6/18/2022

5- Market Failure

Chehara Dias Amaratunga

BSc. Economics and Management and Master of Accounting and
Finance

Market failure due to Externality

• An externality arises when a person engages in an activity that influences the
wellbeing of a bystander who neither pays nor receives compensation for that
effect.

• When the impact of a bystander is negative, it is called a negative externality.

• When the impact of a bystander is positive , it is called a positive externality.

• Because buyers and sellers neglect the external effects of their actions when
deciding how much to demand or supply, the market equilibirum is not efficient.
That is the equilibrium that fails to maximise the total benefit to society as a
whole.
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The Market Equilibrium

Supply
( private cost)
Price of Aluminum

Demand ( private value)

Q market Quantity of Aluminum

Negative Externality in Production

MSC
Supply ( Private cost)
Price of Aluminum

Internalising the externality

Tax the aluminum producers for

each ton of aluminum sold. The tax
would shift the supply curve for
aluminum upwards by the size of the
tax.

D= MPB= MSB
Q Optimum Q Market Quantity of Aluminum
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Public Policies towards Externalities

• Goverment can respond to externalities in one of two ways :

1. Command and control policies : Environmental regulations dictate

the maximum level of pollution that a factory may emit.

2. Market based policies : Corrective taxes and Subsidies.

Market based policies align private incentives with social efficiency.
Taxes enacted to deal with the effects of negative externalities are
called corrective taxes / Pigovian taxes.

Market Based Policies – Tradable Pollution

Permits
Pollution permits are scarce resources . A market to trade these permits will
eventually develop, and that market will be governed by the forces of supply and
demand. The inivisible hand will ensure that the market will allocate the right to
pollute efficiently. That is , the permits will end up in the hands of those firms that
value them most highly as judged by their willingness to pay. A firm’s willingnes to
pay for the right to pollute , in turn will depend on its cost of reducing pollution.
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The Equivalence of Corrective Taxes and

Pollution Permits Pollution permits

Supply of pollution permits

Price of Pollution

Price of
pollution
Corrective tax

Corrective tax
P P

Demand for pollution rights Demand for

Pollution rights
Q
Quantity of Pollution Q Quantity
Of pollution