Unit 5 – Market Failure and the
Role of Government
Externalities
Essential Questions
1. Why are markets inefficient in the presence
of positive and negative externalities?
2. How do we identify the area of efficiency
loss (deadweight loss) when externalities
are present?
3. How can government correct the
inefficiencies created by externalities?
The Perfectly Competitive Market
A Model of Efficiency
P
S
What makes the perfectly
competitive market
efficient?
1. Total surplus is
maximized.
Consumer
Surplus
2. Price = marginal cost.
Pe
3. Marginal benefit =
marginal cost.
Producer
Surplus
Not just to the individual,
but to society.
D
0
Qe
Q
The Perfectly Competitive Market
A Model of Efficiency
P
MSC
Consumer
Surplus
Pe
Producer
Surplus
MSB
0
Qe
Q
In a perfectly competitive
market, marginal social
benefit = marginal social
cost.
Important Point: In the absence of externalities, the benefit to
society is the same as the benefit to the parties involved in the
transaction, and the cost to society is the same as the cost to
the parties involved.
P
Consumer
Surplus
Marginal Social Cost
Pe
is equal to
Producer
Surplus
0
Marginal Social Benefit
Qe
Q
Externalities are additional benefits or costs to
society. Some third party, other than the producer
or the consumer is getting a benefit or incurring a
cost from the transaction.
I. Positive externalities: a third party is enjoying a
benefit from the transaction.
II. Negative externalities: a third party is incurring
a cost from the transaction.
Positive Externalities – Examples.
- Vaccinations
- Education
- Health care
- A fence that your neighbor builds
- Your neighbor insulates his house
Negative Externalities examples:
- cigarettes
- alcohol
- Pollution from a chemical plant
- neighbor plays new kickin’ stereo real loud
Graphing Externalities and
Finding Deadweight Loss
Positive externalities complicate the market by adding
an external benefit to society that is not included in the
private benefit to the consumer.
P
Marginal External Benefit
(MEB)
Marginal Social Benefit
(MSB = MPB + MEB)
Marginal Private Benefit
(MPB)
0
Q
The market underproduces a good with positive
externalities.
P
MSC
Pmkt
Marginal Social Benefit
(MSB = MPB + MEB)
0
Marginal Private Benefit
(MPB)
Qmkt
Qefficient
Q
Where is the area of deadweight loss?
P
MSC
Pmkt
Marginal Social Benefit
(MSB)
0
Marginal Private Benefit
(MPB)
Qmkt
Qefficient
Q
Negative externalities complicate the market by adding
an external cost to society that is not included in the
private cost to the consumer or the producer.
P
Marginal Social Cost
(MSC = MPC + MEC)
Marginal Private Cost
(MPC)
Marginal External Cost
(MEC)
0
Q
The market overproduces a good with negative
externalities.
P
MSC = MPC + MEC
MPC
Pmkt
MSB
0
Qefficient
Qmkt
Q
Where is the area of deadweight loss?
P
MSC
MPC
Pmkt
MSB
0
Qefficient
Qmkt
Q
P
What type of externality?
S2
What is:
S1
C
A
S1
S2
Q1
Q2
E
B
AB
Deadweight loss
D
0
Q1
Q2
Q
What type of externality?
P
What is:
The area of deadweight
loss?
S
A
The marginal external
benefit?
C
The market quantity?
The socially efficient
quantity?
B
E
0
The marginal social
D2 benefit?
The marginal private
benefit?
D1
Q1
Q2
Q
How can government correct the
inefficiencies caused by
externalities?
For Positive Externalities
The Government can provide subsidies.
1. To the consumer.
P
MSC
2. To the producer.
- Must be a per unit
subsidy rather than a
lump-sum subsidy in order
to affect the marginal cost
curve.
Pmkt
MSB
0
MPB
Qmkt
Qefficient
Q
For Positive Externalities
Subsidy to the consumer shifts the demand curve up by
the amount of the subsidy.
P
1. How much should the
subsidy be?
MSC
2. With the subsidy,
MPB = MSB, so the
externality and the
deadweight loss are
eliminated.
Psubsidy
Pmkt
MSB
MSB = MPB
0
MPB
Qmkt
Qefficient
Q
For Positive Externalities
Subsidy to the producer shifts the supply curve down by
the amount of the subsidy.
P
1. How much should the
subsidy be?
MSC
MSC2
Pmkt
MSB
Psubsidy
0
MPB
Qmkt
Qefficient
Q
2. With the subsidy,
deadweight loss is
eliminated because the
new output level will be at
the socially efficient
quantity.
For negative externalities, the government can levy a
tax in the amount of the marginal external cost.
P
MSC = MPC
MPC
Ptax
Pmkt
MSB
0
Qefficient
Qmkt
Q
2. With the tax,
MPC = MSC, so the
externality and the
deadweight loss are
eliminated.