Question

1. Discuss, with EXAMPLES, why markets might fail to allocate resources efficeintly.

2. Externalities are a major cause of market failure. Using a supply and demand diagram, with an EXAMPLE, illustrate an analysis of positive externality in consumption. Explain how governments could internalise the effects of a positive externality.

Answer 1

A market will be unable to allocate resources efficiently if there is some externality present. This is because in a positive externality, the decision is made on the basis of marginal private benefit and marginal cost and marginal social benefit is not taken into acount. This means that a market underproduces a good which has a positive externality. For example, education. It has a marginal social benefit (MSB) more than the marginal private benefit (MPB) but equilibrium quantity of education will be based on the marginal cost (MC) of attaining education and marginal personal benefit of attaining education. This brings the equilibrium quantity to Q which is less than the social optimum level Q'. To improve this outcome, the government might give education a subsidy, which will lead to decrease in marginal cost leading to shift in marginal cost from MC to MC'. Which increases the quantity to socially optimal level Q'

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