Market Failure

Oxford (pp. 129 – 158)

 Public Goods, Common
Resources, and Private Goods
 You believe that if everyone is eligible to receive a benefit, everyone should have to pay for that
benefit.
 We may all use something as much as we want.
 You believe that only those people that use the benefit should pay for the benefit.
Why should I have to pay for something I do not use?

 These are the extremes of the issue of public vs. private goods, and the problem of free riders
 The underlying question is can there be an agreement reached (management of externalities)
Excludable and Rival Goods

When thinking about the goods produced in an economy, one must determine
whether they are excludable, or rival
 Excludable—People can be prevented from using the good e.g cinema
 Rival—One person’s use diminishes another person’s ability to use that good
e.g clothes, cars
https://www.youtube.com/watch?v=pJU028t-7mg
 Public Goods —Non-excludable, Non-rival
Public Goods—Non-excludable, Non-rival.
Examples: Police, Firefighters, Education, National Defense ,Lighthouses, Parks

Problem: Free Rider (someone who receives the benefit of a good, but avoids paying for it)
Example of Free Rider comes from the issue of illegal immigration Illegal immigrants enter the
country and use firefighters, police, educational resources, but do not pay taxes. This is the
central argument against illegal immigration. Also, the absence, or reduction of public goods
creates market failure
Solution
 Privatize the public good
Convert public education to private education
Only those who really want a good education will receive it with no distractions from those
students who have no interest and use school only as a social center or sleeping quarters
 Direct provision by the government
 Creation of Public-Private-Partnerships (PPP) e.g a hospital building financed and
constructed by a private developer and then leased to the hospital authority
 Common Resources—Non-excludable,
but Rival
  Example: Salmon, Elephants , Water, Global Warming
No one can be excluded from fishing, hunting, using water, driving polluting
cars, but the more fish and elephants taken, water used, and cars driven
results in fewer fish, elephants, water, and life-sustaining climate for
everyone else
 Common Resources

Problem: Tragedy of the Commons

 Main economic activity in the town is raising sheep. The sheep graze on the land
surrounding the town (Town Common). The land is non-excludable, but it is rival as
more sheep graze. Eventually, the land becomes barren because, although everyone
benefits from the land, no one person has the incentive to care for the land. The
result is a common loss.
 A solution would be to privatize the land (parcel the land out to each family)
Solutions
Privatize the common resource (much like the solution for free riders in public
goods)
 Town Common: Privatize the land and parcel out the land to the residents of the town
 Water: Place a price on water use for farmers
 Salmon: Private fish hatcheries
 Elephants: Private game preserves (“safari ranches”)
NOTE: The value of ivory is a threat to the elephant, but the value of beef is guardian
of the cow.
Buffalo were going extinct until the invention of barbed wire. Example of the conversion
of a common resource into a private good
 Common Resources – Solutions cont
Coase Theorem (“Collective Self-Governance”)—Alternative to privatization. Addresses how
effective the
private market is in dealing with externalities. Can correct negative externality of production
 Named after economics Robert Coase (Theorem in 1959. Nobel Prize in 1991)
 Private economic actors can solve the problem of externalities among themselves. Whatever
the initial distribution of rights, the interested parties can always reach a bargain in which
everyone is better of and the outcome is efficient
 This comes as a result of extending property rights to the actors involved
 Assumes that the actors involved are rational. If irrationality results, the Coase Theorem will
not work.
 The basis behind the Coase Theorem came in the form of radio frequency allocation In the
1950s, the proliferation of radio had become so massive that government regulators were
having a very difficult time assigning frequencies to different radio stations without each
station interfering with (“stepping on”) other frequencies. Coase suggested, and the radio
industry later implemented a plan by which, when property rights were assigned to each
firm, the firms would work within their own markets to pay off the offending firms and thus
eliminate the interference
 Common Resources – Solutions cont
 Example I: Ice Cream truck was driving around my neighborhood while I was
completing the writing of this unit. The music that it constantly played was
disrupting my thought process.
 Question: How much was silence worth to me?
 Answer: I stopped the ice cream truck and asked how much he typically sells
on this block in an average day. He told me it was approximately $20. So I paid
him $25 to not play the music.
 The problem with this theorem is that it assumes both individuals are
rational actors. Bargaining does not always work as the costs of bargaining
(“transaction costs”) can exceed the benefit being sought, thus the problem
remains unresolved and social inefficiency persists
 This problem can be addressed through government, whose function is to
serve the best interests of society and can act on behalf of a collective group
against a creator of negative externalities (since collective action on the part of
the victims may result in such high transaction costs so as to make bargaining
impractical)
 Example: Theodore Roosevelt and the US government (Department of
Justice)vs. J.P. Morgan in 1902 (stopped the consolidation of railroad
companies)
Private Goods—Excludable and Rival
 Example: Practically anything produced for profit. Ice Cream Cone.
 Problem: Externalities (a.k.a. “Market Failure”)
Market Failure – When the allocation of goods and services in the free market
is inefficient, resulting in overproduction (negative externality of production),
underproduction (positive externality of production), over-consumption
(negative externality of consumption), under-consumption (positive
externality of consumption)
 “Spillover Costs” – Too much is produced or consumed
 “Spillover Benefits” – Too little is produced or consumed

