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Explain, with relevant examples, the economic circumstances when prices do not accurately or correctly reflect actual benefits and costs, and explain how free markets fail as a result. [10]


The general theme of this economics essay is on market failure. The circumstances when prices do not correctly reflect costs and benefits include the presence of externalities, both positive and negative, merit and demerit goods, as well as imperfect pricing information. Therefore, this essay aims to explain how the above mentioned circumstances will lead to market failure.
What are externalities? Externalities refer to the spillover effects on third parties arising from the production or consumption of a good. They can then be sub-divided into positive externalities, referring to benefits imposed on third parties, and negative externalities, referring to adverse effects imposed on third parties.
Prices are usually set at the intersection point of the market demand and supply curves. However, in the case of positive externalities, prices do not reflect the actual costs and benefits since the market demand and supply curves fail to take into account the marginal external benefits brought about by the consumption and production of the good.

[Insert diagrams on positive externalities from consumption and production]
Marginal external benefits (MEB) is defined as the additional benefit enjoyed by third parties from the production or consumption of a good. For positive externalities in consumption, assuming no externalities on the production side, positive externalities results in MSB exceeding MPB by the amount equal to MEB. Without government intervention, the private equilibrium is at Qp, where MPB = MPC. However, the socially optimum equilibrium is at Qs where MSB = MSC. Since Qp < Qs, the good is under-consumed, resulting in allocative inefficiency and hence the market fails. An example would be the consumption of vaccination, where the risk of disease is reduced for both the vaccinated person and third parties he comes into contact with.

Similarly, for positive externalities in production, assuming no externalities on the consumption side, there is a divergence between MPC and MSC due to MEB. The private equilibrium is at Qp where MPC = MPB, while the socially optimal equilibrium is at Qs, where MSC = MSB. Since Qp < Qs, the good is under-produced, resulting in allocative inefficiency and hence market failure. An example would be the production of honey which bees would pollinate the nearby fruit orchards.
In the case of negative externalities, prices do not reflect the actual costs and benefits as the market demand and supply curves do not take into account the marginal external costs bought by the consumption or production of the good.

[Insert diagrams on negative externalities from consumption and production]
Marginal external costs (MEC) id defined as the additional costs imposed on third parties from the production or consumption of a good. For negative externalities from consumption, assuming no externalities on the production side, there exist a divergence between MSB and MPB due to MEC. This results in the over-consumption of the good as seen from how the private outcome Qp exceeds the socially optimal outcome of Qs. The outcome is allocative inefficient and thus the market fails. An example would be smoking, where third parties incur costs such as the inhalation and breathing in of second hand smoke.

For negative externalities from production, assuming no externalities from consumption, there exist a divergence between MPC and MSC due to MEC. This results in the over-production of the good, seen from how Qp exceeds Qs, resulting in allocative inefficiency and hence the failure of the market. An example would be the disposal of industrial waste into rivers, causing water pollution which poisons the catches of fishermen whom are third parties.
Next, prices also do not reflect the actual costs and benefits in the case of merit and demerit goods. Merit goods refer to goods in which the state believes will be under-consumed if left to the free market because some individuals are unable to factor in the full private benefits of consumption. 

[Insert diagram on merit good]
For merit good, between Qp and Qs, MSB > MSC, thus the triangle pointing towards Qs represents the area of deadweight loss arising from allocative inefficiency, since the good is under-consumed. Hence the price will not be accurate in reflecting the benefits instead it is at MPB. An example would be the consumption of education where a person may leave school early because he is too young to understand education can improve his future. 
On the other hand, demerit goods are goods which the government believes will be over-consumed if left to the free market because some individuals are unable to factor in the full private costs of consumption.

[Insert diagram on demerit good]
For demerit good, between Qs and Qp, MSC > MSB and Qp > Qs, thus the triangle pointing towards Qs represents the area of deadweight loss arising from the over-consumption of the good, resulting in allocative inefficiency and thus market failure. Hence the price of the good will not be accurate in reflecting the costs since the demand of the good is at MPB, while it should have been at MSB. Examples of demerit goods include alcohol, where excessive consumption results in serious health and financial problems.
Lastly, where there is information asymmetry with regards to pricing, prices will not reflect the actual costs of production as sellers will be able to charge prices that are higher than marginal costs. This is due to the fact that buyers find difficulty acquiring pricing information from different sellers, thus gives seller pricing power and enable them to charge prices that are higher than marginal costs. Therefore, deadweight loss is generated and market failure occurs.
In conclusion, there are various instances where prices do not reflect the actual costs and benefits and in most of the cases, the resulting market failure arises due to the presence of allocative inefficiency.

JC Economics Essays - H1, H2, H3 economics essays - tutor's comments: This economics essay paper is very well done, by directly addressing the question requirements, and providing clear, simple to understand, direct examples that target the requirements of the economics exam question. Always remember to answer your economics exam question as it stands, and not as you imagine it to be. The student also has a very sound understanding of economic theory, and knows how to properly structure the memorised economics material and essay answer to make this paper a model essay. This model paper was done under timed conditions, which makes it even more remarkable. Thanks to S for editing work done, and thanks to A G and S H for their kind and invaluable contributions. Usual question applies - how can you apply this to your essay writing, and how could you write a better economics paper? Always seek to improve and better your standards. 

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