5.
MARKET FAILURE
Definition: Market failure is defined as the failure of the market to achieve allocative
efficiency resulting in an over allocation or under allocation of resources.
Activity: 1 Using a diagram, and the concepts of consumer
and producer surplus, and marginal benefits
and marginal costs, explain the meaning of
allocative efficiency.
2 Explain, in a general way, the meaning of
market failure.
5.2 Externalities
Activity: What is;
- Marginal Private Benefit (MPB)
- Marginal Social Benefit (MSB)
- Marginal Private Cost (MPC)
- Marginal Social Cost (MSC) ?
- When does externalities occur?
An externality occurs when production or consumption of a good has an effect on a third
party for which the latter does not pay or does not get compensated.
This effect can be positive (benefit) in which case we speak of positive
externalities. Examples include getting educated. The third party that would benefit in this
case would be the society in general.
This effect can be negative (cost) in which case we speak of negative
externalities. Examples include pollution from the production of a good, which hurts society
(the third party).
There is no externality when the actions of the buyers and sellers do not produce any side
effects on the 3rd parties. Hence there is allocative efficiency.
This leads to Social optimum achieved when the Marginal Private Benefit (D) curve and
Marginal Private Cost (S) curve determine and equilibrium price and quantity
Social optimum refers to a ‘best’ situation from the point of view of
allocative efficiency.
Marginal private costs (MPC) are the costs of production that are taken into
account in a firm’s decision making process. The MPC curve is equal to the supply curve.
Marginal private benefits (MPB) benefits an individual enjoys from the
consumption of an extra unit of a good. The MPB curve is equal to the demand curve.
Marginal social costs (MSC) refer to costs to society of producing one more unit of a good.
Marginal social benefits (MSB) refer to benefits to society from consuming one more unit
of a good.
Allocative efficiency is achieved when MSC = MSB. When there is no externality, the
competitive free market leads to an outcome where;
MPC = MSC =MPB = MSB, as in the Figure below.
An externality creates a divergence between MPC
and MSC or between MPB and MSB.
Meaning there is externality when:
* MSC > MPC; negative externality of production
* MSC < MPC; positive externality of production
* MSB < MPB; negative externality of consumption
* MSB > MPB; positive externality of consumption.
In general we can say the following: the ideal
situation is reached when the externalities
are equal to zero:
NB:
All negative externalities (of production and consumption) create external costs. When
there are external costs, MSC > MSB at the point of production by the market
All positive externalities (of production and consumption) create external benefits.
When there are external benefits MSB > MSC at the point of production by the market
All production externalities (positive and negative) create a divergence between private
and social costs (MPC and MSC).
All consumption externalities (positive and negative) create a divergence between
private and social benefits (MPB and MSB).
5.3 Negative Externalities Of Production And Consumption
Objectives:
- Explain negative externalities of production and consumption using diagrams and explain welfare loss
associated with the production and consumption of a good
- Explain that consuming demerit goods create external cost
- Evaluate the use of the different policies used to respond to the problems of negative externalities of
production and consumption e.g. market based policies ( taxation and tradable permits) and government
regulations.
Negative externalities of production
Negative externalities of production arise when the production of a good creates spillover
costs on a third party, which is often times the environment as a whole. The Marginal Social
Cost of producing a good is greater than the Marginal Private Cost of producing it.
(MSC>MPC)
Consider a cement factory that emits smoke into the air and disposes its waste by dumping
it into the ocean. There is a production externality because over and above the firm’s
private costs of production, there are additional costs that spill over onto society due to
the polluted air and ocean, with negative consequences for the local inhabitants,
swimmers, sea life, the fishing industry and the marine ecosystem.
The supply curve S=MPC reflects the cost of
production to the firm.
The MSC represents the cost to the society of
producing cement. E.g. water pollution that
destroys fish stock.
The free market outcome is determined by the
intersection of the MPC and the MPB curves
resulting in the quantity and price respectively.
The social optimum outcome (best outcome) is
given by the intersection of MSC and MSB
which determines the quantity and price .
It is seen that, the cost to the society to produce
the quantity of cement (MSC) is greater than
the firm’s private cost (MPC)
The vertical distance between the two
represents the external cost.
The demand curve represents both MPB and
MSB since we are talking of production
externality.
It is seen from the diagram that when there is
negative production externalities, there is over
allocation of resources for the good in the
market.
This is seen as the free market quantity is
greater than the social optimum output .
The welfare loss of negative production
Externalities
The existence of externalities makes social cost to exceed the
private cost. As a result:
There is a deadweight loss created by the unregulated
market shown by the shaded portion of the diagram.
At the equilibrium output of Qm the marginal social cost
exceeds the marginal social benefit, meaning too much of
the good is being produced by the free market! This is a
market failure!
The welfare loss is equal to the difference between MSC
and MSB for the amount of output that is overproduced
(Qm – Qopt).
If the externality were corrected, so that the economy
reaches the social optimum, the loss of benefits would
disappear.
