market failure and externalities

• Market failure


  When the free market fails to allocate resources to the best interests of society, so there is an inefficient allocation of scarce resources
• Economic and social welfare is not maximised where there is market failure
• Types of market failure


  • Externalities
• Externality


  The cost or benefit a third party receives from an economic transaction outside of the market mechanism
• Externalities


  • Can be positive (external benefits) or negative (external costs)
• Negative externalities


  Caused by demerit goods, associated with information failure, consumers are not aware of the long run implications, usually overprovided
• Negative externalities


  • Cigarettes and alcohol
• Positive externalities


  Caused by merit goods, associated with information failure, consumers do not realise the long run benefits, underprovided in a free market
• Positive externalities


  • Education and healthcare
• The extent to which the market fails involves a value judgement, so it is hard to determine what the monetary value of an externality is
• Private costs


  Producers are concerned with private costs of production
• Private costs determine how much the producer will supply
• Private costs could refer to the market price which the consumer pays for the good
• Marginal private cost


  The cost to a firm of producing one extra unit
• Social costs


  Calculated by private costs plus external costs
• External costs are shown by the vertical distance between the private cost and social cost curves
• Marginal social cost and marginal private cost diverge from each other, with external costs increasing disproportionately with increased output
• Marginal social cost


  The extra cost on society derived per extra unit consumed
• Marginal social cost = marginal external cost + marginal private cost
• Private benefit


  Consumers are concerned with the private benefit derived from the consumption of a good
• Social benefit


  Social benefits are private benefits plus external benefits
• External benefits are the difference between private and social benefits, and increase disproportionately as output increases
• Marginal social benefit


  The extra benefit on society derived per extra unit consumed
• Marginal social benefit = marginal external benefit + marginal private benefit
• Social optimum position


  Where marginal social cost = marginal social benefit, the point of maximum welfare
• External costs of production

  Occur when a good is being produced or consumed, such as pollution, shown by the vertical distance between marginal social cost and marginal private cost
• The market equilibrium ignores negative externalities, leading to over-provision and under-pricing
• With negative externalities, marginal social cost > marginal private cost of supply, leading to an excess of social costs over benefits and a deadweight welfare loss
• External benefits of production

  An example is the decline of diseases and healthier lives from vaccination programmes, underprovided and under consumed in the free market
• The excess of social benefits over costs from external benefits is the area of welfare gain
• Government policies for negative externalities

  • Indirect taxes
  • Subsidies
  • Regulation
  • Provide the good directly
  • Provide information
  • Property rights
  • Personal carbon allowances
• Indirect taxes can internalise the externality by increasing the price to the socially optimal level
• Subsidies can encourage the consumption of merit goods by including the full social benefit in the market price
• Regulation can enforce less consumption of a good, but can be difficult to police and have high administrative costs
• Bans are only useful where marginal social cost > marginal private benefit
• Providing the good directly, providing information, and establishing property rights can also address market failure from externalities
• Personal carbon allowances that are tradeable can allow firms and consumers to pollute up to a certain amount