 Solution: Internalize the Externality (all measures (public or private) that

guarantee that unpaid benefits or costs are taken into account in the composition of
goods and services prices)
 Merit Goods
 A good or service whose consumption or production is considered
healthy and socially desirable, leading to spillover benefits
 NOTE: All positive externalities are caused by merit goods/services,
but not all merit goods/services cause positive externalities
 o Example:
  Merit Good: Vaccine when consumed only by one person
 Positive Externality: Vaccine consumed by a large population
 Example: Healthcare, Education, Vaccines
 Demerit Goods
  A good or service whose consumption or production is considered
unhealthy, degrading, or otherwise socially undesirable leading to
spillover costs.
 Example: Cigarettes. Alcohol
  NOTE: All negative externalities are caused by demerit
goods/services, but not all demerit goods/services cause negative
externalities
 Example:
  Demerit Good: Alcohol when consumed excessively while alone in one’s
own home
 Negative Externality: Alcohol when consumed while driving
 Questions
 (a) What is a merit good?
A good or service with strong positive externalities of consumption and / or production.
 (b) Identify some examples of merit goods that provide obvious positive
benefits to any society.
merit goods - provision of food stamps to improve nutrition, subsidised housing, education
and health services
 (c) Why are many merit goods under demanded (relative to the social
optimum level of production), in free market systems?
By definition, all merit goods are likely to be undervalued and relevant to the socially
optimum level of consumption level. This is because consumers consider only their own
private benefit (utility) and not the benefits (or costs) enjoyed by other third parties.
 (d) What other reasons does the video give to explain why many merit goods
are provided by governments?
Providing merit goods is often a more popular way of redistributing income than doing so
via taxation and welfare benefits? Other reasons identified include the dangers of addiction
or other socially undesirable consumption such as prostitution or pollution.
https://www.youtube.com/watch?v=jLtEkEJco-o&t=2s
 Market Failure
 The inefficient allocation of resources (when DWL is
present because MC is not equal to Price/Demand).
 This results in “externalities” due to overproduction,
overconsumption, underproduction, or under-consumption of
a good or service.

 This often occurs due to imperfect information being received,

leading to consumers and producers making “bad” choices
 This is where “Nudge Theory” becomes useful
 Externalities
 The uncompensated impact of a positive or negative
transaction on the well-being of a bystander(the third
party).
 1st Party: Producers
 2nd Party: Consumers
 3rd Party: Bystanders (general public that neither produces
nor consumes the good or service)
MPB (Marginal Private Benefit)
 The additional benefit received by an individual or firm from the consumption of a good or
service
 This is the Demand Curve

MSB (Marginal Social Benefit)

 The additional benefit received by society as a whole from the consumption of a good or service
 This is the Demand Curve

MPC (Marginal Private Cost)

The additional cost incurred by an individual or firm from the production of a good or service (also
known as marginal production costs)
 This is the Supply Curve

MSC (Marginal Social Cost)

 The additional cost incurred by society as a whole from the production of a good or service
 This is the Supply Curve

Social efficiency
 This occurs when the resources in an economy are used in the most efficient way possible and
are represented by the output level where the social marginal costs = the social marginal
benefits of production.
 Activity
 What are the spillover costs associated with flu shots? And why does this
represent a market failure in free market systems?

