Market Failure - Introduction to Externalities

Table of Contents

1. Topic pack - Microeconomics - introduction
2. 1.1 Competitive Markets: Demand and Supply
3. 1.1 Competitive Markets: Demand and Supply - notes
4. 1.1 Competitive markets - questions
5. 1.1 Competitive markets - simulations and activities
6. 1.2 Elasticities
7. 1.2 Elasticities - notes
8. Section 1.2 Elasticities - questions
9. Section 1.2 Elasticities - simulations and activities
10. 1.3 Government intervention
11. 1.3 Government Intervention - notes
12. 1.3 Government intervention - questions
13. 1.3 Government intervention - simulations and activities
14. 1.4 Market failure
15. 1.4 Market failure - notes
    1. The meaning of externalities
    2. Types of externalities
    3. How do externalities affect allocative efficiency?
    4. Negative externalities of production
    5. Negative externalities of consumption
    6. The economic theory of traffic congestion
    7. Demerit goods
    8. Government responses - demerit goods
    9. Possible government responses to externalities
    10. Direct government provision
    11. Extension of property rights
    12. Taxes and subsidies
    13. Tradeable pollution rights
    14. Regulation, legislation and direct controls
    15. Positive externalities of production
    16. Positive externalities of consumption
    17. Merit goods
    18. Why might merit goods be underprovided by the market?
    19. Government responses - merit goods
    20. Public goods
    21. Common access resources & sustainability
    22. The tragedy of the Commons
    23. Common access resources in practice
    24. Sustainability
    25. Threats to Sustainability
    26. The threat to sustainability from the use of fossil fuels
    27. The threat to sustainability from poverty
    28. Government responses to threats to sustainability
    29. Cap and Trade Schemes
    30. Promoting Clean Technologies
    31. The 'dirty side' of cleaner technologies
    32. International responses to threats to sustainability
    33. Asymmetric information
    34. Abuse of monopoly power
    35. Inequality
16. Section 1.4 Market failure - questions
17. Section 1.4 Market failure - simulations and activities
18. 1.5 Theory of the firm
19. 1.5 Theory of the firm - notes (HL only)
20. Section 1.5 Theory of the firm - questions
21. Section 1.5 Theory of the firm - simulations and activities
22. Print View

The meaning of externalities

Syllabus: Explain the concepts of marginal private benefits (MPB), marginal social benefits (MSB), marginal private costs (MPC) and marginal social costs (MSC).

Defining Externalities Externalities are costs (negative externalities) or benefits (positive externalities), which are not reflected in free market prices. Externalities are sometimes referred to as 'by-products', 'spillover effects', 'neighbourhood effects' 'third-party effects' or 'side-effects'.

In a given market there are producers (first parties) and consumers (second parties) but their actions in making transactions sometimes affect others (third parties). The main point about this is that generally producers make decisions on how much to produce based on their own benefits (Profits usually) and consumers make decisions on how much to consume based on the benefit to themselves only. Neither party taking into account their effects on others (third parties). Therefore the market equilibrium (and consequent allocation of resources) is not equal to what society as a whole would want it to be (ie maximising community surplus) in other words the market equilibrium is not at the social optimum.

Free Market economists such as Milton Friedman and the Austrian School have argued that externalities particularly arise because of the absence of markets - as no markets exist for such things as clean air and seas, beautiful views or tranquillity, economic agents are not obliged to take them into account when formulating their production and consumption decisions, which are based on private costs and benefits i.e. those which are internal to themselves.

Another way of putting this is to say individuals have no private property rights over such resources as the air, sea and rivers, and thus ignore them in making their production and consumption decisions.

Property rights refer to those laws and rules that establish rights relating to:

• ownership of property;
• access to property;
• protection of property ownership;
• the transfer of property.

Thus a firm may feel free to dump effluent into a river as the spoiling of the environment and the killing of fish is not a cost that it would directly have to bear (think Sao Paulo´s Rio Teite). Similarly for consumption externalities like smoking.

The solution therefore is to sell property rights to interested parties so they have an incentive to look after the `property´they own - Or sell the right to pollute and the fee could cover the cleaning up or the solution to the problem etc.

Those on the political left (Interventionists) such as Paul Krugman would be more likely to argue that such an externality would arise because the market system is not regulated and therefore there is a role for government to intrevene to solve problems caused by market failure and to ensure the optimal allocation of resources.

To analyse market failure due to externalities you need to be clear about these concepts:

Marginal - means extra (actually you need two extras to define anything that is marginal

Benefit - Something perceived as a good or helpful result or effect 

Private Benefits - Benefits to producers and consumers

External benefits - Benefits to anyone not defined as a consumer or producer

Social Benefits -the sum of private and external benefits

Therefore Marginal Private Benefits (MPB) are the extra benefits from producing (profits) and/or consuming (utility) one extra unit of a good or service.

Marginal Social Benefits (MSB) are the extra private benefits plus extra external benefits from producing (profits) and/or consuming (utility) one extra unit of a good or service.

Marginal Private Costs (MPC) - are the extra private costs from producing (eg wages) and/or consuming (disutility or neg benefit) one extra unit of a good or service.

Marginal Social Costs(MSC) - are the extra private costs plus extra external costs from producing and/or consuming one extra unit of a good or service.