Externalities and Market failure

Market failure occurs when the free market forces of demand and supply, fail to produce the quantities of goods/services that people want at prices which reflect their marginal utilities (price they are prepared to pay for that additional satisfaction) Market failure leads to the failure of market forces to achieve an efficient allocation of resources. Efficiency occurs when the quantity in the market is optimal in the sense that the amount of community surplus (= consumer surplus + producer surplus) is maximised, i.e. no deadweight loss exists.

Externality: A benefit or cost that affects someone (a third party) who is not directly involved in the production or consumption of a good or service. The Jargon of Externalities o Private cost (PC) The cost borne by the producer of a good or service. o Social cost (SC=PC+EC) The total cost of producing a good, including both the private cost and any external cost (EC). o Private benefit (PB) The benefit received by the consumer of a good or service. o Social benefit (SB=PB+EB) The total benefit from consuming a good, including both the private benefit and any external benefit (EB).

Negative Externalities/ External costs The costs of an economic decision to a third party (someone other than the producer or consumer) Decision makers do not take into account the cost imposed on society and others as a result of their decision, e.g. pollution, traffic congestion, environmental degradation, depletion of the ozone layer, misuse of alcohol, tobacco, anti-social behaviour, drug abuse and gun crime Positive Externalities/External benefits The benefits of production or consumption of a good/service that is good for third parties. e.g. education and training, public transport, health education and preventative medicine, refuse collection, mosquito nets, public libraries & law and order

Negative externalities of production- pollution MSC>MPC

When a chemical company dumps waste into a river or pollutes the air, the community bears costs additional to those of the firm. Diagrammatically the MSC is above the MPC. The firm will maximize profits at output Q1 where the MPC equals the MPB/Demand. However, the socially optimum output level is at Q2 where MSC = MPB/Demand. At this output the higher price P2 reflects the additional external costs associated with production. Thus external costs lead to overproduction from societys point of view.

MSC S = MPC

Price $
P2 P1 Q2 Q1

D= MPB

Quantity

Q1 profit maximization level Q2 socially optimum output (not zero because society needs chemicals)

Negative externalities of consumption- DEMERIT GOODS MPB>MSB

When people smoke cigarettes other people suffer from second hand smoke. These negative externalities make the MSB of smoking less than the MPB to the smoker. Free market equilibrium (where MPB= MPC/Supply) will be at a higher output (Q1) than the socially optimum level (Q2)- where MSB = MPC/Supply. The lower price (P2) reflects the lower value of benefit society places on the consumption of cigarettes. The good in this instance is over-consumed.

MSB

MPB

Positive externalities of consumption- MERIT GOODS MSB>MPB

When students gain a college education there are greater benefits to society (MSB) than just to the individual. The consumer will benefit as they will have received a higher education which could make them more attractive in the labour market. Society will benefit from a more educated member of the public who is likely to make good decisions and benefit others. Free market equilibrium will be at a lower output (Q1) where MPB = MPC/Supply than the socially optimum level (Q2). In addition, society would be willing to pay a higher price (P2) to receive all the benefits from a college education. INSERT DIAGRAM HERE

Price $
P1 P2

Q2

Q1

Quantity

Positive externalities of production- e.g. forestry plantation (MPC>MSC)

When a forestry project plants new trees, society benefits from the trees as locals have a greater and cheaper source of firewood and less soil is lost to erosion benefiting others. The MSC of the forestry project is therefore lower than the MPC. The firm will maximize profits at output Q1 where the MPC equals MPB/Demand. However, the socially optimum output level is at Q2 where MSC = MPB. At this output the lower price P2 reflects the reduced costs of firewood and other benefits. Thus external benefits lead to underproduction from societys point of view. INSERT DIAGRAM HERE