Types of market failure

The meaning of externalities

Externality: is an unintended side effect that result from production or consumption of a good, affecting the third parties.

  • When this is externality, the market does not achieve a social optimum where MSB=MSC
  • Negative externalities → also called spill-over costs or social costs
  • Positive externalities → also called spill-over benefits or social benefits
Figure 4.1 - Social equilibrium
 

Social equilibrium: occurs at Ps, Qs

Internalizing an externality: is a government action to achieve socially desirable equilibrium for the economy.

Negative externalities of production and consumption

Negative externalities of production: is a harmful side effect to the society due to the production by a firm.

i.e. Factory releasing poisoning materials that are harmful to the area; Power house burning fossil fuels, releasing greenhouse gases that would cause global warming.

Figure 4.2 - A negative externality of production
  • There is a misallocation of resources: too much is being produced at a too low price than is socially desirable.
  • There is a welfare lost to society of the extra units from Qp to Qs because MSC is greater than MSB (shaded area)

Negative externalities of consumption: is a harmful side effect to the society due to the consumption by an individual.

i.e. Smokers giving passive smoking to other people, causing them to get illnesses.

Figure 4.3 - A negative externality of consumption

  • This is a misallocation of resources: too much is being consumed at a too high price than is socially desirable.
  • There is welfare lost to society of the extra units from Qp to Qs because MSC is greater than MSB (shaded area)

Demerit goods: are goods that the government thinks are bad both for the consumer and the society. They are over-provided by the market and will be over-consumed.

  • They are examples for negative externalities of consumption

Internalizing a negative externality:

  1. Market based policies: Taxation & tradable permitsincrease private costs to firmsMPC shifts up towards the point of socially desirable equilibrium
  2. Government regulations: Banning → stops the consumption or production completely; Restricting outputsincrease private costs for firms to meet the standard → MPC shifts up towards the point of socially desirable equilibrium
  3. Publicity campaign → provide education on demerit goods OR fund negative advertising on demerit goodsless consumptionshifts MPB to left towards the point of socially desirable equilibrium

Positive externalities of production and consumption

Lack of public goods

Common access resources and the threat to sustainability

Asymmetric information

Abuse of monopoly power