The spillover costs associated with the under consumption of flu shots is that when an
individual receives the jab they are protected from catching the disease. This is an
obvious marginal private benefit to them and the reason why many people are
prepared to pay the market price for the shot. However, in receiving the jab they not
only protect themselves against the flu but also anybody else who might otherwise
come into contact with them - a marginal social benefit.
When an insufficient number of people receive the flu shots this creates spillover
costs for the society and this represents a market failure, because the number of
people receiving the shot is equal to MPB and not the MSB.

 https://www.youtube.com/watch?v=hvMAec06_Uo&t=4s
 Activity: Education
 The diagram to the left illustrates the market for a merit good, education in a
free market.
 (a) What are the private benefits of a university education?
Enhanced future financial and career prospects.
 (b) What are the social benefits to society of university education?
Society benefits from a better educated and hence more productive workforce.
 (c) In a free market how many students will enter university and what level of
tuition would be charged?
Q1 students paying P1, where the marginal private benefit equals the marginal
private cost.
 (d) What is the socially optimum level of students receiving a university
education?
 Q2, where the marginal social benefit equals the marginal social cost.
Internalizing the Externality
 If there are no externalities present, then MPC = MSC for
production, or MPB = MSB for consumption
 How to reduce or eliminate negative externalities, or increase
positive externalities
 How to reduce overconsumption or overproduction
 How to increase underconsumption or underproduction
 Making a change to an individual or firm’s private benefits or
costs in order to make them equal to the individual or firm’s
social benefits or costs e.g charging polluters the damage cost
of the pollution generated
 Negative Externality of
Production (Overproduction)
 Definition: When the production of a good or service creates spillover
costs to bystanders (3rd Party)
  Example: MINING. Clayton, Idaho molybdenum mine leaks copper
sulfate and arsenic into the Salmon River fromits mining tailings. The
mine benefits because it reduces production costs on disposal.
Consumers benefit because the molybdenum produced has a
resulting lower price. The public at large (society) suffers the cost due
to the resultingpollution causing undrinkable water and unbreathable
air.
 Overproduction reduces common pool resources (overfishing,
overmining, etc.)
Explanation
If NEP is in the form of the production of molybdenum, society would
benefit if less was produced(overproduction is currently present). The
line “MPC” represents the marginal private cost which represents the
additional costs incurred by the individual due to the production of the
good. The line “MSC” represents the marginal social cost which are the
costs incurred by society as a whole result of the production of that
good. “MSC” is greater than “MPC” which shows that there is a negative
externality of production (NEP), as the costs to society are greater than
the costs to the individual. These “spillover costs” of production are
evident in the area of Social Welfare Loss (SWL) which would take the
form of mining pollution which would result in negative health impacts
due to a population drinking polluted water, or breathing polluted air.
Solution
 To reduce or eliminate the SWL, government can intervene to impose an indirect
tax on the production of molybdenum. This tax would shift the supply curve to
the left (S=MSC+Tax). This would decrease the quantity supplied and demanded
to Qso. The area of tax revenue lies between Pso (the price paid by consumers)
and P4 (the price received by producers), and 0 and Qso. P3 represents the MSC
that exists at Qe before the indirect tax is implemented. Unfortunately, the
implementation of this indirect tax creates deadweight loss (DWL), which
represents the loss of surplus to both producers and consumers.
 Also, international environmental agreements can be used to diminish NEP for
common pool resources (Paris Accords, Kyoto Protocols, etc.)
 Tradable permits (“Cap and Trade” via Assigned Amounts Units (AAUs) or
“carbon permits. These are adjusted downward annually)—How to monitor
emissions? Strength of punishments? Are the limits enough to result in
reduction of NEP? Would companies simply absorb the costs and not change
their production habits?
 Pigouvian Taxes
 Named after economist Arthur Pigou whose work on welfare economics just prior
to World War I effectively set governmental policy concerning externalities
 Taxes placed on private firms that create negative externalities in the belief that the
added tax burden will dissuade further production of negative externalities
 These are found to be of greater value and more effective than simple regulation.
Regulation requires government oversight of production whereas taxes simply
require monetary expenditure until the firm being taxed proves it has reduced the
offending negative externality
 This effectively places a price on the negative externality
 NOTE: Pigouvian Taxes are not like other Taxes in that there is no deadweight loss. In
fact, Pigouvian Taxes are designed to encourage market efficiency and eliminate the
deadweight loss incurred by negative externalities of production
 In essence, the government places large taxes on all producers, who then must prove
that they are reducing their carbon emissions in order to have their taxbburden reduced.
 Pigouvian Taxes
 A Pigouvian tax places a price on pollution, which effectively makes the supply
curve totally elastic, whereas as demand is downward sloping. The equilibrium
point identifies the quantity of pollution
 Example: Carbon Emission Taxing and the suggested purchase of emission rights
between economic actors.
 Example: Pollution Permits effectively makes the supply curve totally inelastic, as
the number of permits issued is finite. With demand still downward sloping, the
equilibrium point still identifies the quantity of pollution
 Example: Gas Taxes. Higher taxes result in reduced congestion via incentive to
use public transportation. Higher taxes lead to more smaller/efficient cars being
purchased. Higher taxes leads to less driving which diminishes pollution
Pigouvian Taxes - Evaluation
 Advantages
 The decrease in production would result in the decrease or elimination of the negative
externality
 (social welfare loss SWL)
 Identify the type of SWL that is apparent (examples)—what is “bad” about overproduction of
certain goods/services
 This is called “internalizing the externality”

