Market Failure and Externalities
ALLOCATIVE EFFICIENCY (MB = MC)
- Free market fails to reach this equilibrium
Overproduction & overconsumption of demerit goods
Underproduction & underconsumption of merit goods
Market failure = failure of the market to allocate resources efficiently/reach allocative efficiency
- Reduce/eliminate negative externalities
- Increase/maximise positive externalities
- Increases supply of merit goods
- Reduce the supply of demerit goods
- Supply public goods that would otherwise be under-supplied by the market
Externality (side effects)
- Created by buyers and sellers
- When consumer actions give rise to negative or positive side-effects on other people that are
not direct parts of these actions, and whose interests are not considered
- Other people = 3rd party
- Positive externality (external benefit) >> positive side effects
E.g. pharmaceutical companies research and create new treatments for profits >> people with
other uncured diseases won’t die
- Negative externality (external loss) >> negative side effects
E.g. smoking > second hand smoke, increased lung cancer risk
Socially Optimum Output
- Demand = MB curve, as benefits of consumption go to individuals = Marginal Private
Benefits (MPB)
- Supply = MC curve as costs are incurred by firms = Marginal Private Costs (MPC)
- When there are NO externalities, MPB = MPC to produce a socially desirable output Qopt
ALLOCATIVE EFFICIENCY
- If there are negative externalities, the full costs to society are higher than that to a firm, or
individual, creating the externalities
Marginal Social Costs (MSC) = MPC + Negative Externality, costs to society are higher >> gov
will take action (taxation, price floor) to eliminate the negative externality and achieve MPB =
MPC
- If there are positive externalities, the full benefits to society are higher than that of a
firm/individual who creates them
Marginal Social Benefits (MSB) = MPB + Positive Externality, benefits to society are higher >>
gov will take action (subsidies, price ceiling) to achieve MSB = MPB
ALLOCATIVE EFFICIENT EQUILIBRIUM:
- Markets reach equilibrium, MSC = MSB, there are no externalities and there is allocative
efficiency
- MSB = MPB = MSC = MPC >> MSC = MSB
- Externality creates a divergence between MSB and MPB, and between MSC and MPC
= refers to a gap between MSB and MPB
In this case: MPB = MPC but MSB ≠ MSC
, - MB = MC are markets with NO market failures and are unrealistic (hence the need to clarify)
4 Types of Externalities:
Negative Production Externality
E.g. Air pollution, Pollution from fertilisers, Industrial waste, Collapsing fish stocks, Methane
emissions
Negative Consumption Externality
E.g. Vehicle particulates, Household waste, Noise pollution, Traffic congestion, Litter
Positive Production Externality
E.g. Development and Research
Positive Consumption Externality
E.g. Health programmes, Education, Subsidised bike scheme, Community spaces, Free school
meals
ALLOCATIVE EFFICIENCY (MB = MC)
- Free market fails to reach this equilibrium
Overproduction & overconsumption of demerit goods
Underproduction & underconsumption of merit goods
Market failure = failure of the market to allocate resources efficiently/reach allocative efficiency
- Reduce/eliminate negative externalities
- Increase/maximise positive externalities
- Increases supply of merit goods
- Reduce the supply of demerit goods
- Supply public goods that would otherwise be under-supplied by the market
Externality (side effects)
- Created by buyers and sellers
- When consumer actions give rise to negative or positive side-effects on other people that are
not direct parts of these actions, and whose interests are not considered
- Other people = 3rd party
- Positive externality (external benefit) >> positive side effects
E.g. pharmaceutical companies research and create new treatments for profits >> people with
other uncured diseases won’t die
- Negative externality (external loss) >> negative side effects
E.g. smoking > second hand smoke, increased lung cancer risk
Socially Optimum Output
- Demand = MB curve, as benefits of consumption go to individuals = Marginal Private
Benefits (MPB)
- Supply = MC curve as costs are incurred by firms = Marginal Private Costs (MPC)
- When there are NO externalities, MPB = MPC to produce a socially desirable output Qopt
ALLOCATIVE EFFICIENCY
- If there are negative externalities, the full costs to society are higher than that to a firm, or
individual, creating the externalities
Marginal Social Costs (MSC) = MPC + Negative Externality, costs to society are higher >> gov
will take action (taxation, price floor) to eliminate the negative externality and achieve MPB =
MPC
- If there are positive externalities, the full benefits to society are higher than that of a
firm/individual who creates them
Marginal Social Benefits (MSB) = MPB + Positive Externality, benefits to society are higher >>
gov will take action (subsidies, price ceiling) to achieve MSB = MPB
ALLOCATIVE EFFICIENT EQUILIBRIUM:
- Markets reach equilibrium, MSC = MSB, there are no externalities and there is allocative
efficiency
- MSB = MPB = MSC = MPC >> MSC = MSB
- Externality creates a divergence between MSB and MPB, and between MSC and MPC
= refers to a gap between MSB and MPB
In this case: MPB = MPC but MSB ≠ MSC
, - MB = MC are markets with NO market failures and are unrealistic (hence the need to clarify)
4 Types of Externalities:
Negative Production Externality
E.g. Air pollution, Pollution from fertilisers, Industrial waste, Collapsing fish stocks, Methane
emissions
Negative Consumption Externality
E.g. Vehicle particulates, Household waste, Noise pollution, Traffic congestion, Litter
Positive Production Externality
E.g. Development and Research
Positive Consumption Externality
E.g. Health programmes, Education, Subsidised bike scheme, Community spaces, Free school
meals
