Market Failure – Externalities
Topic Fifteen

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An externality is a benefit that is enjoyed by a third-party or a loss incurred by a third-party as a result of an economic transaction. Third-parties include any individuals and organizations that are indirectly affected. While individuals who benefit from positive externalities without paying are considered to be free-riders, it may be in the interests of society to encourage free-riders to consume goods which generate substantial external benefits. Unlike the case of negative externalities, which should be discouraged to achieve a socially efficient allocation of scarce resources, positive externalities should be encouraged. Therefore, there are positive and negative externalities. A positive externality occurs when a third party gains as a result of production. Examples of positive externalities are health care, security and education. A negative externality is a cost that is suffered by a third party as a result of an economic transaction. Examples of negative externalities are alcohol, smoking of cigarettes and pollution.

Positive Externalities in Production

A positive production externality occurs when a third party gains as a result of production. At Q0 (free market allocation), which is without the subsidy and which is the free market point, marginal private benefit equals marginal private cost. With the subsidy to encourage the positive externality, marginal social cost falls and output increases to Q1 (the socially efficient allocation) where the marginal social benefit equals the marginal private benefit as can be seen in the following graph. The triangle ABC represents the welfare loss to society as a result of under producing at Q0. When output is increased to Q1, the loss is eliminated which is sometimes referred to as a welfare gain.

Figure 1

Positive Externalities in Consumption

A positive consumption externality occurs when consuming a good gives a benefit to others. For example, attending university gives benefit to rest of society where you may be able to teach others. Because there is a benefit to others from your consumption, the social marginal benefit (SMB) is greater than private marginal benefit (PMB). In a free market, there will be under-consumption of goods with positive consumption externalities. Output in a free market will be at Q0, but social efficiency is at Q1 (where SMC = SMB) as can be seen in the following graph.. The triangle ABC represents the welfare loss to society by producing at the free market level or by under consuming the positive good. Output needs to be increased to Q1.

Figure 2

Encouraging Positive Externalities

There are two general approaches to promoting positive externalities: to increase the supply of, and to increase the demand for, goods, services and resources that generate positive external benefits.

Increasing Supply

  • Government grants and subsidies to producers of goods and services that generate external benefits will reduce costs of production, and encourage more supply.
  • Public goods, such as roads, bridges and airports, also generate considerable positive externalities, and can be built, maintained and fully or partially, funded by the government.

Increasing Demand

  • Subsiding - demand for goods, which generate positive externalities, can be encouraged by reducing the price paid by consumers. For example, subsidizing the tuition fees of university students will encourage more young people to attend university which will generate a positive externality for future generations.
  • Provision of free information - Government can also provide free information to consumers to compensate for the information failure that discourages consumption. If individuals are fully informed about the benefits of consuming goods and services that generate external benefits, they may develop a better understanding of the product and they will demand more of it.

Negative Externalities in Production

A negative externality is a cost, by production or consumption, that is suffered by a third party as a result of an economic action or transaction. Examples of negative externalities include:

  • Loud music at night that can deny neighbours’s the night sleep,
  • The production of chemicals that can cause pollution.

Negative externalities in production make the marginal social cost (MSC) curve higher than the private marginal cost (MPC). In the following graph, the free market point is at A where the price is P0 and output is Q0. At this output level, the marginal social cost is higher than the marginal social benefit. With the intervention by the government to reduce the negative externality, output fall from Q0 to Q1 and price increases from P0 to P1. The welfare loss of the negative externality is ABC which is eliminated by the government intervention.

Negative Externality in Consumption

When certain goods are consumed, such as demerit goods, negative effects can arise on third parties. Common examples include cigarette smoking, which can create passive smoking and drinking excessive alcohol, which can cause vehicular accidents. When consumption takes place in the free market situation, output is Q0 with price being at P0 as can be seen in the following graph. The triangle ABC is the welfare loss as a result of consuming the demerit good at the free market output level. When the government steps in to reduce the consumption of this demerit good, consumption falls to Q1 and the welfare loss of ABC is eliminated.

Figure 3

Discouraging Negative Externalities

Discouraging Negative Production Externalities

There are some measures which the government can take in order to reduce the negative production externalities some of which are explained below.

Market based solutions- Market-based solutions is where the government can intervene through direct controls and regulations, such as:

  1. Taxing polluters.
  2. Subsidizing households or firms to be non-polluters, such as giving grants for home insulation improvements.
  3. Providing more information to consumers and producers.

Discouraging Negative Consumption Externalities

There are several measures which the government can take in order to address negative consumption externalities, including imposing indirect taxes, setting minimum prices and imposing fines for over-consumption.

Indirect taxes - the imposition of indirect taxes on consumption will have the effect of making these demerit goods such as cigarettes more expensive and this can have the effect of consumers reducing the use of cigarettes,

Fines - in terms of fines for the consumption of these demerit goods, fines such as for drunk driving can have the effect of citizens being more incline not to drink and drive and to designate a driver when they have too much of the demerit good to consume, in this case it is alcohol.

Next - Government Intervention