Market Failure - Externalities and Resource Allocation

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

How do externalities affect allocative efficiency?

Syllabus: Describe the meaning of externalities as the failure of the market to achieve a social
optimum where MSB = MSC.

Allocative efficiency is when resources are allocated to their most valued use as in the best use for society as a whole - Social Optimum

Allocative efficiency automatically occurs where price equals marginal cost (P=MC) in all markets, assuming that neither negative nor positive externalities are present.

Why MUST price equal Marginal cost for there to be an efficient allocation of resources? Price = MC for efficient allocation of resources Private Cost = cost to procucer or comsumer only External Cost = cost to 3rd parties Social Cost = private costs + external costs

The price of a good reflects the value (the benefits gained) consumers place on  consuming each unit of a good. The Marginal Cost is the full cost (including normal profit) society has to pay to produce each unit of a good (or service).

If Price > MC more of the good will be produced and as each unit is consumed the value reduces and the cost increases until Price = MC.

If Price < MC then less of the good will be produced and the value of the last unit produced and consumed will be greater and the cost of production (for the last unit produced) will be less until Price = MC. Therefore there will be production and consumption adjustments until Price = MC.

For most goods only private costs and benefits are involved therefore the market equilibrium is at the Social Optimum and P= MSC (Marginal Social Cost)

Effect of Externalities

The problem when significant externalities exist is that the effects of consumer and producer actions on other people (3rd parties) are not considered when production and consumption decisions are made. Consequently there is no mechanism (method) to bring the market to an equilibrium at the social optimum level of output. Resources are misallocated in that case.

Consider the case of a firm which produces paper and discharges its waste products into a river. Such a firm would be treating the environment as a free resource, and would be imposing a cost on society greater than just the costs paid for factors of production needed to produce the paper. The price charged to consumers would not therefore reflect the true cost of the product; if the firm were compelled to install equipment which could treat its effluence and make it harmless to the environment, its production costs would increase; therefore its selling prices would rise and consumers would reduce their demand. Resources would then be reallocated away from the production of paper from this firm and towards other markets. Because the firm does not pay the environmental costs of production prices are lower than the Social Optimum, quantity produced is higherthan the Social Optimum and resource allocation to this market is higher than the Social Optimum.

In this case there is a divergence (gap) between private costs and social costs.

• The private cost is the internal money cost of production incurred by the firm i.e. costs (for Land, Labour, Capital and the Entrepreneuer) such as raw materials, wages, machinery and normal profit that must be paid to carry out production.
• The social cost, on the other hand, is the real (full) cost to society as a whole; it is the private, internal costs to the firm plus the value of the negative externalities (external costs). Social costs = Private costs plus external costs, remember:

The significance of this analysis is that allocative inefficiency will occur if private cost or benefit diverges from social cost or benefit. Where externalities exist the condition for allocative efficiency is that price = social marginal cost i.e. the price must equal the true marginal cost of production to society as a whole, rather than just the private marginal cost.

Hence externalities cause market failure: when a negative production externality is initiated, the firm will not be made to pay for the cost imposed on others, and will therefore have no market incentive to produce less; from society's standpoint it will therefore overproduce; when a positive externality arises, the firm will lack any incentive to increase its output to the socially desirable level, as it does not receive any payment for the generation of the external benefit; underproduction therefore occurs.