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
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.
- 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:
- Market based policies: Taxation & tradable permits → increase private costs to firms → MPC shifts up towards the point of socially desirable equilibrium
- Government regulations: Banning → stops the consumption or production completely; Restricting outputs → increase private costs for firms to meet the standard → MPC shifts up towards the point of socially desirable equilibrium
- Publicity campaign → provide education on demerit goods OR fund negative advertising on demerit goods → less consumption → shifts 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
