Market Failure: Externalities

Market Failure: Externalities

Introduction

  • Course: ECO 2023: Introductory Microeconomics

  • Instructor: Viviana Rodriguez

  • Semester: Fall 2025

Concept of Market Failure

  • Definition: Market failure occurs when an unregulated market does not maximize total surplus, leading to inefficiency.

  • Key Causes of Market Failure:

    • Absence of Property Rights

    • This week focuses on externalities.

    • Next week will cover public goods.

    • Market Power

    • Asymmetric Information

Externalities

  • Definition: An externality is an activity that imposes costs or benefits on third parties who are not involved in the activity.

  • Third Party Problem: External costs or benefits are not integrated into decision-making, leading decision-makers to fail in internalizing these costs or benefits.

  • Result: Activities are performed either too much (over-performed) or too little (under-performed) relative to social optimal levels.

Types of Externalities

  1. Negative Externalities: Involve external costs.

  2. Positive Externalities: Involve external benefits.

  • Can occur on either side of the market:

    • Production Externalities: Marginal Social Costs (MSC) ≠ Marginal Private Costs (MPC); affects supply curve.

    • Consumption Externalities: Marginal Social Benefits (MSB) ≠ Marginal Private Benefits (MPB); affects demand curve.

Negative Externalities

  • Examples Include:

    • Air Pollution

    • Production Waste

    • Water Pollution

Effects of Negative Production Externalities on Equilibrium

  • Scenario:

    • Equilibrium Quantity (Q) = 4.5

    • Equilibrium Price (P) = $5.50

  • Illustrates the shift in price and quantity due to the externality, with a cost of $3.00.

  • Social Optimum:

    • Price (P) = $7

    • Quantity (Q) = 3

Total Surplus Implication

  • Total Surplus can be calculated:

    • Consumer Surplus (CS) = $10.125

    • Producer Surplus (PS) = $10.125

    • External Cost (EC) = $13.50

    • Total Surplus (TS) = $6.75

    • Deadweight Loss (DWL) = $2.25

Negative Consumption Externalities

  • Examples Include:

    • Second-Hand Smoke

    • Driving

Equilibrium Effects

  • Equilibrium Quantity (Q) = 4.5

    • Equilibrium Price (P) = $5.50

  • Social Optimum calculations relate to the same externality cost of $3.00.

  • Social Optimum Values:

    • Quantity (Q) = 3

    • Price (P) = $4.00

Total Surplus Calculations Again

  • Same calculations apply:

    • Consumer Surplus (CS) = $10.125

    • Producer Surplus (PS) = $10.125

    • External Cost (EC) = $13.50

    • Total Surplus (TS) = $6.75

    • Deadweight Loss (DWL) = $2.25

Positive Externalities

  • Definition: Situations that produce external benefits.

  • Examples Include:

    • Research

    • Vaccination

Positive Production Externalities

  • Equilibrium Effects:

    • Equilibrium Quantity (Q) = 3.5

    • Equilibrium Price (P) = $6.50

    • Social Optimum values indicate a price of $5.00 and quantity of 5 units.

Total Surplus Calculation for Positive Production Externalities

  • Consumer Surplus (CS) = $6.125

  • Producer Surplus (PS) = $6.125

  • External Benefit (EB) = $10.50

  • Total Surplus (TS) = $22.75

  • Deadweight Loss (DWL) = $2.25

Positive Consumption Externalities

  • Equilibrium Effects: Scenario where positive benefits arise.

    • Equilibrium Quantity (Q) = 3

    • Equilibrium Price (P) = $4.00

    • Social Optimum indicates a price of $5.50 and quantity of 4.5.

Total Surplus for Positive Consumption Externalities

  • Consumer Surplus (CS) = $4.50

  • Producer Surplus (PS) = $4.50

  • External Benefit (EB) = $9.00

  • Total Surplus (TS) = $18.00

  • Deadweight Loss (DWL) = $2.25

Coase Theorem

  • Definition: If there are zero transaction costs and property rights are fully specified, resource allocation will not depend on the distribution of property rights.

  • Application Example: Sturges v. Bridgman (1879) - a case illustrating the need to allocate property rights between neighbors to reduce externalities.

Example Activity

  1. Pair up with a partner.

  2. Role-play as businesses: a doctor and a confectioner.

  3. Discuss costs and resource allocations linked to disruptions caused by noise.

Judicial Decisions

  • Decisions regarding property rights:

    • Confectioner possesses the right to make noise.

    • Doctor possesses the right to silence.

  • Possible Outcomes:

    • Confectioner compensates the doctor.

    • Doctor pays for a sound barrier.

Total Surplus in Judicial Ruling

  • Persists on balancing costs and ultimately achieving optimum alignment of revenues and expenses.

Economic Implications of Externalities

  • Markets demonstrate inefficiency under externalities leading to potential deadweight loss (DWL).

  • Goal: Reaching social optimum in the presence of externalities, as suggested by Coase Theorem regarding property rights.

Coase Theorem Reiteration

  • Crucial to address property rights and transaction costs when discussing externalities.

  • Total surplus must be evaluated based on the agreements deriving from property rights distribution.

Applications of Externality Solutions

  1. Cap-and-Trade Programs: Designed to cap total emissions by issuing limited permits for pollution.

    • Government controls total emissions through a limited number of annual permits.

    • Each allowance permits one ton of emissions, creating rights to pollution.

    • Companies have financial incentives to reduce emissions as permit prices rise over time.

  2. Pigouvian Taxes:

    • Definition: Designed to ensure that firms internalize externalities.

    • Examples:

      • Carbon taxes impose costs based on emissions.

      • Congestion pricing minimizes urban traffic.

Internalizing Externalities via Taxes

  • Efficiency is improved by taxing at levels that reflect marginal external costs.

    • Example:

    • An unregulated market might reveal: P = $5.50 and Q = 4.5.

    • The goal is to achieve P = $7 and Q = 3 through the designed tax to internalize the externality.

Total Surplus under Pigouvian Taxes

  • Calculation Factors to Consider:

    • Marginal External Cost = $3.00

    • Consumer Surplus, Producer Surplus, Gross Revenue (GR), and variations in Total Surplus are essential for evaluating overall market efficiency.