Understanding Market Failure: Externalities and Government Intervention

Market Failure Market failure exists when the market forces of demand and supply do not provide the optimum resource allocation. Market failure may occur because of four different reasons one of which is the existence of externalities. Externalities: ● The effects of a decision made by consumers and/or producers that impact upon a third party (definition). ● The existence of these will cause market failure to a greater or lesser degree if left uncontrolled. ● Positive externalities are external benefits to a third party resulting from one’s production or consumption of a good or service. ● Negative externalities are external costs to a third party resulting from one’s production or consumption of a good or service. ● The third party consists of anyone who is not directly involved in the production or consumption of the good or service in question. Examples: ➔ Healthcare has external benefits: ◆ It prevents a work force from sickening and so decreasing in productivity. ◆ Vaccinations against contagious diseases prevent friends and close associates of the vaccinated person from contacting the said disease from the aforementioned vaccinated person. ➔ Education has external benefits: ◆ Allows people to understand writing. ◆ Lowers the tendency towards violence exhibited in some young people. ➔ Smoking has external costs: ◆ Passive smoking. Calculations: ➔ Social Costs = Private Costs + External Costs. ➔ Social Benefits = Private Benefits + External Benefits. ➔ Social costs and benefits are therefore the costs and benefits incurred by the entirety of society (producer, consumer and third party) as a result of the production and/or consumption of a good or service. ➔ Private costs and benefits are the costs and benefits incurred by individuals directly involved in the production and/or consumption of a good or service. ➔ Where no market failure exists social costs would be equal to private costs etc. ➔ If external benefits exist more of the said good should be produced and consumed (it is being under-produced or under-consumed) thus the market system is not supplying the optimum resource allocation. ➔ If external costs exist, then less of the said good should be produced and consumed (it is being consumed or produced in excessive quantities) thus the market system is not supplying the optimum resource allocation. ➔ Firms and individuals will not consume/produce any good or service unless the private benefit of their activity exceeds the private cost incurred by their activity. Others: ➔ External costs and benefits are weighed before regulation. ➔ If something cannot be outlawed effectively then the government may choose to legalize it to control it and gain revenue from it through heavy taxation. Firms and Externalities: ➔ Firms will produce goods given that they earn more revenue than what costs them to produce the said good (private benefit > private cost); in such a circumstance externalities are ignored. ➔ When external costs are ignored the product is produced and consumed in quantities that are greater than what is socially desirable simply because they are being produced and consumed in the quantities present in such a situation. ◆ When this happens the good is over-produced and over-consumed. (It results from the fact that it would be more beneficial for firms and consumers to do so.) ➔ When external benefits are ignored the product is produced and consumed in quantities that are less than what is socially desirable for that said product: ◆ This is because a firm or consumer would have no reason to produce or consume more of that good as doing so would either drive up supply or demand which both result in decreased prices and so decreased profits or increased prices for consumers. ◆ At the same time, consumers would have no reason to consume more of the said good because of the cost they themselves will incur as a result of their consumption. ◆ When this happens under-production occurs as well as under-consumption. (It results from the fact that firms and consumers cannot benefit directly from external benefits). Government Intervention: ➔ The government will make sure that: ◆ Merit goods (goods with EBs) are encouraged (to prevent under-consumption or under-production from occurring.) ◆ Demerit goods (goods with ECs) are discouraged (to prevent over-consumption or over-production from occurring.) ➔ Demerit goods do not have prices which account for their external costs. ◆ Smoking and alcohol are examples of demerit goods. ➔ The government will: ◆ Subsidize merit good producers to reduce the costs of production and thereby encourage production of such goods whilst causing prices to be lowered as a result of the increase in supply. ◆ Tax demerit good producers to increase the costs of production and thereby discourage production of such goods whilst causing prices to increase as a result of the decrease in supply caused by taxations. ◆ Sometimes the government may choose to nationalize certain industries that are producing externalities to regulate and control them and so force them to produce at the socially optimum level. ◆ Laws and regulations – Limits on the level of emissions of certain chemicals through use of the law and a fining system to punish firms for infringement. ◆ Ban on the use of certain chemicals which may result in significant external costs through use of the law and a fining system to punish any infringement. ◆ Forcing firms to internalize all costs: ● Pollution permits (these can be traded to firms who can then pollute more at a reasonable price). ● Pollution permits are given out to firms by the government before any trading is done. (Equivalent and derived from the Carbon Credits used internationally to restrict national pollution). ● But this scheme is costly (administration costs are high) to implement, it is difficult to measure pollution levels accurately, rich firms may simply buy their permits off poorer firms and so pollution may not have been decreased at all, it is hard to calculate how many pollution permits to give out. ➔ If external benefits exist than the government would be willing to pay more for a certain good to assure that it is produced at the socially optimum level. (Increase in demand, extension along the supply curve): ◆ Speculation. ➔ If external costs exist that the government would be willing to pay more to assure that it is produced at the socially optimum level. (Decrease in supply, contraction along the demand curve.): ◆ Speculation