 Disadvantages
 The imposition of a tax would create market inefficiency in the form of DWL (Deadweight
Loss) in which less is produced, less is consumed, and the government cannot tax this
missing amount. In other words, there is a loss of surplus to both consumers and
producers.
 Ultimately, the decision to implement such an indirect tax is based on the analysis of
whether the elimination/reduction of negative externality (SWL) is equal to, grater than, or
less than the market inefficiency that is imposed (DWL).
Activity
Market failure in the market for private cars
The diagram to the right illustrates the market for petrol in an
unregulated market.

(a) Explain why the consumption of petrol is above the socially

optimum level of Qso.
At each output level above Qso the MSC of production is greater than the
MSB.
(b) Explain why in an unregulated market the market for fuel will
also represent a market failure?
When a car owner drives their car he / she (and passengers) receive the
exclusive benefits from their consumption through increased utility. However,
the costs are paid by both the car driver and third parties which the car owner
does not consider when making their consumption decision.

(c) Explain why some third parties suffer as a result of the

purchase.
Third parties suffer because the already crowded city has one more car
clogging up the roads plus the car will take up a valuable parking space.
 The government decides to try
and correct the market failure
by imposing a tax on petrol
sales, equal in size to the
negative externality, in the hope
that car owners may use their
cars less often.
https://www.youtube.com/watch?
v=pGGmKi4y0kA
Watch the videos and answer the following questions

1. Why is the absence of a comprehensive metro system an example of market

failure?
The absence of a more comprehensive metro system increases the number of car,
taxi and bus journeys made in the city to a level beyond the equilibrium level.
2. Explain how an electronic road pricing scheme might help reduce the externality
caused by excessive car consumption in the city?
An electronic pricing system, as used in London or Singapore might help reduce
the volume of cars on the cities roads closer to the socially optimum level, leading
to less congestion. Such a policy would increase the cost of each car journey to a
price closer to the marginal social cost.
 (b) The government also decides
as part of its commitment reduce
the number of private cars on the
roads, to invest in a government
education campaign. They hope
that this will encourage
consumers to leave their cars at
home and instead use public
transport. How would this be
illustrated on a supply and
demand diagram? Is this policy
likely to be effective?
Explain why the overproduction of a demerit good is an
example of market failure. [10 marks]

