Lecture 6: Market Failures and Externalities

Introduction to Market Failures

• Overview of Efficient Markets: In previous discussions (Lecture 5), it was established that competitive markets typically achieve an allocation of scarce resources that is efficient. An efficient allocation is defined as one that results in the largest possible level of surplus for society. In such scenarios, government intervention (like taxes or subsidies) that shifts the market away from its equilibrium results in a welfare cost, known as a deadweight loss.

• Definition of Market Failure: A market failure occurs when a market on its own fails to achieve an efficient allocation of resources. In these instances, government intervention has the potential to increase overall social welfare.

• Types of Market Failures:

  • Externalities: The focus of the current lecture. The market equilibrium is inefficient because it produces too much or too little of a good.

  • Public Goods.

  • Asymmetric Information.

  • Non-competitive Markets.

Understanding Externalities

• Definition: An externality is the uncompensated impact of one person’s actions on the wellbeing of a bystander (a third party who is neither the buyer nor the seller).

• Core Problem: The externality problem arise because the individual taking the action does NOT take into account the effects—whether beneficial or adverse—that their action has on the bystander's wellbeing.

• Classifications:

  • Negative Externality: If the impact on the bystander is adverse (a cost).

  • Positive Externality: If the impact on the bystander is beneficial (a benefit).

Categorized Examples of Externalities

• Negative Externalities:

  • Air Pollution: Suffered by bystanders due to industries burning fossil fuels.

  • Climate Change: Suffered by bystanders resulting from industries emitting greenhouse gases.

  • Health Risks: Catching a virus from sick individuals who violate pandemic lockdowns.

  • Passive Smoking: Suffered by bystanders from smokers in their vicinity.

  • General Examples: Cigarette smoking, environmental pollution, violating lockdowns.

• Positive Externalities:

  • Technology Spillover: Increases in productivity enjoyed by bystanders due to research and development (R&D) performed by other firms.

  • Health Benefits: Not catching a virus because people in the vicinity have been vaccinated (immunization).

  • Restored Historic Buildings: Increased business activity enjoyed by bystanders in the local area.

  • Education: Higher productivity enjoyed by a bystander due to having an educated workforce in their environment.

Externalities and Market Inefficiency: Supply and Demand Recap

• The Supply Curve: Reflects the private costs of the good or service to producers.

• The Demand Curve: Reflects the private value of the good or service to consumers.

• Market Equilibrium: At equilibrium, the quantity traded is $Q_{market}$.

• Total Welfare: Calculated as the sum of Producer Surplus ($PS$) and Consumer Surplus ($CS$).

• Efficiency Criteria: A market is efficient if it produces only (and all) those units where the social value is greater than the social cost.

Negative Externalities in Production

• The Case of Aluminium: Consider aluminium factories that emit pollution for every unit produced.

• Social Cost vs. Private Cost:

  • For each unit produced, the "true" cost to society (Social Cost) includes the private cost to the producer plus the external cost to bystanders (e.g., health problems from pollution).

  • The formula for Social Cost is: $\text{Social Cost} = \text{Private Cost} + \text{External Cost}$.

  • This results in a Social Cost curve that sits above the Supply (Private Cost) curve.

• The Social Optimum:

  • To maximize total surplus, a social planner would aim for the quantity where the Social Cost curve intersects the Demand curve ($Q_{optimum}$).

  • Market Failure: Because producers ignore external costs, the market equilibrium ($Q_{market}$) is higher than the efficient quantity ($Q_{optimum}$).

  • Result: The market produces a larger quantity than is socially desirable (Q_{market} > Q_{optimum}

• Welfare Cost:

  • For every unit produced between $Q_{optimum}$ and $Q_{market}$, the social cost exceeds the social value.

  • The resulting loss in total surplus is represented graphically as a triangle (often labeled $ABC$), which constitutes the Deadweight Loss (DWL) of the externality.

• Solution: Internalizing the Externality:

  • This involves altering incentives so people consider the external effects of their actions.

  • Corrective Tax: Implementing a tax on each unit traded. If the tax equals the cost of the pollution, the Supply curve shifts upward to align with the Social Cost curve.

  • The new equilibrium will occur at $Q_{optimum}$. This tax can be levied on either buyers or sellers to achieve the same result.

Positive Externalities in Production

• The Case of Industrial Robots: These yield benefits to third parties (technology spillovers) that enter the collective pool of knowledge, and the producers are not compensated for this benefit.

• Social Cost vs. Private Cost:

  • Because of the external benefit, the Social Cost of production is actually lower than the private cost to producers.

  • The Social Cost curve sits below the Supply (Private Cost) curve.

• The Social Optimum:

  • The efficient quantity ($Q_{optimum}$) is found at the intersection of the Social Cost curve and the Demand curve.

  • Market Failure: Producers only see their private costs and ignore the benefits to others. Consequently, the market equilibrium quantity is too low (Q_{market} < Q_{optimum}).

