Market Failure - Externalities

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• Occurs when the actions of consumers or producers give rise to negative or positive side effects on others who are not part of these actions, and whose interests are not taken into consideration
• People (not involved in the economic transaction) feeling the effects of an externality are often referred to as “third parties”
• If these side-effects (spillovers) on third parties involve benefits, there arises a positive externality, also known as external benefit
• If they involve costs in the form of side-effects (spillovers), there arises a negative externality, also known as external costs
• Externalities can arise from either consumption activities (consumption externalities) or producer activities (producer externalities)
• There are 4 types of externalities
  1. Negative Production Externalities
  2. Negative Consumption Externalities
  3. Positive Production Externalities
  4. Positive Consumption Externalities
• Marginal External Cost (MEC): Additional cost incurred by third parties who are not involved in the consumption and production of additional unit of the good
• Marginal Social Cost (MSC): MPC + MEC; Additional costs incurred by society… additional unit of the good
• Marginal External Benefit (MEB): Additional benefit enjoyed by the third parties who are not involved in the consumption and production of additional unit of the good
• Marginal Social Benefit (MSB): MPB + MEB, Additional benefit accrued by society … for additional units of the good
• When MSB=MSC, social welfare is at a maximum

Negative Externalities

• In general, negative externalities, whether these arise from production or consumption activities, lead to allocative inefficiency arising from an overallocation of resources to the good and to its over-provision.

Negative Production Externalities

• Negative externalities of production refer to external costs created by producers
• The problem of environmental pollution, created as a side-effect of production activities, is very commonly analysed as a negative production externalities

Cement factory

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. This is shown in the Figure, where the supply curve, S = MPC, reflects the firm’s private costs of production, and the marginal social cost curve given by MSC represents the full cost to society of producing cement.

For each level of output, Q, social costs of producing cement given by MSC are greater than the firm’s private costs. The vertical difference between MSC and MPC represents the external costs. Since the externality involves only production (the supply curve), the demand curve represents both marginal private benefits and marginal social benefits. The Figure illustrates a general point that you should keep in mind whenever you examine (or draw) an externality diagram: the free market outcome is determined by the intersection of MPB and MPC, resulting in quantity $Q_m$ and price $P_m$. The social optimum (or ‘best’) outcome is given by the intersection of MSB with MSC, which determines quantity $Q_{opt}$ and price $P_{opt}$.

Welfare Loss

• Whenever there is an externality, there is a welfare (deadweight) loss, involving a reduction in social benefits, due to the misallocation of resources.
• In the Figure, the shaded area represents the welfare loss arising from the negative production externality.
• For all units of output greater than $Q_{opt}$, MSC > MSB, meaning that society would be better off if less were produced.
• The welfare loss is equal to the difference between MSC and MSB for the amount of output that is overproduced ($Q_m-Q_{opt}$).
• It is a loss of social benefits due to overproduction of the good caused by the externality
• If the externality were corrected, so that the economy reaches the social optimum, the loss of benefits would disappear.
• It may be useful to note that the point of the welfare loss triangle always lies at the $Q_{opt}$ quantity of output.

Negative Consumption Externalities

• Negative externalities of consumption refer to external costs created by consumers
• For example, when consumers smoke in public places, there are external costs that spill over onto society in the form of costs to non-smokers due to passive smoking
• Furthermore, smoking-related diseases result in higher-than-necessary health care costs that are an additional burden upon society
• When there is a consumption externality, the marginal private benefit (demand) curve does not reflect social benefits
• When there is a negative consumption externality, the free market overallocates resources to the production of the good, and too much of it is produced relative to what is socially optimum.
• This is shown by Qm > Qs and MSC > MSB at Qm in the figure.

Cigarette Smokers

• In the Figure, the buyers of cigarettes have a demand curve, MPB, but when smoking, create external costs for non- smokers
• These costs can be thought of as ‘negative benefits’, which therefore cause the MSB curve to lie below the MPB curve.
• The vertical difference between MPB and MSB represents the external costs.
• Note that since the externality involves consumption (i.e. the demand curve), the supply curve represents both marginal private costs and marginal social costs.
• The market determines an equilibrium quantity, Qm, and price Pm, given by the intersection of the MPB and MPC curves, but the social optimum is Qopt and Popt, determined by the intersection of the MSB and MSC curves.

