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Allocative efficiency: Situation where resources are allocated to produce the

combinations of goods and services yield maximum satisfaction for society

Parties involved seek to maximise their net private benefitrs
If MPB> MPC for additional unit of good,
The price that consumers are willing to pay for that unit is more than the costs of
producing that unit of good
Producing that unit thus results in net gain (as total private benefits is more than
the total private costs ) That additional unit of good produced to maximise

If MPB<MPC for additional unit of good,

The prices consumers are willing to pay for the good is less than the costs of
producing that additional unit of the good
Producing that unit of good results in net loss (Total private benefit less than total
private costs)
Hence that unit will not be produced to maximise welfare

Social equilibrium is the socially desirable state for the market, achieved when
whole societys welfare is maximised (Take into account external costs and
benefits incurred (MEC and MEB)
Social equilibrium and market equilibrium only coincide under FREE MARKETS
ZERO EXTERNAL COSTS OR BENEFITS , allocatively efficient outcome
Externality occurs when activity of a person or firm directly affects the welfare of
another, without transmission in market prices
Negative externality: Occurs when third parties who are not consuming or
producing the good are affected adversely

Negative externality from production

1) Assuming there are no external benefits, Negative externalities cause a

divergence between the MSC and MPC (MSC>MPC) resulting in a gap
2) If the output is determined by market prices, profit maximising private
producers will only consider their private benefits and costs . The market
will produce or consume where MPB=MPC and the market equilibrium is at
output Q0
Society take into account all costs and benefits, hence social equilibrium
will be where MSB=MSC, at output Q*
Hence, market equilibrium output will be greater than the social
equilibrium output of Q*
3) Overproduction of output Q*Q occurs. This additional output Q*Q was
produced as producers who only look to maximise their own private
benefit, will only consider their marginal private costs and their marginal
private benefits
4) Deadweight loss of area D occurs is incurred as the total social costs s
greater than the total social benefits. Due to the lack of consideration of
MEC, there will be overproduction of Q*Q units
5) Due to this deadweight loss of area D< output Q is socially inefficient. The
market has failed to allocate resources efficiently.

Demerit Good (Ignorance/Irrationality Explanation)

Those who consume the demerit goods do not understand or recognise the true
consequences of their actions. Due to ignorance, lack of complete info,
irrationality, a wrong demand is generated, which is reflected in the perceived
marginal value, which is too high and these good are consumed in excessive
Ignorance is due to a lack of information. For instance, an uneducated person are
not really aware of the long term health consequences of smoking and did not
take this risk to health into consideration in his decision making. Consumption of
demerit goods due to irrationality is when consumers are aware of the
consequences of consuming, but still chooses to consume anyway

Command Approach:
Legal Regulation: Directly influence firms or consumers behaviour, compel firms
and consumers to moderate their actions
Banning: Only used when it is very difficult to use oter policies to limit
externalities or when damage caused is very severe (Can be on consumption or

Banning is socially optimal if MEC is so high that socially optimum level of output
is actually zero
Compare net social benefit via diagram when comparing socially optimu level of
pollution vs zero pollution

Legal Regulations (Evaluation)


1) Easy to understand and implement

2) Certainty of outcome on inefficiency Controlled by the govt and not

left to market
Demerits: 1) High monitoring costs required
2) Lack of incentives to do better, once firms reach the pollution emission
standards, unlikely to reduce the externalities any further
3) Too blunt of a policy Does not take into account any of the special
conditions (Force firms to use relatively more costly ways to remove their wastes
or they may even cease production

Firms will only produce up to the level of Q, since profit maximising firms only
look at their own private benefit and cost. Demand is deemed as too low as it
does not reflect the true vale to society. MSB reflects the true value, but does not
show up as demand
Social efficiency can be attained by giving a unit subsidy
When unit subsidy equal to MEB at Q* is given, MPC drops to MPC as private
party internalises the external benefit to society
Govt aims to mimic what would happen to output when all people who benefitted
from the good would pay what it is worth to them

1) Market mechanism can continue to operate, internalising the external benefit
2) Subsidy is adjustable according to magnitude of externalities
3) Incentivises firms to adopt good practices


1) Hard to determine value of divergence between MSB and MPB. Overcorrection

or undercorrection could happen, which may worsen the problem of market
2) Subsidies also increases the producers profits, maybe wrongly targeted at
producers, INEQUITY occurs
1. Improvement over state provisions
2. Increased productive efficiency as firms will compete for the vouchers by
offering better services and lowering their costs Only deserving firms will get,
hence more targeted approach

Direct Provisions Directly supplied by the govt. free of charge. Non profit state
run hospitals can prevent asymmetric information from happening
1) Without profit motive, lack the incentive to minimise costs Productively
2) Mismanagement of resources and poor quality of services could be provided
Underpaid and overworked labour since without market pricing to guide Lead
to chronic shortages and poor quality
3) Overconsumption of goods could occur since its free, worsening allocative
inefficiency Greater social inefficiency