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Market Failure:
Externalities
Introducing Market Failure
Externalities in Depth
Government Policy Options
Private Solutions
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Market Failure: Externalities > Introducing Market Failure
Introducing Market Failure
• Defining Market Failure
• Causes of Market Failure
• Introducing Externalities
• Externality Impacts on Efficiency
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Market Failure: Externalities > Introducing Market Failure
Defining Market Failure
• Prior to market failure, the supply and demand within the market do not produce
quantities of the goods where the price reflects the marginal benefit of
consumption.
• The structure of market systems contributes to market failure. In the real world, it
is not possible for markets to be perfect due to inefficient producers, externalities,
environmental concerns, and lack of public goods.
• Government responses to market failure include legislation, direct provision of
merit goods and public goods, taxation, subsidies, tradable permits, extension of
property rights, advertising, and international cooperation among governments.
Air pollution
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Market Failure: Externalities > Introducing Market Failure
Causes of Market Failure
• A price mechanism fails to account for all of the costs and benefits involved when
providing or consuming a specific good. When this happens, the market will not
produce the supply of the good that is socially optimal – it will be over or under
produced.
• Due to the structure of markets, it may be impossible for them to be perfect.
• Reasons for market failure include: positive and negative externalities,
environmental concerns, lack of public goods, underprovision of merit goods,
overprovision of demerit goods, and abuse of monopoly power.
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Market Failure: Externalities > Introducing Market Failure
Introducing Externalities
• In regards to externalities, the cost and benefit to society is the sum of the
benefits and costs for all parties involved.
• Market failure occurs when the price mechanism fails to consider all of the costs
and benefits necessary for providing and consuming a good.
• In regards to externalities, one way to correct the issue is to internalize the third
party costs and benefits. However, in many cases, internalizing the costs is not
feasible. When externalities exist, it is possible that the particular industry will
experience market failure.
• In many cases, the government intervenes when there is market failure.
Externality
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Market Failure: Externalities > Introducing Market Failure
Externality Impacts on Efficiency
• An economically efficient society can produce more goods or services than
another society without using more resources.
• An externality is a cost or benefit that results from an activity or transaction and
affects a third party who did not choose to incur the cost or benefit. Externalities
are either positive or negative depending on the nature of the impact on the third
party.
• Neoclassical welfare economics states that the existence of externalities results in
outcomes that are not ideal for society as a whole.
• In order to maximize economic efficiency, regulations are needed to reduce
market failures and imperfections, like internalizing externalities. When market
Externality
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imperfections exist, the efficiency of the market declines.
• In order for economic efficiency to be achieved, one defining rule is that no one
can be made better off without making someone else worse off. When
externalities are present, not everyone benefits from the production of the good or
service.
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Market Failure: Externalities > Externalities in Depth
Externalities in Depth
• Negative Externalities
• Positive Externalities
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Market Failure: Externalities > Externalities in Depth
Negative Externalities
• The reason these negative externalities, otherwise known as social costs, occur is
that these expenses are generally not included in calculating the costs of
production.
• Government intervention is necessary to help "price" negative externalities. They
do this through regulations or by instituting market-based policies such as taxes,
subsidies, or permit systems.
• Graphically, social costs will be lower than private costs because they do not take
into account the additional costs of negative externalities. As a result, firms may
produce more units than is optimal from a societal standpoint.
• Graphically, social costs will be lower than private costs because they do not take
Negative Externality
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into account the additional costs of negative externalities. As a result, firms may
produce more units than is optimal from a societal standpoint.
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Market Failure: Externalities > Externalities in Depth
Positive Externalities
• Externalities occur all the time because economic events do not occur within a
vacuum. Transactions often require the use of common resources that are shared
with parties are not involved with the exchange. The use of these resources in
turn impacts the uninvolved parties.
• The problem with positive externalities is that the people who create the
externality cannot charge the beneficiaries; the beneficiaries can "free ride," or
benefit without paying.
• Free riding results in a suboptimal result, because the producers of the externality
will generally create less of the benefit than the larger community needs.
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Market Failure: Externalities > Government Policy Options
Government Policy Options
• Regulation
• Tax
• Quotas
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Market Failure: Externalities > Government Policy Options
Regulation
• Command-and-control regulation requires or forbids certain behaviors with the
goal of addressing an externality.