  • Result: Surplus is "left on the table" because units that would provide more social benefit than social cost are not produced.

• Solution: Subsidies:

  • The government can internalize the benefit by providing a per-unit subsidy to producers.

  • This shifts the Supply curve down toward the Social Cost curve, moving the equilibrium to $Q_{optimum}$. This can also be achieved by subsidizing buyers.

Externalities in Consumption

• Negative Consumption Externalities:

  • Examples: Excessive alcohol consumption, smoking cigarettes.

  • Social Value is less than Private Value.

  • Graph: The Social Value curve sits below the Demand (Private Value) curve.

  • Outcome: Q_{market} > Q_{optimum}.

  • Solution: Corrective Tax.

• Positive Consumption Externalities:

  • Examples: Vaccination, Education.

  • Social Value is greater than Private Value.

  • Graph: The Social Value curve sits above the Demand (Private Value) curve.

  • Outcome: Q_{market} < Q_{optimum}.

  • Solution: Corrective Subsidy.

General Policy Lessons

• Negative Externalities: Lead markets to produce a quantity larger than is socially desirable. Remedy: Tax the good to internalize the externality.

• Positive Externalities: Lead markets to produce a quantity smaller than is socially desirable. Remedy: Subsidize the good to internalize the externality.

Private Solutions to Externalities

• Mechanism: Private solutions involve creating incentives to reduce activities with negative externalities and promote activities with positive externalities.

• Examples:

  • Moral codes and social sanctions.

  • Private donations (functioning as private subsidies).

  • Contracts between affected parties.

• The Coase Theorem:

  • If private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own, reaching an efficient outcome without government intervention.

  • Case Study: Fred and Barney:

  • Fred (Partier) benefit: $1000$.

  • Barney (Neighbor) cost from noise: $1600$.

  • Socially efficient solution: Fred should stop partying (Total Cost $1600$ > Total Benefit $1000$).

  • If Fred has the legal right to party: Barney can offer Fred a payment between $1000$ and $1600$ to stop. Both are better off; Fred gets more than his benefit, and Barney pays less than his cost.

  • If Barney has the legal right to quiet: Fred would have to pay Barney more than $1600$ to party, which he won't do because his benefit is only $1000$. The efficient outcome (no partying) still occurs.

  • Conclusion: The initial distribution of legal rights does not affect the market's ability to reach the efficient outcome, but it does determine the direction of payment and the relative wealth of the parties.

• Failure of Private Solutions:

  • Transaction Costs: The costs parties incur in the process of agreeing and following through (e.g., lawyer fees for drafting/enforcing contracts). If costs are too high, bargaining fails.

  • Large Numbers: Coordination becomes difficult when many people are involved.

Public Solutions to Externalities

• Command-and-Control Policies (Regulation):

  • The government forbids or requires certain behaviors.

  • Examples: Smoking bans in specific areas, limits on pollution emission levels.

• Market-Based Policy 1: Corrective Taxes and Subsidies:

  • Pigovian Taxes: Taxes enacted to correct the effects of a negative externality.

  • While taxes usually distort incentives and cause DWL in clean markets, in markets with externalities, they move the allocation toward efficiency and reduce existing DWL.

• Market-Based Policy 2: Tradeable Permits (Cap-and-Trade):

  • The government sets a limit ("cap") on the total level of pollution allowed.

  • It issues a fixed number of "pollution permits," each allowing a certain quantity of emissions.

  • Supply: The supply of permits is perfectly inelastic (a vertical line at the fixed quantity set by the government).

  • Demand: Determined by firms' willingness to pay for the right to pollute.

  • Outcome: The market price for permits is determined by the intersection of demand and the fixed supply. Firms that can reduce pollution cheaply will sell their permits to firms for whom reducing pollution is expensive.

• Equivalence: A Pigovian tax and a tradeable permit system can achieve the same efficient outcome. In the tax model, the price of pollution is fixed by the tax and determines the quantity. In the permit model, the quantity of pollution is fixed and determines the price.

Questions & Discussion

• Question 1: Would visiting shops and bars while being sick generate an externality?

  • Response: Yes, a negative one (risk of infecting bystanders).

• Question 2: Would getting the flu vaccine generate an externality?

  • Response: Yes, a positive one (reducing the risk of infecting others).

• Lecture Summary Q&A:

  • Q: What is an externality?

  • A: An uncompensated impact of one person's actions on a bystander. It can be positive or negative, from production or consumption.

  • Q: Why do externalities cause market failure?

  • A: Because buyers and sellers ignore bystander effects. Market prices fail to reflect the true social cost/benefit.

  • Q: How can the problem be solved?

  • A: Via private solutions (moral codes, donations, Coase bargaining) or public solutions (regulation, Pigovian taxes/subsidies, cap-and-trade).