2.8 Market failure – externalities

market failure

when the free market forces of demand and supply lead to an allocation of resources that does not maximise the welfare of a country’s citizens.

MSC done not equal MSB

• misallocation of resources

misallocation of resources

when resources are not used where they are most efficient or most needed

Allocative efficiency

resources are used in a way that maximises overall benefit to society

• the exact amount is produced for what people want and need

→ MSC=MSB

→ Demand = supply

→ no externalities exist in the market

BASICALLY EQUILIBRIUM STATE

Marginal social cost

total cost of society of producing one more unit of a good

(cost of society - pollution is cause of production on society) + private

Marginal Social Benefit

total benefit to society from consuming one more unit of a good

(benefit to society - external benefit to society like improved nutrition) + private

→ MSC + external costs = MSC

What does MSC=MSB ?

the cost to society of producing one more unit of a good is exactly equal to the benefit society gets from consuming that unit

Externalities

Any impact that the production or consumption of a good or service has on a third party (often stakeholders) - negatively or positively affecting them

external costs / negative externalities

spillover costs that negatively impact third parties resulting from producing or consuming a good or service .

→ production external costs (not paid by producer)

→ consumption external costs

How do external production costs lead to market failure?

External production costs are costs to society that the producer doesn’t pay for.

Because these costs are not included in the market price, the good seems cheaper than it actually is.

This causes producers to make too much of it.

As a result MSC>MSB - resources are not used efficiently

The misallocation of resources causes market failure and leads to welfare loss

consumption external costs

Exist when third parties experience the external cost from the consumption of a good or service.

example: cigarettes

→ marginal private benefit + external cost + marginal social benefit

how do external consumption costs lead to market failure?

External consumption costs:

negative effects on others from consumption of a good or service, like a second-hand smoke or drunk driving.

These costs are not paid by the consumer or included in the market price(price consumer sees)

Because of this people consumer more than is socially desirable.

Consider only MPB vs MPC

As a result: MSC>MSB - society looses out when extra consumption happens

This overconsumption leads to misallocation of resources where too much is consumer, causing market failure and welfare loss.

External benefits / positive externalities

spillover benefits that positively impact third parties as a result of the consumption or production of a good or service

→ production external benefits

→ consumption external benefits

How do external production benefits lead to market failure?

External production benefits are positive effects on others from producing a good (firm training workers).

These benefits are not included in the producers decision of the ,market price.

Because the producers don’t receive the full benefit they produce, less than is socially optimal(MAX TOTAL WELFARE)

Private producers only consider their own costs and benefits (MPC, MPB)

→ EXTERNAL BENEFITS ARE IGNORED

At that output MSB>MSC

→ society would gain more by producing more (underproducing)

→ this underproduction causes a misallocation of resources leading to a market failure and a welfare loss

Consumption external benefits

when a good or service is consumed and there are spill-over benefits on third parties

How do external consumption benefits lead to market failure?

External consumption benefits are positive effects on others when someone consumes a good, like vaccines reducing the spread of disease.

These benefits are not included in the market demand curve, because consumers only consider their private benefit and not the full social benefit, they under-consume the good.

At that level MSB > MSC (underconsumption)

→ this causes misallocation of resources where too little is consumed leading to market failure and a welfare loss