Externalities
Externalities are the effects, on the third party, of consumption/production by a first party. I.e. the effects on those who are not taking part in the transaction.
Externalities can be positive or negative. Positive externalities are also known as external benefits, whereas negative externalities are also known as external costs.
Definitions:
Market failure occurs because externalities are ignored – i.e. only private benefits and costs are taken into consideration in any decision or transaction.
Some equations:
Externalities can be positive or negative. Positive externalities are also known as external benefits, whereas negative externalities are also known as external costs.
Definitions:
- A private cost is a cost incurred to a first party in a transaction – e.g. the cost to the consumer of purchasing a pack of cigarettes.
- An external cost is a cost incurred to a third party due to a transaction of first parties – e.g. the illness suffered by a non-smoker due to passive smoking caused by a smoker.
- Social cost is the sum of the private costs and external costs. It is the entire cost to society of a good/service.
- A private benefit is a benefit gained by a first party of a transaction – e.g. the satisfaction to the consumer gained from the chocolate bar which they purchased.
- An external benefit is the benefit gained by a third party due to a transaction of a first party – e.g. new jobs created due to a new factory opening.
- The social benefit is the sum of the private benefits and external benefits. It is the total of the benefits gained by society from a good/service.
Market failure occurs because externalities are ignored – i.e. only private benefits and costs are taken into consideration in any decision or transaction.
Some equations:
There are a few diagrams which we can use to illustrate market failure:
Negative externalities in production
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Positive externalities in consumption
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Negative externalities in consumption
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Positive externalities in production
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Where –
Diagram about consumption
If we are talking about a diagram to do with consumption, we define MPC as the cost to the first party of consuming the last unit of a good/service. Also, we define MPB as the benefit to the first party of consuming the last unit of a good/service.
Diagram about production
If we are talking about a diagram to do with production, we define MPC as the cost to the first party of producing the last unit of a good/service. Also, we define MPB as the benefit to the first party of producing the last unit of a good/service.
Equilibria
The distance between the MPB and MSB line shows the external benefit. The distance between the MPC and MSC line shows the external cost. The welfare loss or welfare gain area can be seen on the diagram. These is the welfare lost/gained due to ignoring externalities.
If the cost curves diverge, then the external cost per unit rises for each extra unit consumed/produced. If the benefit curves diverge, then the external benefit per unit rises for each extra unit consumed/produced. If the curves are parallel, then the cost/benefit rise per unit is constant.
Property rights
Private and public goods
Private goods:
(e.g. chocolate bar, teddy bear)
Public goods:
(e.g. street lighting, lighthouses, positive externalities)
Quasi-public goods
These are public goods which can exhibit excludability and rivalry – e.g. roads with road tolls requiring payment.
Why are public goods under-provided by the free market?
The free rider problem – the inability to exclude people from consuming public goods means that they can benefit without paying for the good/service. There is no profit incentive in providing public goods, which is why the free market underprovide them.
The price mechanism cannot operate with free riders. Also, it is difficult to set a price for public goods, as it is hard to work out their value to consumers. Producers tend to overvalue them, so they can charge higher prices, however consumers tend to undervalue them to get a lower price.
These reasons are why firms are reluctant to provide public goods – this is a market failure.
The tragedy of the commons
This is an economic theory which states that the idea of people acting in their own best interests will overuse a common resource without considering its depletion or degradation. This explains a lot of the causes of environmental market failure.
Information gaps
In traditional economic theory, a competitive market would boast perfect information. This means that all agents in the economy would have complete knowledge of all benefits, costs, prices etc.
Usually, sellers have more information than buyers, but not always. When one party has more information than the other, this is known as asymmetric information. This can lead to moral hazard; the state where one party may take a risk due to knowing that they will not bear the consequences, but another party will.
Information failure causes market failure. This results in merit goods being underconsumed and underprovided, and demerit goods being overconsumed and overprovided. This is a misallocation of resources.
- MPB = marginal private benefit
- MSB = marginal social benefit
- MPC = marginal private cost
- MSC = marginal social cost
Diagram about consumption
If we are talking about a diagram to do with consumption, we define MPC as the cost to the first party of consuming the last unit of a good/service. Also, we define MPB as the benefit to the first party of consuming the last unit of a good/service.
Diagram about production
If we are talking about a diagram to do with production, we define MPC as the cost to the first party of producing the last unit of a good/service. Also, we define MPB as the benefit to the first party of producing the last unit of a good/service.
Equilibria
- On these diagrams, the market equilibrium occurs where MPC = MPB. This is because, in a free market, consumers and producers only consider private benefits and costs. This is shown by Qe Pe on each diagram.
- The socially optimum equilibrium (level of output) is where MSC = MSB, as this considers externalities. This is shown by Q1 P1 on each diagram.
The distance between the MPB and MSB line shows the external benefit. The distance between the MPC and MSC line shows the external cost. The welfare loss or welfare gain area can be seen on the diagram. These is the welfare lost/gained due to ignoring externalities.
If the cost curves diverge, then the external cost per unit rises for each extra unit consumed/produced. If the benefit curves diverge, then the external benefit per unit rises for each extra unit consumed/produced. If the curves are parallel, then the cost/benefit rise per unit is constant.
Property rights
- If there is a lack of property rights, there are likely to be negative externalities as a result. For example, if nobody owned a body of land which was being polluted, firms would not think twice about polluting.
- As soon as someone takes responsibility for some land, they can charge for or disallow pollution on it. This reduces the misuse of scarce resources.
Private and public goods
Private goods:
(e.g. chocolate bar, teddy bear)
- Excludable – you are able to prevent others from consuming them
- Rivalrous – one person consuming them means other cannot benefit
- Choice – you can choose whether or not to consume them; they can be rejected
Public goods:
(e.g. street lighting, lighthouses, positive externalities)
- Non-excludable – it is impossible to prevent others from consuming them, even if they have not paid for their use
- Non-rivalrous – one person consuming them does not prevent others also benefitting
- No choice – you cannot reject public goods
Quasi-public goods
These are public goods which can exhibit excludability and rivalry – e.g. roads with road tolls requiring payment.
Why are public goods under-provided by the free market?
The free rider problem – the inability to exclude people from consuming public goods means that they can benefit without paying for the good/service. There is no profit incentive in providing public goods, which is why the free market underprovide them.
The price mechanism cannot operate with free riders. Also, it is difficult to set a price for public goods, as it is hard to work out their value to consumers. Producers tend to overvalue them, so they can charge higher prices, however consumers tend to undervalue them to get a lower price.
These reasons are why firms are reluctant to provide public goods – this is a market failure.
The tragedy of the commons
This is an economic theory which states that the idea of people acting in their own best interests will overuse a common resource without considering its depletion or degradation. This explains a lot of the causes of environmental market failure.
Information gaps
In traditional economic theory, a competitive market would boast perfect information. This means that all agents in the economy would have complete knowledge of all benefits, costs, prices etc.
- Perfect information is the state where each agent in a transaction has symmetric information, i.e. the same information as each other.
- If we consider each agent to be rational, then we can assume that only right decisions will be made based on this symmetry of information.
- In reality, symmetric information rarely exists, usually due to time restraints.
Usually, sellers have more information than buyers, but not always. When one party has more information than the other, this is known as asymmetric information. This can lead to moral hazard; the state where one party may take a risk due to knowing that they will not bear the consequences, but another party will.
Information failure causes market failure. This results in merit goods being underconsumed and underprovided, and demerit goods being overconsumed and overprovided. This is a misallocation of resources.