1. Define Market failure, NEP and demerit

2. Choose a real world example of the overproduction of a
demerit goods, give some statistics which indicate that this
has led to Negative Externality of Production.
3. Draw a diagram showing the impact of an indirect tax on
the demerit good explain your diagram ( refer to example
diagram explanation and solution given)
4. Evaluate the indirect tax (advantages and disadvantages)
Positive Externality of
Production (Underproduction)
 https://www.youtube.com/watch?v=lb1fnodI3YU
Positive Externality of
Production (Underproduction)
Definition: When the production of a good or service creates spillover
benefits to bystanders (3rd Party)
 Example: SPORTS STADIUM. The construction of Safeco Field
(Baseball) in downtown Seattle created spillover benefits to the
businesses proximal to the new stadium, and enhanced building
technology due to the revolutionary retractable roof.
 o NOTE: Vaccines can also be used here (and can also be used for
positive externality of consumption)
 o NOTE II: Alternative “Green” production methods (solar, wind, wave,
etc.)

 Video: You Tube: “Origin of Safeco Field” (3.28 mins)

 Explanation
If PEP is in the form of the production of a football stadium, society would benefit if
more was produced(underproduction is currently present). The line “MPC”
represents the marginal private cost which represent the additional costs incurred
by the individual due to the production of the good. The line “MSC” represents the
marginal social cost which are the costs incurred by society as a whole result of the
production of that good. “MPC” is greater than “MSC” which shows that there is a
positive externality of production (PEP), as the costs to the individual are greater
than the costs to society. These “spillover benefits” of production are evident in the
area of Social Welfare Gain (SWG) which would take the form of increased business
activity surrounding the stadium and increased sales tax revenue received by the
state.
  NOTE: In this example this means that the cost of production of the football
stadium is greater to the individuals (taxpayers and attendees) than the cost to
society, which did not have to suffer the majority of the production costs.
 Solution
 To capture this SWG, government can intervene through the
application of a subsidy. This subsidy would shift the supply
curve to the right (S=MSC+Subsidy). This would increase the
quantity supplied and demanded to Qso and the cost of the
subsidy lies between Pso (the price paid by the consumers) and
P3 (the price received by the producers), and 0 and Qso. P4
represents the MSC that exists at Qe before the subsidy is
applied. Unfortunately, the subsidy creates deadweight loss
(DWL), which represents the opportunity cost to society in the
form of money paid to producers from government that did not
add to the SWG and could have been used for other social
purposes (e.g. roads, bridges, education).
  Another solution is government’s direct provision of the good
or service (NHS, public schools)
Evaluation
Advantages
 The increase in production would result in the capture of the positive externality
(potential Social Welfare Gain SWG)
 Identify the type of SWG that is apparent (examples)—what is “good” about producing
more of this certain good/service
 This is called “internalizing the externality”

Disadvantages
 The imposition of a subsidy would create market inefficiency in the form of DWL
(Deadweight Loss) in which more is produced, but the cost of the subsidy is less than
the benefit received by the producer and consumer.
 This represents an opportunity cost, as the wasted money could have been spent on other
public goods or services
Ultimately, the decision to subsidize is based on the analysis of whether the capture of
the positive externality (SWG) is equal to, greater than, or less than the market
inefficiency that results (DWL).
Evaluate the policies that a government
might use to deal with the market failure
associated with the production of merit
goods. [15 marks]
1. First paragraph – choose a positive externality of production and describe the
benefits it brings to society. Give some relevant information/statistics explaining
why it is important
2. Paragraph 2 – define merit goods, market failure, PEP (spillover, under
production)
3. Paragraph 3 Explain why there is market failure and how to capture the social
welfare gain (SWG). Define MPC and MSC. Choose a method of government
intervention e.g subsidy and explain how this will help. Explain your diagram.
4. Paragraph 4 Explain the disadvantages of the chosen government
intervention (for subsidy deadweight loss)
5. Paragraph 5 Evaluation of the positives and negatives of these action
 Negative Externality of Consumption
(Overconsumption)
 Definition: When the consumption of a good or service creates spillover costs
to bystanders (3rd Party)
 Example: CIGARETTES, ALCOHOL. The consumption of cigarettes and alcohol
leads to the deterioration of the health of the individuals as well as those who
are proximal to them (second-hand smoke, drunk driving).