• Regulation is difficult to implement and enforce correctly.
• Command-and-control regulation can come in the form of government-imposed
standards, targets, process requirements, or outright bans.
• The allocation of tradable permits is a market-based policy that has been primarily
used to combat pollution.
No Smoking
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Market Failure: Externalities > Government Policy Options
Tax
• A corrective tax is a market-based policy option used by the government to
address negative externalities.
• Taxes increase the cost of producing goods or services generating the externality,
thus encouraging firms to produce less output.
• The tax should be set equal to the value of the negative externality, which is very
difficult to do in practice.
• Corrective taxes increase efficiency and provide the government with revenues as
well.
Corrective Tax
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Market Failure: Externalities > Government Policy Options
Quotas
• A permit is a right to produce a certain amount of a negative externality, such as
pollution.
• Permits are traded among firms. Firms that are able to cheaply reduce production
of the externality can sell permits to firms that are unable to make such reductions
and are willing to pay for the permits.
• Regardless of the initial allocation of permits, the market for permits achieves an
outcome that is more efficient for society.
Emissions Trading
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Market Failure: Externalities > Private Solutions
Private Solutions
• Types of Private Solutions
• The Coase Theorem
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Market Failure: Externalities > Private Solutions
Types of Private Solutions
• Private solutions to externalities include moral codes, charities, and business
mergers or contracts in the self interest of relevant parties.
• The Coase theorem states that when transaction cost are low, two parties will be
able to bargain and reach an efficient outcome in the presence of an externality.
• In practice, private parties often fail to resolve the problem of externalities on their
own.
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Market Failure: Externalities > Private Solutions
The Coase Theorem
• According to the theorem, the parties affected by an externality will bargain to
reach an outcome that will be more efficient.
• Transaction costs must be low in order for parties to arrive at a more efficient
outcome.
• In the real world, transaction costs are rarely low, so the Coase theorem is often
inapplicable.
Efficient Solution
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Appendix
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Market Failure: Externalities
Key terms
• Coase Theorem The theorem states that private economic actors can solve the problem of externalities among themselves.
• efficient Making good, thorough, or careful use of resources; not consuming extra. Especially, making good use of time or
energy.
• externality An impact, positive or negative, on any party not involved in a given economic transaction or act.
• externality An impact, positive or negative, on any party not involved in a given economic transaction or act.
• externality An impact, positive or negative, on any party not involved in a given economic transaction or act.
• externality An impact, positive or negative, on any party not involved in a given economic transaction or act.
• externality An impact, positive or negative, on any party not involved in a given economic transaction or act.
• free rider One who obtains benefit from a public good without paying for it directly.
• free rider One who obtains benefit from a public good without paying for it directly.
• intervene To interpose; as, to intervene to settle a quarrel; get involved, so as to alter or hinder an action.
• merit good A commodity which is judged that an individual or society should have on the basis of some concept of need, rather
than ability and willingness to pay.
• monopoly A market where one company is the sole supplier.
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Market Failure: Externalities
• Negative Externality A detremental effect suffered by a party due to a transaction it was not a part of.
• Permit The right to produce a given amount of a negative externality (for example, the right to emit a specific volume of a
pollutant).
• Pigovian tax A tax applied to a market activity that is generating negative externalities (costs for somebody else).
• public good A good that is both non-excludable and non-rivalrous in that individuals cannot be effectively excluded from use
and where use by one individual does not reduce availability to others.
• public good A good that is both non-excludable and non-rivalrous in that individuals cannot be effectively excluded from use
and where use by one individual does not reduce availability to others.
• quota A restriction on the import of something to a specific quantity.
• Transaction cost The cost incurred in making an economic exchange, such as the costs required to come to an acceptable
agreement with the other party to the transaction, drawing up an appropriate contract and so on.
• Transaction cost The cost incurred in making an economic exchange, such as the costs required to come to an acceptable
agreement with the other party to the transaction, drawing up an appropriate contract and so on.
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Market Failure: Externalities
Externality
This diagram shows the voluntary exchange that takes place within a market system. It also shows the economic costs that are associated with
externalities.
