Market Failure & Externalities
When production or consumption of a good or
service affects (impacts) ‘third parties’ (people
other than the buyers and sellers of the good),
these ‘side-effects’ or ‘spillover-effects’ created are
called externalities.
Positive and Negative Externalities
When the impact on the third party is an additional
(external or spillover) cost, the externality is called
a negative externality (i.e. is harmful to others
when produced or consumed)
When the impact on the third party is an additional
(external or spillover) benefit, the externality is
called a positive externality (i.e. provides some
benefit to others when produced or consumed)
Private and Social Costs e.g. cigarette smoking
Social
Costs
Private
=
+
Costs
External
Costs
Private and Social Benefits e.g. using public transport
Social = Private + External
Benefit
Benefit
Benefit
NEGATIVE EXTERNALITIES
OF PRODUCTION
Negative Externality of Production e.g. Pollution From a Power Station
MSC
MC,MB, P
MPC = S
Ps
Pm
External Cost = Tax
MPB = D
Qs Qm
Quantity
POSITIVE EXTERNALITIES
OF PRODUCTION
Positive Externality of Production e.g. Planting a Forest
MC,MB, P
MPC = S
MSC
Pm
External
Benefit =
Subsidy
Ps
MPB = D
Qm
Qs
Quantity
POSITIVE EXTERNALITIES OF
CONSUMPTION
Positive Externality of Consumption e.g. Using Public Transport
MC,MB, P
MPC = S
External
Benefit =
Subsidy
Pm
Ps
MSB
MPB = D
Qm
Qs
Quantity
NEGATIVE EXTERNALITIES
OF CONSUMPTION
Negative Externality of Consumption e.g. Drink Driving
MC,MB, P
MPC = S
Ps
External
Cost = Tax
Pm
MPB = D
MSB
Qs
Qm
Quantity
Public Goods
The problem with a public good is that the market will fail to
produce them at all. Public Goods are :• Non-Rival - where the consumption of a good or service by
one person will not prevent others from enjoying it. It can be
used at the same time by many people.
•Non-Excludable - Once the good or service is provided it is
not possible to stop others from enjoying it too. If you cannot
prevent people from using the good or service then it will be
impossible to charge a price for using it. Creates the “free
rider” problem.
• Non-Depletable - No additional resources are required when
additional people use the good or service. Therefore MC = 0
Collective Good - provided by the government and paid for
by taxes.
Merit Goods
Demerit Goods
Merit Goods - goods and services that the government
considers to be beneficial or good for us. The government
feels that people ought to consume these goods.
Consumers do not have enough information to make an
informed decision about the use of these goods.
Demerit Goods - goods and services that the government
considers to be harmful or bad for us. The government
feels that people ought not to consume these goods.
People over-consume demerit goods as the do not have
enough information to make an informed decision.
The government can use:-
- Taxes
- Subsidies
- Education
- Regulations (Laws)
- Public Provision (provided free)