Video: You Tube: “Anti Smoking Commercial” (1.33 mins)

Video: You Tube: “Never Drink and Drive” (1.00 mins)
 Explanation
If NEC is in the form of the consumption of cigarettes, overconsumption of this
good/service is occurring, and society would benefit if less was consumed. The line
“MPB” represents the marginal private benefit, which is the additional benefit received by
the individual due to the consumption of the good. The line “MSB” represents the
marginal social benefit which are the benefits received by society as a whole as a result
of the consumption of that good. “MPB” is greater than “MSB”, which shows that there is
a negative externality of consumption, as the benefits to society are less than the
benefits to the individual. These “spillover costs” of consumption are evident in the area
of Social Welfare Loss (SWL) which would take the form of increased incidents of
medical complications (liver and lung damage), as well as incidents of drunk driving
(alcohol) and negatively impacting bystanders through second-hand smoke (cigarettes).
 Solution

 To reduce or eliminate the SWL, government can intervene through producing

public service announcements (PSAs / advertisements) identifying the negative
effects of consuming alcohol and cigarettes. This effort would shift the demand
curve left (D=MSB) resulting in the decrease of the quantity demand supplied of
these products to the social optimal price and quantity consumed (Pso, Qso).
P3 represents the value of the current benefit to society, which is less than the
benefit to the individual consumer.
 Evaluation

 Advantages
 The decrease in consumption would result in the decrease or elimination of
the negative externality (Social Welfare Loss SWL). Additionally, there is no
government intervention, so there is no economic inefficiency created
(DWL).
 This is called “internalizing the externality”

 Disadvantages
 Public Service Advertising is notoriously ineffective and would likely not
cause much of a decrease in the demand for cigarettes and alcohol.
Diagram #2: (Indirect Taxation)—This
shifts both Supply and Demand curves
 Video: You Tube: “Cigarette Tax Increase” (2.17 mins)
 Explanation
 IF NEC is in the form of the consumption of cigarettes,
overconsumption of this good/service is occurring, and society would
benefit if less was consumed. The line “MPB” represents the marginal
private benefit, which is the additional benefit received by the
individual due to the consumption of the good. The line “MSB”
represents the marginal social benefit which are the benefits received
by society as a whole as a result of the consumption of that good.
“MPB” is greater than “MSB”, which shows that there is a negative
externality of consumption (NEC), as the benefits to society are less
than the benefits to the individual. These “spillover costs” of
consumption are evident in the area of Social Welfare Loss (SWL)
which would take the form of increased incidents of medical
complications (liver and lung damage), as well as incidents of drunk
driving (alcohol) and negatively impacting bystanders through
second-hand smoke (cigarettes).
 Solution
 To reduce or eliminate this SWL, governmental advertising the negative health
effects of cigarette and alcohol consumption could occur, but his effort would
not be very effective. However, if the government would intervene in the form of
an indirect tax placed on the production of these products, this would shift the
supply curve to the left (S=MSC+Tax). ). This would decrease the quantity
supplied and demanded to Qso. The area of tax revenue lies between Pso (the
price received by producers) and Pc (the price paid by consumers). P3
represents the MSB that exists at Qe before the indirect tax is implemented.
Another solution is legislation/regulation (banning, or rationing – NYC and large
sodas)
 Evaluation
 Advantages
 More tax revenue for government which could be allocated to other public
goods/services
 The decrease in consumption would result in the decrease or elimination of the
negative externality (social welfare loss SWL)
 This is called “internalizing the externality”