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Wikipedia. "Externality." CC BY-SA http://en.wikipedia.org/wiki/File:Externality.svg View on Boundless.com
Market Failure: Externalities
Negative Externality
Graphically, negative externalities occur when social costs are lower than private costs, and firms produce more units than is socially optimal. The ideal
equilibrium quantity that reflects negative externalities is Qs, but firms may produce at Qp.
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Wikipedia. "Negative externality." Public domain http://en.wikipedia.org/wiki/File:Negative_externality.svg View on Boundless.com
Market Failure: Externalities
Corrective Tax
A tax shifts the marginal private cost curve up by the amount of the tax. This gives producers an incentive to reduce output to the socially optimum level.
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http://hhttp//en.wikipedia.org/wiki/File:Social_cost_with_tax.svg. "Social cost with tax." Public domain
http://hhttp//en.wikipedia.org/wiki/File:Social_cost_with_tax.svg View on Boundless.com
Market Failure: Externalities
Emissions Trading
Emissions trading or "cap and trade" is a market-based approach used to control pollution by providing economic incentives for reducing the emissions
of pollutants.
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Wikipedia. "Coal power plant Datteln 2 Crop1." CC BY-SA http://en.wikipedia.org/wiki/File:Coal_power_plant_Datteln_2_Crop1.png View on Boundless.com
Market Failure: Externalities
Cigarette smoke
Secondhand smoke is an example of a negative externality; a person chooses to smoke, but others who do not choose to smoke are harmed.
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Wikipedia. "Cigarette smoking." CC BY-SA http://en.wikipedia.org/wiki/File:Cigarette_smoking.jpg View on Boundless.com
Market Failure: Externalities
Effects of Externalities
This graph exemplifies how Coase's Theorem functions in a practical manner, underlining the effects of an externality in an economic model.
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Wikimedia. CC BY-SA http://upload.wikimedia.org/wikipedia/commons/6/6c/Jonespeartree_graphs.JPG View on Boundless.com
Market Failure: Externalities
Efficient Solution
According to the Coase theorem, two private parties will be able to bargain with each other and find an efficient solution to an externality problem.
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Wikimedia. "Handshake." Public domain http://commons.wikimedia.org/wiki/File:Handshake.svg View on Boundless.com
Market Failure: Externalities
Negative Externality
Air pollution caused by motor vehicles is an example of a negative externality.
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Wikipedia. "Diesel-smoke." Public domain http://en.wikipedia.org/wiki/File:Diesel-smoke.jpg View on Boundless.com
Market Failure: Externalities
Externality
An externality is a cost or benefit that results from an activity or transaction and that affects an otherwise uninvolved party who did not choose to incur
that cost or benefit.
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Market Failure: Externalities
Air pollution
Air pollution is an example of a negative externality. Governments may enact tradable permits to try and reduce industrial pollution.
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Wikimedia. "Pollution de l'air." Public domain http://commons.wikimedia.org/wiki/File:Pollution_de_l%2527air.jpg View on Boundless.com
Market Failure: Externalities
No Smoking
The prohibition of smoking in certain areas is a regulation designed to reduce the negative externalities suffered by non-smokers when they are around
smokers.
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Market Failure: Externalities
Which of the following is a public good?
A) The stock of fish in the ocean
B) Satellite television
C) Clean air
D) Clothing
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Market Failure: Externalities
Which of the following is a public good?
A) The stock of fish in the ocean
B) Satellite television
C) Clean air
D) Clothing
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Market Failure: Externalities
When is it appropriate for a government to provide a subsidy?
A) When a transaction has positive externalities
B) When a transaction has negative externalities
C) When a good is nonrivalrous and nonexcludable
D) When property rights are insufficient
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Market Failure: Externalities
When is it appropriate for a government to provide a subsidy?
A) When a transaction has positive externalities
B) When a transaction has negative externalities
C) When a good is nonrivalrous and nonexcludable
D) When property rights are insufficient
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Market Failure: Externalities
Which of the following is NOT a reason for market failure?
A) Externalities
B) Environmental concerns
C) Abuse of monopoly power
D) Abundance of public goods
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Market Failure: Externalities
Which of the following is NOT a reason for market failure?
