3.1 - Externalities - notes

Market failure and the role of externalities

Market failure happens when the price mechanism, driven by supply and demand, does not distribute limited resources effectively, leading to negative impacts on society. This often results from externalities, which are costs or benefits experienced by third parties not directly involved in a transaction. Governments frequently step in to address these issues and improve resource allocation.

Key concepts in externalities

• Negative externalities - These occur when an activity creates costs for others, such as pollution from a factory affecting local residents' health.
• Positive externalities - These arise when an activity provides benefits to others, like a well-maintained garden improving the neighbourhood's appearance.
• Production externalities - Related to the process of making goods, often involving environmental or social costs.
• Consumption externalities - Linked to the use of goods or services, which can generate broader societal benefits.

Externalities cause a gap between private costs/benefits (experienced by individuals or firms) and social costs/benefits (affecting society as a whole), leading to inefficient outcomes.

Negative externalities from production

Negative externalities in production happen when making goods creates external costs, like environmental damage, that are not reflected in the market price. These can be illustrated using cost curves to show how they lead to market inefficiencies.

Marginal costs in production externalities

Marginal private cost (MPC) represents the cost to a firm of producing one more unit of a good. Marginal social cost (MSC) equals MPC plus any external costs, such as pollution.

MPC and MSC curves:

• If MPC and MSC curves are parallel, external costs per unit are constant.
• If the curves diverge (MSC rises faster than MPC), external costs increase with higher output, for example, due to escalating pollution levels as production grows.

The diagram below shows this, with quantity on the horizontal axis and price, costs and benefits on the vertical axis. The MPC curve slopes upwards, with the MSC curve above it, and the vertical double-headed arrow marks the gap between them: the external cost. Because the curves diverge, the external cost per unit increases as output grows.

Example of negative production externalities

A factory producing chemicals might release toxic fumes into the air, harming nearby communities. If the firm ignores these external costs, it produces more than is socially desirable, resulting in overproduction and societal harm.

Positive externalities from consumption

Positive externalities in consumption occur when using a good or service benefits others beyond the direct user, such as widespread vaccination reducing disease spread. These can be shown using benefit curves to highlight underconsumption in free markets.

Marginal benefits in consumption externalities

Marginal private benefit (MPB) is the gain to an individual from consuming one more unit of a good. Marginal social benefit (MSB) equals MPB plus any external benefits.

MPB and MSB curves:

• If MPB and MSB curves are parallel, external benefits per unit are constant.
• If the curves diverge (the gap between MSB and MPB widens as quantity increases), external benefits grow with higher consumption, for instance, as more vaccinations provide greater herd immunity.

The diagram below shows this, again with quantity on the horizontal axis and price, costs and benefits on the vertical axis. The MPB curve slopes downwards, with the MSB curve above it, and the vertical double-headed arrow marks the gap between them: the external benefit. Because the curves diverge, the external benefit per unit increases as consumption grows.

Examples of positive consumption externalities

Education provides benefits not just to the individual student but to society through a more skilled workforce and informed citizenry. Healthcare services reduce disease transmission, benefiting the wider community. In free markets, these services are often underconsumed because private decisions ignore the wider benefits.

Free market equilibrium compared to socially optimal equilibrium

In markets with externalities, the free market equilibrium (where supply meets demand) differs from the socially optimal point, which maximises societal welfare by accounting for external effects.

Key equilibrium concepts

• Free market equilibrium - Occurs where MPC equals MPB, as participants focus only on private costs and benefits. This is shown at quantity Q_e and price P_e on a diagram combining cost and benefit curves.
• Socially optimal equilibrium - Found where MSC equals MSB, incorporating external costs and benefits. This is at quantity Q₁ and price P₁, providing the greatest net benefit to society.

In the combined diagram below, upward-sloping MPC and MSC curves intersect with downward-sloping MPB and MSB curves. The free market equilibrium at Q_e and P_e ignores externalities, while the social optimum at Q₁ and P₁ balances them.

Overproduction, underconsumption, welfare loss, and welfare gain

Externalities distort market outcomes, leading to either too much or too little activity compared to what benefits society most. This creates areas of welfare loss or potential gain.

Effects of ignoring negative production externalities

• When negative externalities are overlooked, the market settles where MPC meets the demand curve (MPB = MSB), so output reaches Q_e at price P_e. The social optimum, where MSC meets the demand curve, is Q₁ at P₁.
• This results in overproduction (more goods made than ideal) and underpricing (sold too cheaply).
• For units between Q₁ and Q_e, MSC exceeds MSB.
• The welfare loss is the shaded triangle ABC in the diagram below, the area between the MSC curve and the demand curve from Q₁ to Q_e, representing societal harm from ignored costs. The double-headed arrow marks the overproduction, the quantity gap between Q₁ and Q_e.

Effects of ignoring positive consumption externalities

• When positive externalities are ignored, the market settles where the supply curve (MPC = MSC) meets MPB, so output is Q_e at price P_e. The optimum, where the supply curve meets MSB, is Q₁ at P₁.
• This causes underconsumption (less used than ideal) and underpricing.
• For units between Q_e and Q₁, MSB exceeds MSC.
• The potential welfare gain is the shaded triangle DEF in the diagram below, the area between the MSB curve and the supply curve from Q_e to Q₁, showing lost societal benefits. The double-headed arrow marks the underconsumption, the quantity gap between Q_e and Q₁.