition towards monopoly, then firms gain more but the consumers lose their consumer surplus.
Question 2
Explain how taxation and subsidies can be used to correct for the presence of externalities.
If the MPC is lower than the MSC, there will be over production of the good from society’s point of view. In order to encourage firms to produce less the government can impose a tax. If the tax is set correctly, the MPC will become equal to the MSC, and result in private individuals choosing the same level of output as society.
Subsidies will be used when governments fear that the private level of output will be less than the socially optimal level of output. If the PMB is lower than the SMB, government will give firms a subsidy to increase production.
Question 3
a) Provide examples of negative externalities.
(i) Smoking
(ii) Pollution
b) Provide examples of positive externalities.
(i) Vaccinations
(ii) Education
(iii) Research and development
c) For each example highlight how taxes, or subsidies are being, or could be, used to deal with the problem of externalities
Smoking – Tax on cigarettes
Pollution – Rising car tax with generation of pollution provides incentives for cleaner emissions.
Vaccinations - The deterioration of public health system leads to loss of positive externalities.
Education – Some provision of grants and cheap loans represents a subsidy.
Research and development – Generates positive externalities, e.g. anti-cancer drugs. Some provision of tax breaks for R&D, which equates to a subsidy
Question 5
The following diagram shows an industry which was previously perfectly
competitive but is now organised as a monopoly. Cost and revenue curves
are assumed identical in both situations.
a) What is the perfectly competitive price and output? MC=P=AR Q2 and P2..
b) What is the monopoly price and output? MC=MR Q1, Q1=AR P3.
c) What areas represent consumers' surplus in the perfectly competitive situation? ………1,2,3,4,5………………..
d) What areas represent consumers' surplus after the industry has become a monopoly? 1,2………………………..
e) What areas represent the loss in consumers' surplus after the industry has become a monopoly? ……3,4,5…………………..
f) What areas represent producers' surplus in the perfectly competitive situation? ………………6,7,8,9………..
g) What areas represent producer's surplus after the industry has become a monopoly? ………3,4,6,7,9………………..
h) What areas represent the gain in producer's surplus after the industry has become a monopoly? ……3,4…………………..
i) What areas represent total deadweight welfare loss under monopoly?
………………5,8………..
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