A) Externalities
B) Environmental concerns
C) Abuse of monopoly power
D) Abundance of public goods
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Market Failure: Externalities
Which of the following is a feature of externalities?
A) They are not reflected by market prices
B) They can be priced
C) They are always good for the economy
D) They are always bad for the economy
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Market Failure: Externalities
Which of the following is a feature of externalities?
A) They are not reflected by market prices
B) They can be priced
C) They are always good for the economy
D) They are always bad for the economy
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Market Failure: Externalities
In the case of positive externalities, social marginal benefits
__________ private marginal benefits.
A) are less than
B) are equal to
C) exceed
D) are not as important as
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Market Failure: Externalities
In the case of positive externalities, social marginal benefits
__________ private marginal benefits.
A) are less than
B) are equal to
C) exceed
D) are not as important as
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Market Failure: Externalities
Which of the following is an example of an individual who is not
involved in a transaction but is bearing some cost?
A) A producer of aluminum
B) An individual exposed to secondhand smoke
C) A consumer of aluminum
D) A smoker
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Market Failure: Externalities
Which of the following is an example of an individual who is not
involved in a transaction but is bearing some cost?
A) A producer of aluminum
B) An individual exposed to secondhand smoke
C) A consumer of aluminum
D) A smoker
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Market Failure: Externalities
A chemical plant is located close to a river and the residue from
the plant sometimes drains into that river. Although this act of
polluting the river is not taken into account by the firm, this
“negative externality” results in:
A) The firm's private costs exceeding the firm's social costs
B) The firm's social costs exceeding the firm's private costs
C) The firm's private marginal costs exceeding the firm's social marginal
costs
D) The firm's social marginal costs exceeding the firm's private marginal
costs
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Market Failure: Externalities
A chemical plant is located close to a river and the residue from
the plant sometimes drains into that river. Although this act of
polluting the river is not taken into account by the firm, this
“negative externality” results in:
A) The firm's private costs exceeding the firm's social costs
B) The firm's social costs exceeding the firm's private costs
C) The firm's private marginal costs exceeding the firm's social marginal
costs
D) The firm's social marginal costs exceeding the firm's private marginal
costs
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Market Failure: Externalities
Consider an individual who decides to pursue higher education.
Who might experience positive externalities from this decision?
A) The student who benefits from increased economic opportunities
B) Members of society who benefit from a more productive community
C) The university which benefits from increased tuition and fees
D) All of these answers
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Market Failure: Externalities
Consider an individual who decides to pursue higher education.
Who might experience positive externalities from this decision?
A) The student who benefits from increased economic opportunities
B) Members of society who benefit from a more productive community
C) The university which benefits from increased tuition and fees
D) All of these answers
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Market Failure: Externalities
Which of the following statements is true about how externalities
impact economic efficiency?
A) Externalities do not impact efficiency.
B) Economic efficiency requires that the externality is internalized.
C) Externalities have only positive impacts on efficiency.
D) Externalities do not have noticeable impacts of economic efficiency.
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Market Failure: Externalities
Which of the following statements is true about how externalities
impact economic efficiency?
A) Externalities do not impact efficiency.
B) Economic efficiency requires that the externality is internalized.
C) Externalities have only positive impacts on efficiency.
D) Externalities do not have noticeable impacts of economic efficiency.
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Market Failure: Externalities
Which of the following is an example of an individual who is not
involved in a transaction but is bearing some cost?
A) An individual exposed to secondhand smoke
B) A producer of aluminum
C) A consumer of aluminum
D) A smoker
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Market Failure: Externalities
Which of the following is an example of an individual who is not
involved in a transaction but is bearing some cost?
