Chapter 5, Market Failures

negative externalities

A negative externality is a cost imposed on an uninvolved third party as an indirect effect of someone else's economic production or consumption

public goods

a product or service that anyone can use without reducing its availability to others, and from which no one can be easily excluded

tehy are

• nonrival: the amount of any individual’s consumption does not diminish the amount available for others.

• nonexcludable: individuals cannot be prevented from enjoying a public good.

Because all individuals experience the same level of the public good, we must sum their marginal benefits when we consider the efficient amount of the good to provide.

tragedy of the commons

an economic and environmental concept where individuals use a shared, unregulated resource for personal gain, which ultimately destroys the resource for everyone

two conditions:

1. access to the resource must be unrestricted

2. diminishing marginal returns; as the number of people using the resource grows, the benefits from the resource must increase at a slower rate.

also considered collective action problem

externality

an externality results when the actions of one individual (or firm) have a direct, unintentional, and uncompensated effect on the well-being of other individuals or the profits of other firms.

Marginal damages

the additional economic harm or negative impacts caused by producing one more unit of a pollutant or engaging in an extra unit of a harmful activity

private marginal costs

Private marginal cost (MPC) is the direct additional expense incurred by a producer or consumer to make or consume one extra unit of a good

social marginal cost

the total cost to society of producing or consuming one additional unit of a good or service, combining both private and external costs.

the marginal social benefit of a private good must equal its price, ensuring an efficient outcome.

calculated by adding the private cost and the external damage together:

𝑆𝑀𝐶 =𝑃𝑀𝐶+𝑀𝐷

efficiency on externalities graoh

demand = social marginal cost

supply curve and market outcome uneffected by pollution damage

unregulated market equilibrium

greater than the efficient quantity

An unregulated market equilibrium is the price and quantity of a good where supply equals demand without any government rules or interventions

• Prices adjust freely until the amount buyers want equals the amount sellers offer.

• Producers look only at their own private costs and benefits, ignoring broader societal impact

a graph with a market with a negative externality.

curves:

• Demand: Represents the private benefit to consumers.

• Supply = PMC (Private Marginal Cost): The direct cost to the firm for producing each unit (e.g., labor, materials). An unregulated market only looks at this curve.

• MD (Marginal Damage): The external cost imposed on third parties (e.g., pollution, health costs). It increases as more units are produced.

• SMC (Social Marginal Cost): The true total cost to society. It is calculated by adding the private cost and the external damage together: 𝑆𝑀𝐶 =𝑃𝑀𝐶 +𝑀𝐷 Because of the damage, the SMC curve sits higher than the private supply curve.

outcomes:

• 𝑄𝑀 (Market Equilibrium): Where Demand intersects Supply (PMC). This is the quantity an unregulated, free market will naturally produce because buyers and sellers ignore the external damage.

• 𝑄* (Social Optimum): Where Demand intersects SMC. This is the ideal quantity for society, where the total social cost exactly equals the social benefit. Notice that 𝑄* is lower than 𝑄𝑀, meaning the free market overproduces this good.

• 𝑃* (Optimal Price): The price that reflects the true social cost at the ideal quantity level

The Shaded Areas

• Deadweight Loss (Light Gray Triangle): The net welfare loss to society from overproduction. For every unit produced between 𝑄* and 𝑄𝑀, the cost to society (𝑆𝑀𝐶) is higher than the benefit to consumers (𝐷𝑒𝑚𝑎𝑛d).

• Lost Consumer and Producer Surplus (Dark Gray Triangle): If government policies force the market to move from the overproduced level 𝑄𝑀 down to the ideal level (𝑄*), buyers and sellers lose a small amount of private profit and utility. However, cutting this out is beneficial because it eliminates the much larger deadweight loss above it.

deadweight loss

a loss of total social welfare and economic efficiency that happens when a market is not at optimal equilibrium

its size depends on the slopes of demand and supply and on the magnitude of pollution damages

social well fare

measures the overall well-being or total satisfaction of all individuals within a society

key concepts:

• Pareto Efficiency: Allocating resources so no one can be made better off without making someone else worse off.

• Total Surplus: The sum of consumer surplus (buyer benefits) and producer surplus (seller profits).

• Social Welfare Function: A mathematical formula that aggregates individual utilities or happiness to evaluate societal trade-offs.

• Market Failure: Inefficiencies like pollution or monopolies that create deadweight loss and reduce overall societal well-being

club goods

a type of good that is excludable but non-rivalrous in consumption, at least until congestion occur

it is

• Excludable: Suppliers can prevent non-payers from accessing the good or service, typically by charging a fee, toll, or subscriptio

• Non-rivalrous: One person's use of the good does not reduce the amount available for others, and it does not diminish another person's enjoyment—until the point of overcrowding

• Zero Marginal Cost: Because consumption is non-rivalrous, adding an extra user costs essentially nothing extra, leading these goods to often be provided by natural monopolies

The free-riding problem

in which some individuals don’t contribute at all to a public good, instead relying only on the contributions of others becomes more acute as the size of the relevant public increases.

open-access resources

access to the resource must be unrestricted

n open-access resource can be thought of as a resource that is nonexcludable (like pure public goods) but not nonrival.

collective action problem

another name for tragedy of the commons:

collection of in- dividuals—people, or firms, or even nation-states—may find itself in a situation where the group as a whole is better off if all contribute to the common good, but each individual member of the group has incentives to free ride.

Prisoner’s di- lemma

commonly used to describe collective action problems—not just in the environmental arena, but in a broad range of social and economic situations

nonexcludability

it is impossible or too costly to prevent people from using a good or service, even if they have not paid for it

the key to public goods, negtaive externalities,a nd the tragedy fo th comons