Market Failure Market failure exists when the market forces of demand and supply do notpro de the optimum resource allocation. Market failure may occur because of four diﬀerent reasons one of which isthe existence of externalities. Externalities: ● The eﬀects of a decision made by consumers and/or producers thatimpact upon a third party (deﬁnition). ● The existence of these will cause market failure to a greater or lesserdegree if le uncontrolled. ● Positive externalities are external beneﬁts to a third party resultingfrom one’s production or consumption of a good or ser ce. ● Negative externalities are external costs to a third party resultingfrom one’s production or consumption of a good or ser ce. ● The third party consists of anyone who is not directly involved in theproduction or consumption of the good or ser ce in question. Examples: ➔ Healthcare has external beneﬁts: ◆ It prevents a work force from sickening and so decreasing inproducti ty. ◆ Vaccinations against contagious diseases prevent friends andclose associates of the vaccinated person from contacting thesaid disease from the aforementioned vaccinated person. ➔ Education has external beneﬁts: ◆ Allows people to understand writing. ◆ Lowers the tendency towards olence exhibited in some youngpeople. ➔ 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 incurredby the entirety of society (producer, consumer and third party) as aresult of the production and/or consumption of a good or ser ce. ➔ Private costs and beneﬁts are the costs and beneﬁts incurred byindi duals directly involved in the production and/or consumption ofa good or ser ce. ➔ Where no market failure exists social costs would be equal to privatecosts etc. ➔ If external beneﬁts exist more of the said good should be producedand consumed (it is being under-produced or under-consumed) thusthe market system is not supplying the optimum resource allocation. ➔ If external costs exist, then less of the said good should be producedand consumed (it is being consumed or produced in excessivequantities) thus the market system is not supplying the optimumresource allocation. ➔ Firms and indi duals will not consume/produce any good or ser ceunless the private beneﬁt of their acti ty exceeds the private costincurred by their acti ty. Others: ➔ External costs and beneﬁts are weighed before regulation. ➔ If something cannot be outlawed eﬀectively then the government maychoose to legalize it to control it and gain revenue from it throughheavy taxation. Firms and Externalities: ➔ Firms will produce goods given that they earn more revenue thanwhat costs them to produce the said good (private beneﬁt > privatecost); in such a circumstance externalities are ignored. ➔ When external costs are ignored the product is produced andconsumed in quantities that are greater than what is socially
desirable simply because they are being produced and consumed inthe quantities present in such a situation. ◆ When this happens the good is over-produced andover-consumed. (It results from the fact that it would be morebeneﬁcial for ﬁrms and consumers to do so.) ➔ When external beneﬁts are ignored the product is produced andconsumed in quantities that are less than what is socially desirablefor that said product: ◆ This is because a ﬁrm or consumer would have no reason toproduce or consume more of that good as doing so would eitherdrive up supply or demand which both result in decreasedprices and so decreased proﬁts or increased prices forconsumers. ◆ At the same time, consumers would have no reason to consumemore of the said good because of the cost they themselves willincur as a result of their consumption. ◆ When this happens under-production occurs as well asunder-consumption. (It results from the fact that ﬁrms andconsumers cannot beneﬁt directly from external beneﬁts). Government Intervention: ➔ The government will make sure that: ◆ Merit goods (goods with EBs) are encouraged (to preventunder-consumption or under-production from occurring.) ◆ Demerit goods (goods with ECs) are discouraged (to preventover-consumption or over-production from occurring.) ➔ Demerit goods do not have prices which account for their externalcosts. ◆ Smoking and alcohol are examples of demerit goods. ➔ The government will: ◆ Subsidize merit good producers to reduce the costs ofproduction and thereby encourage production of such goodswhilst causing prices to be lowered as a result of the increase insupply.
◆ Tax demerit good producers to increase the costs of productionand thereby discourage production of such goods whilstcausing prices to increase as a result of the decrease in supplycaused by taxations. ◆ Sometimes the government may choose to nationalize certainindustries that are producing externalities to regulate andcontrol them and so force them to produce at the sociallyoptimum level. ◆ Laws and regulations – Limits on the level of emissions ofcertain chemicals through use of the law and a ﬁning system topunish ﬁrms for infringement. ◆ Ban on the use of certain chemicals which may result insigniﬁcant external costs through use of the law and a ﬁningsystem to punish any infringement. ◆ Forcing ﬁrms to internalize all costs: ● Pollution permits (these can be traded to ﬁrms who canthen pollute more at a reasonable price). ● Pollution permits are given out to ﬁrms by thegovernment before any trading is done. (Equivalent andderived from the Carbon Credits used internationally torestrict national pollution). ● But this scheme is costly (administration costs are high)to implement, it is diﬃcult to measure pollution levelsaccurately, rich ﬁrms may simply buy their permits oﬀpoorer ﬁrms and so pollution may not have beendecreased at all, it is hard to calculate how manypollution permits to give out. ➔ If external beneﬁts exist than the government would be willing to paymore for a certain good to assure that it is produced at the sociallyoptimum level. (Increase in demand, extension along the supplycurve): ◆ Speculation. ➔ If external costs exist that the government would be willing to paymore to assure that it is produced at the socially optimum level.(Decrease in supply, contraction along the demand curve.):
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Understanding Market Failure: Externalities and Government Intervention