A) An individual exposed to secondhand smoke
B) A producer of aluminum
C) A consumer of aluminum
D) A smoker
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Market Failure: Externalities
A chemical plant is located close to a river and the residue from
the plant sometimes drains into that river. Although this act of
polluting the river is not taken into account by the firm, this
“negative externality” results in:
A) The firm's private costs exceeding the firm's social costs
B) The firm's social marginal costs exceeding the firm's private marginal
costs
C) The firm's social costs exceeding the firm's private costs
D) The firm's private marginal costs exceeding the firm's social marginal
costs
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Market Failure: Externalities
A chemical plant is located close to a river and the residue from
the plant sometimes drains into that river. Although this act of
polluting the river is not taken into account by the firm, this
“negative externality” results in:
A) The firm's private costs exceeding the firm's social costs
B) The firm's social marginal costs exceeding the firm's private marginal
costs
C) The firm's social costs exceeding the firm's private costs
D) The firm's private marginal costs exceeding the firm's social marginal
costs
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Market Failure: Externalities
Levying environmental taxes and creating cap-and-trade quotas
for emissions are both methods governments may use to reduce
negative externalities. Which of the following best explains the
economic rationale behind these policies?The policies ____.
A) create social awareness of the underlying problems so grassroots
organizations can act
B) place a monetary price on social costs so firms can guage their true
costs accordingly
C) decrease the marginal costs of pollution for the firms while increasing
revenue for governments
D) All of these answers
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Market Failure: Externalities
Levying environmental taxes and creating cap-and-trade quotas
for emissions are both methods governments may use to reduce
negative externalities. Which of the following best explains the
economic rationale behind these policies?The policies ____.
A) create social awareness of the underlying problems so grassroots
organizations can act
B) place a monetary price on social costs so firms can guage their true
costs accordingly
C) decrease the marginal costs of pollution for the firms while increasing
revenue for governments
D) All of these answers
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Market Failure: Externalities
Consider an individual who decides to pursue higher education.
Who might experience positive externalities from this decision?
A) The student who benefits from increased economic opportunities
B) Members of society who benefit from a more productive community
C) The university which benefits from increased tuition and fees
D) All of these answers
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Market Failure: Externalities
Consider an individual who decides to pursue higher education.
Who might experience positive externalities from this decision?
A) The student who benefits from increased economic opportunities
B) Members of society who benefit from a more productive community
C) The university which benefits from increased tuition and fees
D) All of these answers
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Market Failure: Externalities
To solve the problem of externality, all of the following are valid
measures except:
A) The imposition of tax or the provision of subsidy
B) The use of government regulations
C) The allocation of permits
D) Government ownership
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Market Failure: Externalities
To solve the problem of externality, all of the following are valid
measures except:
A) The imposition of tax or the provision of subsidy
B) The use of government regulations
C) The allocation of permits
D) Government ownership
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Market Failure: Externalities
When is government regulation an inefficient method to address
externalities?
A) When a transaction has a measurable, negative impact on those not
taking part in the transaction
B) When the costs of regulation are unknown or outweight the benefits
C) When a good is beneficial for the person receiving it and has a
positive externality for society
D) When a good is detrimental for the person receiving it and has a
negative externality for society
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Market Failure: Externalities
When is government regulation an inefficient method to address
externalities?
A) When a transaction has a measurable, negative impact on those not
taking part in the transaction
B) When the costs of regulation are unknown or outweight the benefits
C) When a good is beneficial for the person receiving it and has a
positive externality for society
D) When a good is detrimental for the person receiving it and has a
negative externality for society
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Market Failure: Externalities
Which of the following is an example of government regulation?
A) The legal prohibition of an act with negative externalities
B) Entities purchase the rights to produce a given amount of negative
externalities
C) A tax on an action that is equal to the cost it imposes on society
D) Firms enter into a private contract governing the social costs of their
actions
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Market Failure: Externalities
Which of the following is an example of government regulation?
A) The legal prohibition of an act with negative externalities
B) Entities purchase the rights to produce a given amount of negative
externalities
C) A tax on an action that is equal to the cost it imposes on society
D) Firms enter into a private contract governing the social costs of their
actions
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Market Failure: Externalities
How do corrective taxes address negative externalities?
A) By decreasing the private cost of producing a good or service
generating the externality
B) By increasing the social cost of producing a good or service
generating the externality
C) By increasing the private cost of producing a good or service
generating the externality
D) By decreasing the social cost of producing a good or service
generating the externality
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Market Failure: Externalities
How do corrective taxes address negative externalities?
