Externalities and Market Failure: Analysis of Social Costs and Benefits

Efficiency in Competitive Markets: Standard economic theory posits that competitive markets are efficient because they maximize the sum of producer and consumer surplus.
Market Failure: Market failure occurs when the statement "competitive markets are efficient" goes wrong. This is a central theme in microeconomics and is explored across various university courses including BUSINESS115, ECON152, ECON301, ECON304, and ECON361.
Sources of Market Failure:
- Market Power: When one or more market participants have the ability to influence prices.
- Externalities: When activities affect third parties without compensation.
- Public Goods and Common Resources: Goods that are non-excludable or non-rivalrous.
- Asymmetric Information: When one party in a transaction has more or better information than the other.

Definition: An externality arises when a person engages in an activity that influences the well-being of a bystander, yet the person performing the activity neither pays nor receives any compensation for that effect.
Types of Externalities:
- Negative Externality: The impact on the bystander is adverse or harmful.
- Positive Externality: The impact on the bystander is beneficial.

Negative Externalities:
- Public Health: Leaving your house if you have contracted Covid-19.
- Public Expenses: Having New Zealand taxpayers pay for quarantine facility stays after a private two-week holiday in Maui.
- Pollution: Car exhaust and environmental degradation.
- Health Hazards: Cigarette smoking and second-hand smoke.
- Neighborhood Disturbances: Mowing your lawn at 7:00 am on a Sunday next to a neighbor's house.
- Neglect: Never mowing your lawn at all, which affects neighbor property values and aesthetics.
- Noise Pollution: Playing loud music in an apartment building.
- Distractions: A roommate's continuous cellphone use while another is trying to study for an Economics exam.
Positive Externalities:
- Health and Safety: Immunizations/vaccinations which reduce the spread of disease to others.
- Culture and Heritage: The restoration of historic buildings.
- Innovation: Research and development into new technologies.
- Personal Achievement: Studying for an Economics degree (which elevates the skills of the workforce).
- Mutual Benefit (Two-way Externality): The classic example of bees and orchards. Bees from a nearby beehive collect nectar from an orchard (benefiting the beekeeper), while simultaneously pollinating the trees (benefiting the orchard owner).

The Cost to Society: In the presence of a negative externality, the production cost to society is higher than the private cost to the producer.
Variables:
- $c$ = The external cost per unit produced.
Social Cost Equation:
- $\text{Social Cost} = \text{Private Cost} + c$
Market Equilibrium vs. Social Optimum:
- Market Equilibrium: Supply is determined strictly by the private marginal cost. The equilibrium is the intersection of the private supply (marginal cost) curve and the demand curve.
- Analytical Discrepancy: In equilibrium, the marginal buyer's willingness to pay (private value) is less than the social cost of the last unit (the marginal seller's cost plus the cost of the externality).
- Social Optimum: This is determined by the intersection of the Social Cost curve and the Demand curve. It accounts for all costs to society.
Welfare Impact: With a negative externality, the market quantity produced and traded is too high relative to the socially optimal level. Market participants over-consume or over-produce the good.

Valuation Methods:
- Health Mortality Studies: Estimating the cost of premature mortality caused by increased air pollution.
- Economic Impact Models: Using models to predict how global warming damages specific countries and calculating the resulting loss in Gross Domestic Product (GDP).
The APEEP Model: This stands for the Air Pollution Emission Experiments and Policy Assessment Model. It involves a three-step process:
1. Identify the specific pollutant causing the harm.
2. Identify the specific economic activities that produce those pollutants.
3. Identify and calculate the monetary value of the damage done to the environment and health.

The Benefit to Society: When consumption provides a positive externality, the total benefit to society is greater than the private benefit to the consumer.
Variables:
- $b$ = The external benefit per unit consumed.
Social Value Equation:
- $\text{Social Value} = \text{Private Value} + b$
Market Equilibrium vs. Social Optimum:
- Market Equilibrium: Demand is determined strictly by the private marginal benefit (private value). The equilibrium remains at the intersection of private demand and supply.
- Analytical Discrepancy: In equilibrium, the social value of the last unit (private value plus the external benefit to the bystander) is greater than the cost to the marginal seller.
- Social Optimum: This is determined by the intersection of the Supply curve and the Social Value curve.
Welfare Impact: With a positive externality, the market quantity produced and traded is too low relative to the socially optimal level. Market participants under-consume or under-produce the good.

Lower Bound Valuation: The OECD often uses additional tax revenue generated from an additional year of education as a baseline for external benefit.
Unmeasured Benefits: Education provides broader societal gains that are harder to quantify, such as the facilitation of more informed civic engagement and the election of better politicians.

Negative Externality: The equilibrium quantity is higher than the social optimum; the market is "too large."
Positive Externality: The equilibrium quantity is lower than the social optimum; the market is "too small."
General Applicability: These principles and market failures apply regardless of whether the externality originates in the production phase or the consumption phase.