11 Market Failure and Externalities

11
MARKET FAILURE AND EXTERNALITIES
FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
Externalities
The intellectual basis for the market system…
◦ … individuals being left to their own devices without
government interference, motivated by self-interest.
Critics of this belief system argue that…
◦ … individuals make decisions without fully
understanding the costs and benefits and lead to
inefficiencies which the market system on its own
does not solve.

Belief Systems
An externality is an uncompensated impact of
one person’s actions on the well-being of a
bystander.
Externalities cause markets to be inefficient,
and so fail to maximise total surplus.
An externality arises...
. . . when a person engages in an activity that affects
the well-being of a bystander and yet neither pays
nor receives any compensation for that effect.

Belief Systems
When the impact on the bystander is adverse,
the externality is called a negative externality.
When the impact on the bystander is
beneficial, the externality is called a positive
externality.
◦ In either situation, decision-makers fail to take
account of the external effects of their behaviour.

The Social Costs and Social
Benefits of Decision Making
Market decisions are based on weighing up
private costs and private benefits.
Social costs and social benefits are lost or
gained by those not party to the initial decision.
Market decisions may not take account of the
social costs and benefits of their actions.
The market equilibrium is not efficient when
there are externalities.

Types of externalities
Negative Externalities
◦ Car exhaust fumes
◦ Cigarette smoking
◦ Barking dogs (loud pets)
◦ Loud stereos in an apartment building
Positive Externalities
◦ Immunisations
◦ Restored historic buildings
◦ Research into new technologies

Externalities And Market
Inefficiency
Negative externalities lead markets to produce
a larger quantity than is socially desirable.
Positive externalities lead markets to produce
a larger quantity than is socially desirable.
◦ Look at the market for aluminium (Figure 11.1)

Figure 11.1 The Market for Aluminium
Price of
Aluminum Supply
(private cost)
Equilibrium
Demand
(private value)
0 QMARKET Quantity of
Aluminum
FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION

9781473725331 © CENGAGE EMEA 2017
The market for aluminium
◦ The quantity produced and consumed in the market
equilibrium is efficient in the sense that it maximises
the sum of producer and consumer surplus.
◦ If the aluminium factories emit pollution (a negative
externality), then the cost to society of producing
aluminium is larger than the cost to aluminium
producers.

The Market for aluminium
◦ For each unit of aluminium produced, the social cost
includes the private costs of the producers plus the
cost to those bystanders adversely affected by the
pollution.

Figure 11.2 Pollution and the Social Optimum

9781473725331 © CENGAGE EMEA 2017
The intersection of the demand curve and the
social-cost curve determines the optimal output
level.
• The socially optimal output level is less than the
market equilibrium quantity.
Internalising an externality involves altering
incentives so that people take account of the
external effects of their actions .

Achieving the Socially Optimal Output
◦ The government can internalise an externality by
imposing a tax on the producer to reduce the
equilibrium quantity to the socially desirable quantity.

A positive externality exists when an externality
benefits the bystanders.
◦ The social value of the good exceeds the private
value.
◦ Example: Education yields positive externalities.
◦ A better-educated population leads to improved
productivity and economic growth. The economic
growth is the positive externality as it benefits
everyone.
◦ The marginal social benefit (MSB) is the private
value plus the external benefit to society at each
price.
Figure 11.3 Education and the Social Optimum

9781473725331 © CENGAGE EMEA 2017
The intersection of the supply curve and the social
value curve determines the optimal output level.
◦ The optimal output level is more than the equilibrium quantity.
◦ The market produces a smaller quantity than is socially
desirable.
◦ The social value of the good exceeds the private value of the
good.

Internalising Externalities:
◦ Subsidies can be used to attempt to internalise
positive externalities.
◦ Government intervention to promote technology-
enhancing industries.
◦ Patent laws give the individual (or firm) with patent protection a
property right over its invention.
◦ Without property rights there would be less research.
◦ Property rights provide the exclusive right of an individual, group or
organisation to determine how a resource is used.

A technology spillover is a type of positive externality
that exists when a firm’s innovation or design not only
benefits the firm, but enters society’s pool of
technological knowledge and benefits society as a
whole.

Positional Externalities
A positional externality is a situation which exists when
the payoff to one individual is dependent on their
relative performance to others.
A positional arms race is a situation where individuals
invest in a series of measures designed to gain them
an advantage but which simply offset each other.

Private Solutions To Externalities
Government action is not always needed to solve the
problem of externalities.

Types of Private Solutions
Social norms and Moral Behaviour
◦ Do unto others as you would have them do unto you
Charities that deal with externalities

◦ E.g. Greenpeace
Self-interest
◦ Where two firms gain from each other’s presence
Social Contracts

The Coase Theorem
The Coase Theorem is a proposition that if private
parties can bargain without cost over the allocation of
resources, they can solve the problem of externalities
on their own.

Why Private Solutions Do Not
Always Work
Transactions Costs
◦ Transaction costs are incurred in the process of agreeing
to and following through on a bargain.
◦ Sometimes the private solution approach fails because
transaction costs can be so high that private agreement is
not possible.
Bargaining Problems
◦ Each party tries to hold out for a better deal.
Difficult to Coordinate the interested parties.
Asymmetric Information and Irrational Behaviour.

Public Policies Toward
Externalities
When externalities are significant and private
solutions are not found, government may
attempt to solve the problem through . . .
◦ Command-and-control policies.
◦ Market-based policies.