Welfare Loss

• The welfare (deadweight) loss resulting from negative consumption externalities is the shaded area in the Figure, and represents the reduction in benefits for society due to the overallocation of resources to the production of the good.
• For all units of output greater than Qopt, MSC > MSB, indicating that too much of the good is produced.
• The welfare loss is equal to the difference between the MSC and MSB curves for the amount of output that is overproduced relative to the social optimum (Qm – Qopt).
• It represents the loss of social benefits from overproduction due to the externality. If this externality were corrected, society would gain the benefits represented by the shaded area.

Positive Externalities

• In general, positive externalities (external benefits), whether these arise from production or consumption activities, lead to an underallocation of resources to the good in question, and therefore to its underprovision.

Positive Production Externalities

• Positive externalities of production refer to external benefits created by producers
• If, for example, a firm engages in research and development, and succeeds in developing a new technology that spreads throughout the economy, there are external benefits because not only the firm, but also society, benefits from widespread adoption of the new technology
• Therefore, the social costs of research and development are lower than the private costs.

Example

• In the Figure, the MSC curve lies below the MPC curve, and the difference between the two curves is the value of the external benefits (these can be thought of as ‘negative costs’).
• The demand curve represents both MPB and MSB since the externality involves only production.
• 
• The market gives rise to equilibrium quantity Q m and price Pm, determined by the intersection of the MPB and MPC curves, while the social optimum is given by Qopt and Popt, determined by the intersection of the MSB with MSC curves.
• Since Qm < Qopt, the market underallocates resources to research and development activities that lead to new technologies, and not enough of them are undertaken.

Welfare Loss

• The underallocation of resources to the production of a good with a positive production externality leads to a welfare loss, shown in the Figure as the shaded area.
• This loss is equal to the difference between the MSB and MSC curves for the amount of output that is underproduced relative to the social optimum (Qopt – Qm).
• It involves external benefits for society that are lost because not enough of the good is produced. If the externality were corrected, society would gain the benefits represented by the shaded area.
• Note that the point of the welfare loss triangle lies at the Qopt quantity of output.

Positive Consumption Externalities

• When there is a positive externality of consumption, the free market under-allocates resources to the production of the good: too few resources are allocated to its production, and too little of it is produced.
• This is shown by Qm < Qopt and MSB > MSC at Qm
• When there is a positive externality of consumption, external benefits are created by consumers.
• For example, the consumption of education benefits the person who receives the education, but in addition gives rise to external benefits, involving social benefits from a more productive workforce, lower unemployment, higher rate of growth, more economic development, lower crime rate, and so on.
• Similarly, the consumption of health care services benefits not only the person receiving the services but also society and the economy, because a healthier population is more productive, enjoys a higher standard of living and may have a higher rate of economic growth.

Example

• In the Figure, we see that the marginal social benefit (MSB) curve lies above the marginal private benefit (MPB) curve, and the difference between the two consists of the external benefits to society.
• The socially optimum quantity, Qopt, is given by the point where MSB = MSC, and the quantity produced by the market is given by the point where MPB = MPC.
• Since Qopt > Qm, the market underallocates resources to education, and too little of it is produced.

Welfare Loss

• The welfare loss arising from a positive consumption externality is the shaded area in the Figure, and is the difference between the MSB and MSC curves for the amount of output that is underproduced relative to the social optimum (Qopt – Qm).
• It represents the loss of social benefits due to underproduction of the good.
• If this externality were corrected, society would gain the benefits represented by the shaded area.
• Once again, we see that the point of the welfare loss triangle lies at the Qopt quantity of output.

• When there is a positive consumption externality, the free market under-allocates resources to the production of the good, and too little of it is produced relative to the social optimum.
• This is shown by Qm < Qopt and MSB > MSC at Qm in the Figure.

Externalities

There are some points to bear in mind as you read about externalities

• 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)