 Disadvantages
 The imposition of a tax would create market inefficiency in the form of DWL
(Deadweight Loss), which represents the loss of surplus to both producers and
consumers. Additionally, the imposition of this indirect tax would not eliminate the
SWL due to the addiction of some of the consumers to these products (inelastic
demand).
 Ultimately, the decision to implement an indirect tax is based on the analysis of
whether the elimination/reduction of negative externality (SWL) is equal to, more
than, or less than the market inefficiency that is imposed (DWL).
Explain how the problems of negative externalities of consumption could be
resolved by the use of indirect taxation? [10 marks]
 Definition of negative externalities of consumption. Describe the negative externalities
to society of your chosen product due to overconsumption and how it creates a SWL
 Definition of indirect taxation
 Diagram to show a negative externality of consumption being abated by the use of
indirect taxation
 Explanation of diagram
 Examples of (demerit) goods, with negative externalities of consumption, which are
subject to indirect taxes
 Evaluation:
 Advantage: SWL is reduced or eliminated
 Advantage: Revenue received by government could be used to dissuade the market
from further consumption of the good/service.
 Disadvantage: DWL resulting from imposition of indirect tax (inefficiency)
 Disadvantage: May be ineffective due to the inelastic demand evident in the
good/service.
Positive Externality of Consumption
(Underconsumption)
 Definition: When the consumption of a good or service creates
spillover benefits to bystanders (3rd Party)
 Example: EDUCATION. HEALTHCARE. VACCINATIONS. The
consumption of education leads to a more productive workforce that
is also more tolerant, which diminishes crime and violence, and
improves the general standard of living in society.

Video: You Tube: “Go On Idaho – Public Service Announcement” (1.02

mins)
Video: You Tube: “Go On Idaho (campaign failure)” (1.02 mins.)
Diagram #1 (Advertising)
 Explanation

 If PEC is in the form of the consumption of education, society would benefit if

more was consumed (underconsumption is currently present). The line “MPB”
represents the marginal private benefit which represent the additional benefit
received by the individual due to the consumption of the good. The line “MSB”
represents the marginal social benefit which are the benefits received by
society as a whole due to the consumption of the good. “MSB” is greater than
“MPB” which shows that there is a positive externality of consumption (PEC), as
the benefits to society are greater than the benefit to the individual consumer.
These “spillover benefits” of consumption are evident in the area of Social
Welfare Gain (SWG) which would take the form of a more educated, tolerant,
and productive labor force.
 Solution

 To capture this SWG government can intervene through producing public

service announcements (PSAs /advertisements) explaining the benefits of
being more educated. This effort would shift the demand curve right (D=MSB)
resulting in the increase of the quantity demand and supplied of these products
to the social optimal price and quantity consumed (Pso, Qso). P3 represents
the value of the current benefit to society, which is greater than the benefit to
the individual consumer.
 Evaluation

Advantages
 The increase in consumption would result in the capture of the SWG.
Additionally, there is no government intervention in the form of subsidization, so
there is no economic inefficiency created (DWL).
  This is called “internalizing the externality”

Disadvantages
 Public Service Advertising is notoriously ineffective and would likely not cause
much of an increase in the consumption of education services.
  Diagram #2 (Subsidies)-- This shifts both
Supply and Demand curves

 o Video: You Tube – “Medical Science Conquers Polio (1955)” (1.57 mins)
 o Video: You Tube – “Could You Patent the Sun?” (1.02 mins)
 Diagram #2 (Subsidies)-- This shifts both
Supply and Demand curves
  Explanation
 If PEC is in the form of the consumption of education, society would benefit if more
was consumed (underconsumption is currently present). The line “MPB” represents
the marginal private benefit which represent the additional benefit received by the
individual due to the consumption of the good. The line “MSB” represents the
marginal social benefit which are the benefits received by society as a whole due to
the consumption of the good. “MSB” is greater than “MPB” which shows that there
is a positive externality of consumption (PEC), as the benefits to society are greater
than the benefit to the individual consumer. These “spillover benefits” of
consumption are evident in the area of Social Welfare Gain (SWG) which would
takethe form of a more educated, tolerant, and productive labor force.
 Solution
 To capture this gain advertising the positive health effects of
vaccine consumption could occur. Unfortunately,
advertising is not very effective, and Qso is unlikely to be
obtained through advertising. In order to increase
consumption, government can intervene through the
application of a subsidy. This subsidy would shift the supply
curve to the right (S=MSC+Subsidy). This would increase
the quantity supplied and demanded to Qso and the cost of
the subsidy lies between Pso (the price received by
producers) and P4 (the price paid by consumers).
  Also, legislation requiring consumption (Obamacare)
  Evaluation
Advantages
 The increase in consumption would result in the capture, or attainment of
the potential social welfare gain SWG. This is called “internalizing the
externality”