Command and Control:
Regulation
Command-and-Control Policies
◦ Usually take the form of regulations:
◦ Forbid certain behaviours.
◦ Require certain behaviours.
◦ Examples:
◦ Requirements that all students be immunised.
◦ Stipulations on pollution emission levels set by the government.
◦ Needs good information

Market based policies
Pigovian taxes are taxes enacted to correct
the effects of a negative externality.
• Government uses taxes and subsidies to align private
incentives with social efficiency.
• The intention of such a tax would be to encourage factories
to reduce pollution up to a point where the marginal
abatement cost is equal to the tax rate imposed.
• Firms that can reduce pollution with the least cost are likely
to do so (to avoid the tax) while firms that encounter high
costs when reducing pollution will pay the tax.

Regulation Versus Pigovian
Tax
If the government decides it wants to reduce the
amount of pollution coming from a specific plant, the
government could…
◦ Tell the firm to reduce its pollution by a specific amount (i.e.
regulation).
◦ Levy a tax of a given amount for each unit of pollution the firm
emits (i.e. Pigovian tax).

Tradable Pollution Permits
Tradable pollution permits allow the voluntary
transfer of the right to pollute from one firm to
another
◦ A market for these permits will eventually develop.
◦ A firm that can reduce pollution at a low cost may
prefer to sell its permit to a firm that can reduce
pollution only at a high cost.

Figure 11.4 The Equivalence of Pigovian
Taxes and Pollution Permits
(a) Pigovian Tax
Price of
Pollution
P Pigovian
tax
1. A Pigovian
tax sets the
price of Demand for
pollution . . . pollution rights
0 Q Quantity of
Pollution
2. . . . which, together
with the demand curve,
determines the quantity
of pollution.
9781473725331 © CENGAGE EMEA 2017
Figure 11.4 The Equivalence of Pigovian
Taxes and Pollution Permits
(b) Pollution Permits
Price of Supply of

Pollution pollution permits

P
Demand for
pollution rights
0 Q Quantity of
Pollution
2. . . . which, together 1. Pollution
with the demand curve, permits set
determines the price the quantity
of ECONOMICS
of pollution. FOR USE WITH MANKIW AND TAYLOR, pollution ...
4 EDITION
TH
9781473725331 © CENGAGE EMEA 2017

Public/Private Policy Toward
Externalities: Property Rights
Property rights
◦ If I have ownership rights over the air 1 km above my
house then no one can legally pollute it.
◦ I can negotiate with a firm that wishes to pollute that
air and agree a price for the right to do so.
◦ However, it is a complex task to establish a system
of such property rights and they may be expensive to
enforce.

Control of Positional Arms
Races
An incentive must exist to prevent the
investment in attempts to gain some benefit
which is ultimately mutually offsetting.
◦ Laws against performance enhancing drugs in sport
◦ External body overseeing any dispute over the social
norms

Objections to the Economic
Analysis of Pollution
Some individuals dislike the idea of allowing
companies to purchase the right to pollute
• These people fail to understand that an economy
has limited ability to eliminate pollution and such
elimination would come at a high opportunity cost.
• “People face trade-offs” and we must decide how
much we would be willing to give up to have no
pollution.

Government Failure
Government decision-making is often flawed
and not based on perfect information or
rational, positive analysis.
◦ The benefits accrue to a small number of people
but the costs are spread across large sections of
the population.
◦ Government failure is a situation where political
power and incentives distort decision-making so
that decisions are made which conflict with
economic efficiency.

Public Choice Theory
Governments might intervene in markets as a
reaction to public pressure or moral panic
spread by news organisations.
◦ Public choice theory is the analysis of governmental
behaviour, and the behaviour of individuals who
interact with government.
◦ Public interest: making decisions based on a
principle where the maximum benefit is gained by
the largest number of people at minimum cost.

The Invisible Hand versus Public Interest
Public choice theory looks at are cases where
individual interest leads to decisions and the
allocation of resources which may not be the
most efficient allocation.

Voter, Politician and Bureaucrat
Incentives
Rational ignorance
◦ A voter tends not to not seek out information to make
an informed choice in elections since they do not see
their individual vote as making any difference.
Politicians will reflect the interests of the local
communities they are seeking to serve.
◦ They want to be re-elected.
Bureaucrat
◦ Civil servants providing advice have power.

Other Distorting Behaviour
The special-interest effect may lead to minorities
gaining significant benefits but the cost is borne by the
population as a whole.
Logrolling is a term used to describe vote trading in
government.
Rent seeking is where individuals or groups take
actions to redirect resources to generate income
(rents) for themselves or the group.

Other Distorting Behaviour
Cronyism (returning favours).
Inefficiency in the Tax System
◦ Individuals and companies using of loopholes in the
tax system to avoid paying tax.
◦ Tax avoidance is legal.
◦ Tax evasion is illegal and includes the informal
economy.

Summary
o When one party’s activity affects another party, the effect
is called an externality.
o Negative externalities cause the socially optimal quantity
in a market to be less than the equilibrium quantity.
o Positive externalities cause the socially optimal quantity
in a market to be greater than the equilibrium quantity.
o Those affected by externalities can sometimes solve the
problem privately.

Summary
o Coase theorem states that if people can bargain without
a cost they can always reach an agreement in which
resources are allocated efficiently.
o When private parties cannot adequately deal with
externalities, then the government steps in.
o The government can either regulate behaviour or
internalise the externality by:
o Using Pigovian taxes or by issuing permits
o It might create property rights so that the private parties may
be able to bargain and reach a satisfactory outcome.

Summary
o Government intervention to correct market failure might
be subject to its own failures.
o Minority groups are able to exercise political power to
influence decision-making of politicians and bureaucrats to
gain benefits which might be outweighed by the costs
imposed on the majority.


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11

MARKET FAILURE AND EXTERNALITIES

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION

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Charities that deal with externalities

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FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018

9781473725331 © CENGAGE EMEA 2017

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

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