Externalities

Market Failure

Market Failure

Refers to any situation when the price mechanism allocates scarce resources in an inefficient way. Market failure can result in overproduction of certain goods and services.

Private benefits

The gains of consumption and production enjoyed by an individual or firm or person.

Private costs

Of production and consumption are the expenses incurred by an individual firm or person.

Social benefits

The total benefits of consumption or production to society. It’s the sum of private benefits and external benefits

Social costs

The total costs of consumption or production to society. The sum of private costs and external cost

Externalities (spillover effects)

The external costs or benefits of an economic transaction, causing the market to fail to achieve the social optimal level of production or consumption.

Positive externalities

The benefits enjoyed by a third party not directly involved in an economic transaction. The production and consumption of public and merit goods exert positive externalities

Merit goods

Products that create positive externalities when produced or consumption.

Rivalrous

Means that consumption of a merit goods reduces the amount available to others at that point in time

Excludable

Means that it can be possible for suppliers to prevent non payers benefiting from the merit good

Negative externalities

Are expenses incurred by third parties in an economic transaction for which no compensation is paid. For example air pollution caused by factories.

Demerit goods

Products that create negative spillover effects to others in society. For example cigarettes, alcohol, and junk food.

Common pool resources

Are those that are non excludable but rivalrous in consumption and and create a situation of tragedy of the commons. They result in negative externalities

Tragedy of the commons

The degradation, depletion, or destruction of a common pool resource caused by the problems of rivalry and overuse

Government intervention

• Piggouvian tax

• Carbon tax

• Legislation and regulation

• Education campaigns

• Tradable permit

• Subsidies

Indirect tax

A form of intervention in response to negative externalities and common pool resources by taxing the producer or consumer in order to make them pay for the negative externalities of production and consumption. For example indirect taxes can be placed on cigarettes or alcohol.

Advantages of indirect taxes

• Increases the price of the product so the demand will decrease

• Creates tax revenue for the government

Disadvantages of indirect taxes

• The demand for these certain good tends to be price inelastic so the tax may have little impact

• The tax is regressive so it has a greater impact on low-income individuals than high-income individuals

• Can encourage smuggling and black markets

Carbon tax

A tax on greenhouse emissions in order to reduce pollution prom particular industries by internalizing negative externalities of production

Advantages of carbon tax

• Raises the cost of production for firms

• Encourages firms to invest in newer technology

• Government revenue

Disadvantages of carbon tax

• The effectiveness of the tax relies on the elasticity

• Some businesses may be unable to pay the tax so they might shut down

• Lay off workers in order to pay the tax

Tradable permits

Government-regulated emissions trading schemes that limit pollution in an industry to a more socially efficient level. Firms can sell their permit that they don’t use

Legislation

Refers to the laws on the use of scarce resources such as laws to protect marine life

Regulation

The management of complex rules, laws, and policies that firms need to comply with.

Advantages of legislation and regulations

• Individuals or firms may be fined/imprisoned for breaking the rules

• They help to reduce the external costs of demerit goods or harmful production activities

• Fines can generate extra government revenue

Disadvantages of legislation and regulations

• Enforcing laws requires the government to hire more people to work for the regulatory agencies

• Enforcing laws can be difficult as it is a complex process to determine if firms/consumersare breaking the laws

• The regulation may create underground (illegal) marketswhich could generate even higher external costs on society

Education campaigns

Raising awareness of the external benefits or costs associated with the consumption of a good/service is an effective long-term method of changing consumer behaviour

Advantages of education campaigns

• Education can create positive cultural changes

• Education can, over time, help improve the economic development within a country

• The amount governments spend in raising awareness is usually far less than the savingsthey generate in the long term

Disadvantages of educational campaigns

• It takes a long time to change behaviour through education

• There is an opportunity costassociated with the government spending on the education program 

• Demerit goods are often addictive and as a result, the change in behaviour takes longer

Subsidy

to encourage production/consumption of merit goods such as energy-efficient products, electric vehicles, healthcare, and education