2.8 Market failure and externalities

DEFINITION:

1. Market Failure: Market failure occurs when the allocation of goods and services by a free market is not efficient, leading to a net social welfare loss.
2. Marginal Social Cost (MSC): Marginal social cost is the total cost to society of producing an additional unit of a good or service, including both private and external costs.
3. Marginal External Cost (MEC): Marginal external cost is the additional cost imposed on third parties or society as a whole when an additional unit of a good or service is produced or consumed.
4. Marginal Private Cost (MPC): Marginal private cost is the additional cost incurred by a producer or consumer in producing or consuming one more unit of a good or service, not accounting for any external costs.
5. Marginal Social Benefit (MSB): Marginal social benefit is the total benefit to society from consuming an additional unit of a good or service, including both private and external benefits.
6. Marginal External Benefit (MEB): Marginal external benefit is the additional benefit received by third parties or society as a whole when an additional unit of a good or service is produced or consumed.
7. Marginal Private Benefit (MPB): Marginal private benefit is the additional benefit received by the consumer from consuming one more unit of a good or service, excluding any external benefits.
8. Externalities: Externalities are the positive or negative side effects on third parties or society that occur when a good or service is produced or consumed, which are not reflected in market prices.

Explain:

2.8.1 Market failure

Market failure occurs when the allocation of goods and services by a free market is not efficient. This typically happens when the market fails to produce an optimal level of goods and services or when the social costs or benefits of production and consumption are not fully reflected in market prices. Common causes of market failure include:

9. Externalities: When the actions of individuals or firms have side effects (positive or negative) on third parties that are not reflected in the market prices. For example, pollution from a factory (negative externality) or education benefits (positive externality).
10. Public Goods: Goods that are non-excludable (cannot prevent people from using them) and non-rivalrous (one person's use does not reduce availability for others), such as national defence. Markets may underprovide these goods because they cannot charge everyone who benefits from them.
11. Market Power: When a single firm or a group of firms has the ability to influence prices and output levels, leading to inefficiencies. For example, monopolies can reduce output and increase prices compared to competitive markets.
12. Information Asymmetry: When one party in a transaction has more or better information than the other, leading to market inefficiencies. For instance, in the market for used cars, sellers may know more about the car's condition than buyers, which can lead to adverse selection.
13. Merit and Demerit Goods: Goods that are undervalued or overvalued by consumers. Merit goods, like education and healthcare, are often underconsumed, while demerit goods, like cigarettes, may be overconsumed. Market failure often justifies government intervention to correct inefficiencies and achieve a more socially optimal allocation of resources.

2.8.2 Marginal social cost, marginal external cost, marginal private cost, marginal social benefit, marginal external benefit and marginal private benefit

1. Marginal Social Cost (MSC):

• Definition: The additional cost to society of producing one more unit of a good or service.
• Explanation: MSC includes both the marginal private cost (MPC) incurred by the producer and any additional external costs (negative externalities) imposed on third parties.

2. Marginal External Cost (MEC):

• Definition: The additional cost imposed on third parties or society from the production or consumption of one more unit of a good or service.
• Explanation: MEC is the external cost that is not reflected in the market price but affects those not directly involved in the transaction, such as pollution from a factory.

3. Marginal Private Cost (MPC):

• Definition: The additional cost to the producer from producing one more unit of a good or service.
• Explanation: MPC includes costs such as raw materials, labour, and other expenses directly incurred by the producer, excluding any external costs.

4. Marginal Social Benefit (MSB):

• Definition: The additional benefit to society from consuming one more unit of a good or service.
• Explanation: MSB includes both the marginal private benefit (MPB) received by the consumer and any additional external benefits (positive externalities) enjoyed by others.

5. Marginal External Benefit (MEB):

• Definition: The additional benefit to third parties or society from the consumption or production of one more unit of a good or service.
• Explanation: MEB reflects the positive externalities that are not captured by the market price but benefit others, such as increased community health from a public vaccination program.

6. Marginal Private Benefit (MPB):

• Definition: The additional benefit to the individual consumer from consuming one more unit of a good or service.
• Explanation: MPB is the direct benefit experienced by the consumer, such as enjoyment or satisfaction, and does not account for any external benefits or costs. These concepts are crucial for understanding market outcomes and evaluating the impact of externalities on economic efficiency.

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Explain, with the aid of a diagram

2.8.3 Positive and Negative Externalities in Consumption and Production

Externalities refer to the side effects or consequences of economic activities that affect third parties who are not directly involved in the transaction. These can be either positive or negative.

Positive Externalities

Positive externalities occur when a third party benefits from an economic activity. These can arise in both consumption and production.

Consumption Positive Externality: When individuals consume a good, and it benefits others.

Example: Education. When a person receives an education, society benefits from having a more educated workforce, which can lead to higher productivity and innovation.

Production Positive Externality: When production benefits others.

Example: A beekeeper's bees pollinate nearby crops, enhancing agricultural yields for neighbouring farmers.

Diagram for Positive Externality (Consumption):

• MPB: Marginal Private Benefit (benefit to consumers)
• MSB: Marginal Social Benefit (benefit to society)
• Q1: Private equilibrium quantity
• Q: Socially optimal quantity (where MSB = MSC)

Negative Externalities

Negative externalities occur when a third party suffers from an economic activity. These can also arise in both consumption and production.

Consumption Negative Externality: When individuals consume a good, and it imposes costs on others.

• Example: Smoking. When people smoke, non-smokers are exposed to second-hand smoke, which can lead to health problems. Production Negative Externality: When production imposes costs on others.

• Example: Factory pollution. A factory emitting pollutants into the air or water imposes health and environmental costs on the surrounding community. Diagram for Negative Externality (Production):

• MPC: Marginal Private Cost (cost to producers)
• MSC: Marginal Social Cost (cost to society)
• Q1: Private equilibrium quantity
• Q: Socially optimal quantity (where MSB = MSC)

Explanation:

• Positive Externalities: The social benefit (MSB) exceeds the private benefit (MPB). The market under-allocates resources to the production or consumption of goods with positive externalities, resulting in a lower quantity (Q1) than is socially optimal (Q*).
• Negative Externalities: The social cost (MSC) exceeds the private cost (MPC). The market over-allocates resources to the production or consumption of goods with negative externalities, resulting in a higher quantity (Q1) than is socially optimal (Q*).

Government Intervention:

To correct these market failures, governments can intervene:

• Positive Externalities: Subsidies, public provision, or tax incentives can encourage more consumption or production of goods with positive externalities.
• Negative Externalities: Taxes, regulations, or pollution permits can discourage the consumption or production of goods with negative externalities.