A) By decreasing the private cost of producing a good or service
generating the externality
B) By increasing the social cost of producing a good or service
generating the externality
C) By increasing the private cost of producing a good or service
generating the externality
D) By decreasing the social cost of producing a good or service
generating the externality
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Market Failure: Externalities
Which of the following is an example of a permit system?
A) The legal prohibition of an act with negative externalities
B) A tax on an action that is equal to the cost it imposes on society
C) Firms enter into a private contract governing the social costs of their
actions
D) Entities purchase the rights to produce a given amount of negative
externalities
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Market Failure: Externalities
Which of the following is an example of a permit system?
A) The legal prohibition of an act with negative externalities
B) A tax on an action that is equal to the cost it imposes on society
C) Firms enter into a private contract governing the social costs of their
actions
D) Entities purchase the rights to produce a given amount of negative
externalities
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Market Failure: Externalities
According to Coase, what conditions must be met in order for a
private solution to externalities to be successful?
A) Well defined property rights and an honest criminal justice system
B) Well defined property rights and no transaction costs
C) An honest criminal justice system and a competitive market
D) No transaction costs and a competitive market
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Market Failure: Externalities
According to Coase, what conditions must be met in order for a
private solution to externalities to be successful?
A) Well defined property rights and an honest criminal justice system
B) Well defined property rights and no transaction costs
C) An honest criminal justice system and a competitive market
D) No transaction costs and a competitive market
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Market Failure: Externalities
Why is the Coase theorem often inapplicable to real world
situations?
A) The government usually intervenes
B) Transaction costs are rarely low
C) Bargaining outcomes are usually inefficient
D) Trades in externalities are impossible
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Market Failure: Externalities
Why is the Coase theorem often inapplicable to real world
situations?
A) The government usually intervenes
B) Transaction costs are rarely low
C) Bargaining outcomes are usually inefficient
D) Trades in externalities are impossible
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Market Failure: Externalities
Attribution
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• Wikibooks. "Transportation Economics/Negative externalities." CC BY-SA 3.0
http://en.wikibooks.org/wiki/Transportation_Economics/Negative_externalities
• Wikibooks. "IB Economics/Microeconomics/Market Failure." CC BY-SA 3.0
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Market_Failure
• Wiktionary. "externality." CC BY-SA 3.0 http://en.wiktionary.org/wiki/externality
• Wikipedia. "merit good." CC BY-SA 3.0 http://en.wikipedia.org/wiki/merit%20good
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• Wiktionary. "free rider." CC BY-SA 3.0 http://en.wiktionary.org/wiki/free+rider
• Boundless Learning. "Boundless." CC BY-SA 3.0 http://www.boundless.com//economics/definition/monopoly
• Wikipedia. "public good." CC BY-SA 3.0 http://en.wikipedia.org/wiki/public%20good
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• Wikibooks. "IB Economics/Microeconomics/Market Failure." CC BY-SA 3.0
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Market_Failure
• Wikipedia. "Externalities." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Externalities
• Wikibooks. "IB Economics/Microeconomics/Market Failure." CC BY-SA 3.0
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Market_Failure
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• Wikipedia. "Externalities." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Externalities
Free to share, print, make copies and changes. Get yours at www.boundless.com
Market Failure: Externalities
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http://en.wikibooks.org/wiki/Transportation_Economics/Negative_externalities#Definitions
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http://en.wikibooks.org/wiki/Transportation_Economics/Positive_externalities
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• Wikibooks. "IB Economics/Microeconomics/Market Failure." CC BY-SA 3.0
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Market_Failure
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• Boundless Learning. "Boundless." CC BY-SA 3.0 http://www.boundless.com//economics/definition/negative-externalityd2e01a33-651c-4aef-b734-94b1fcd34e3c
Free to share, print, make copies and changes. Get yours at www.boundless.com
Market Failure: Externalities
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http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Market_Failure
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http://en.wikipedia.org/wiki/Tradable_smoking_pollution_permits
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• Wikipedia. "Individual fishing quota." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Individual_fishing_quota
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Market Failure: Externalities
• Wikipedia. "Coase theorem." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Coase_theorem
• Wikipedia. "Coase theorem." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Coase_theorem
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• Wikipedia. "Transaction cost." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Transaction%20cost
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