Market Failure Response Questions

1 a) Explain the concept of negative externalities of consumption.

A negative externality is the secondary, harmful effect a good or service can have on society.
Consumption is the act of using a good or service, and in the economic sense it is done by
consumers.

In this diagram, MSC (marginal social cost) simply depicts the cost to society that consuming
a said product has, in this case, cigarettes. MSB is the marginal social benefit, which is how
much society as a whole benefits from the quantity of cigarettes consumed. MPB is the
marginal private benefit, which shows how much members in society individually benefit
from the consumption of cigarettes. When MSB = MSC, the societal costs of cigarettes equal
the benefits that the cigarettes give, therefore there is no market failure, but in this case
MPB (which is where society is producing cigarettes) is greater than MSC, therefore there IS
market failure.

The concept of negative externalities of consumption are that when a good or service is
used/consumed, there are adverse effects that affect third party individuals. The most
obvious one was the one used in the diagram, cigarettes, and how secondary smoking
affects individuals in society. However other examples, such as large factories and air
pollution, deforestation, loud music and noise pollution also affect third parties. Since there
is a free market, people will always ignore the social costs that consuming certain products
have on society, and produce at their marginal private benefit. This means that it’s up to the
government to regulate certain products that have third party effects on society.
1 b) Evaluate two policies that may be used by governments to reduce
external costs of production.
A policy is the legislation that the can government follow to receive a certain outcome.
External costs are third-party costs society suffers as a result of the production of a product.

In this diagram, you can see that the marginal private costs of producing paint are below the
marginal social costs, which means that society is paying the costs between the marginal
social costs and marginal private costs (blue triangle), and therefore this creates market
failure. For there not to be any market failure in this situation, the marginal social costs
would have to equal the marginal social benefit (P*aQ*0).

A government policy that could be employed in this situation is to tax the firm to shift the
MPC curve to equal the MSC. Even if MPC doesn’t equal MSC, taxing the firm will still reduce
the external costs to society. Although in theory this idea seems to solve or partially solve
the issue of external costs, some downsides to this are that it’s difficult to put a price on
pollution and identify how much the firm needs to be taxed based off that, and even more
so it’s also incredibly hard to identify which firms are the main contributors to the pollution
in the first place.

Another government policy is for governments to legislate and ban polluting firms, and
therefore restricting their output (and the external cost). Ways it could do this are by for
example passing new environmental legislature regarding how much the firm can pollute
the environment by. In order to meet these standards the firms would be forced to use their
profits, which in turn increases their MPC. The downside with this policy is that with the
firms forced to use their profits, they might need to drop employees, ultimately creating a
job loss problem.
2 a) Using diagrams, explain how airplane flights may create either a
negative externality of consumption or a negative externality of
production.
A negative externality is the secondary, harmful effect a good or service can have on society.
Consumption is the act of using a good or service, and in the economic sense it is done by
consumers. Production is the act of making goods or services, and in the economic sense it
is done by suppliers.

Quantity of airplane flights

This diagram depicts negative externalities of consumption, you can see that the marginal
private costs of producing airplane flights are below the marginal social costs, which means
that society is paying the costs between the marginal social costs and marginal private costs
(blue triangle), and therefore this creates market failure. For there not to be any market
failure, the marginal social costs would have to equal the marginal social benefit.

From this diagram, you can see that when people buy plane flights (i.e. consumption) there
is a negative externality to society as airplane flights are being overconsumed. This negative
externality would be the air pollution created by airplanes, which is the extra cost society is
paying from this market failure.

This negative externality is identical if it were a negative externality of production, as the

market failure in both cases is the pollution produced from the airplanes.

2 b) Discuss the view that government policies are the best way to
reduce the market failure caused by airline flights.
A policy is the legislation that the can government follow to receive a certain outcome.
Market failure occurs when community surplus is not maximized and therefore goods and
services are not properly distributed in an economy.