Disadvantages
 Unfortunately, the subsidy creates deadweight loss (DWL), which
represents the opportunity cost to society in the form of money paid to
producers from government that did not add to the SWG and could have
been used for other social purposes (e.g. roads, bridges, education).
 Ultimately, the decision to subsidize is based on the analysis of whether
the elimination/reduction of positive externality (SWG) is equal to, greater
than, or less than the market inefficiency that is imposed (DWL).
1. Discuss whether advertising by the
government is the most appropriate way of
increasing
consumption
1 paragraph – Discuss aof
st
reala merit
world examplegood. [15being
of a merit good marks]
underconsumed
and explain why this has happened (e.g Russian governments failure to share its
research leads to a distrust of the Russian Vaccine for Covid 19 by the Russian public)
2nd paragraph – definition of a merit good and State how PEC leads to spillover benefits
positive externalities to society
Diagram of subsidy capturing the SWG
3rd paragraph – What is the SWG from your merit good example? How can it be
captured? Define MPB AND MSB. State how it is possible to increase demand
(D=MPB) through an advertisement campaign but that it is ultimately ineffectual as
evidence by the continued underconsumption. A subsidy would be more effective
4th paragraph- Describe the diagram
5th paragraph -evaluation of the advantages and disadvantages of the advertisement
and subsidy methods
6th Briefly describe another alternative e.g direct provisions of goods by the
governments i.e free vaccinations
 Asymmetric Information)—HL Only
 Asymmetric Information as Market Failure (Supply) –
“Adverse Selection” – When one party to an economic transaction possesses greater knowledge
than the other party. The resulting market failure occurs before the economic transaction is made.

Q. How can this lead to negative/positive externalities of

production/consumption?
Cigarettes 100 years ago
Used car sales man
Insurance fraud
Negative Externality of Production as
Adverse Selection

The seller knows more than the buyer about the good/service being produced .
This leads to overproduction (less would be consumed if the buyers had the
same information as the seller)
 Example #1: Cigarettes (nicotine as an addictive substance)
 Example #2: Selling of CDOs (Collateralized Debt Obligation) knowing the
risk to the consumer was greater than what was explained.
Video: Movie Clip: “The Big Short” (29.00 – 35.00 mins)
 Example #3: Mechanic fixing your car or selling a used car
 Solution: “Signaling” – When the producer signals the value of the product by
offering guarantees or warranties. Also, government regulation and oversight
Video: You Tube: Almanac: Cigarette Warning Labels (2.07 mins)
 https://consterrect.monster/movies/play/the-big-short-2015?
mid=17&sid=&sec=e90891eb7e4f780588210359bf9ea978de59588e
&t=1674199566
 Positive Externality of
Production as Adverse Selection
 The seller knows more than the buyer about the good/service being produced
This leads to underproduction (more would be consumed if the buyers had the same
information as the seller)
 Example: CHIPS (Children’s Health Insurance Program)
Video: YouTube: CHIP expiration affecting thousands of Idaho kids (1.43 mins)
 Solution: Activists advertising this existence
Negative Externality of Consumption
as Adverse Selection
 The buyer knows more about what is being consumed than the seller.
 This leads to overconsumption (less would be produced if the seller
had the same information as the buyer)
 Example #1: MNC buying resources from LDCs
 This was the plot behind the James Bond film, “Quantum of Solace”
 Example: Health Insurance for those who are extreme smokers (the
patient knows their existing health risks, but will not divulge this to the
insurance company)
 Solution: “Screening”—Attempts by the producer to gain more
information through questioning the potential consumer
Positive Externality of Consumption
as Adverse Selection
 The buyer knows more about what is being consumed than the seller
 This leads to underconsumption (more would be produced if the seller had the
same information as the buyer)
 Example #1: Finding a Picasso at a garage sale
 Example #2: Microsoft licensing DOS to IBM (not selling it)
 Video: You Tube: “Pirates of Silicon Valley IBM Scene” (2.57 mins)
 Solution: Better market research