Microeconomics Topic #3

Market Failure
Introduction to Market Failure &
Negative Externalities
Why is the existence of externalities a market
failure?
• Negative vs. Positive Externalities
• Marginal Social Cost (MSC) = Marginal Private Cost (MPC)
• No externalities  MSC=MPC
• MPC is the private supply curve
• Marginal Social Benefit (MSB) = Marginal Private Benefit (MPB)
• No externalities  MSB=MPB
• MPB is the private demand curve that is based on the utility to consumers
• MSC= MSB
• Social efficiency
• MSC ≠ MSB  market failure & inefficient allocation of society resources
Negative Externality of Production

DWL
Negative Externality of Consumption

DWL
Market Failure
• Any situation where the allocation of resources by the free market is
not efficient
• When the price mechanism fails to allocate resources towards the
socially optimal amount
• There is either an under-allocation or over allocation of resources to
the market
Market Failure
1. Free markets tend to be allocatively efficient
Market Failure
2. Free Markets also tend to produce the Socially Optimal amount of a
good or service
Market Failure
3. Types of Market Failure
1. Externalities
2. Public Goods
3. Common Access Resources
4. Imperfect Competition
5. Asymmetric Information
Negative Externalities
1. Private v. Social Benefits
i. Private Benefit:
• The benefit gained from the consumption of a good or service
ii. Marginal Private Benefit:
• The benefit a consumer gains from consuming an additional unit of the
good
iii. Marginal Social Benefit:
• The benefits to society from consuming additional units of the good
iv. Spillover Effect:
• Can be negative (MSB < MPB) or positive (MSB > MPB)
Negative Externalities
2. Private vs. Social Costs
1. Private Cost
• The costs firms incur producing goods or services to supply the
market
2. Marginal Private Cost
• The change in total cost that comes from making one more product
3. Marginal Social Cost
• The costs to society of producing one more unit of a good or
service
4. Spillover effects
• Can be negative (MSC > MPC) or positive (MSC < MPC)
Negative Externalities
3. Negative Externality of Production
Negative Externality of Production
MSC > MPC
• With a negative externality of
production the free market has
overproduced the good
• Consequently, the market price is
too low
Negative Externalities of Production
Negative Externalities of Consumption
Negative Externalities of Consumption
MSB < MPB
• Demerit Good:
• Goods and services that
create negative externalities
when they are consumed—
often, they are harmful to the
consumer as well
• Not all goods that create
negative externalities of
consumption are demerit
goods
• Example: petrol from cars
Demerit Goods
Product Examples of the possible Examples of the possible
harm to the consumer harm to third parties
Cigarettes
Unpleasant smell (small cost)
Respiratory illnesses, cancer,
All the same problems as the harm
death, damage to unborn
to consumers as a result of passive
children
smoking
Alcohol
Health consequences, such as Problems to society as a result of
hangovers, liver disease, high excessive (binge) drinking, such as
blood pressure aggressive behavior, domestic
Unhealthy food (i.e. violence, costs of medical care
sugary drinks, food
with high sugar or fat
content) Possible health consequences, Health care costs are borne by
such as high blood pressure, society
problems associated with being
overweight
Negative Externalities of Consumption
Example
• Increasing rates of obesity across the world are a pressing global
issue. How can it be seen as an economic problem in the context of
market failure? What types of policies are governments implementing
to fight obesity?
Correcting Negative Externalities of Production
Methods fall into these broad categories:
1. Government Regulations (i.e. pollution limits)
2. Market-Based Policies (i.e. pollution charges or taxes)
Effects of Government Regulation
• Governments can enact
legislation that aims to achieve:
Pollution Limit
Market based approach
• Indirect Taxes (Pigouvian tax)
Per-Unit Tax
Carbon Tax
Cap & Trade
• Cap

• Trade
Example
Advantages to Market Based Policies
• Reduces the size of the externality and move the output toward the socially
optimal level
• Makes those involved in the transaction (producers & consumers) internalize
the costs to society
• Carbon Taxes and Permits incentivize firms to adopt new technologies and
production methods
• With permits, firms that are best able to lessen pollution in the least costly
method will do so and sell permits to firms where it is more costly (this results
in less impact on overall output)
• Tax revenue can be used by the government to help those affected by
externalities or to less the impact of negative externalities
Disadvantages of Market Based Policies
• Assessing the magnitude of the
externality is extremely difficult
and costly
• It is almost impossible to
estimate the true cost to society
—these policies will only shift
the MPC curve closer to the
MSC curve
Disadvantages of Market Based Policies
(cont)
• If the tax is too high, it can cause significant economic harm
• If the tax is too low, firms will set it as “cost of doing business”
and continue to pollute
• May not deter pollution, only reduce it (“pay to pollute”)
• With per unit taxes, significant resources leave the market and
there is little incentive for firms to alter their production
methods
Advantages to Government Regulations
• Reduces the size of the externality and moves the output toward the
socially optimal level
• Simpler and can be more easily implemented than market-based
policies
• Can raise additional government revenue if firms are non-compliant
Disadvantages to Government Regulations
• Can be influences by political motivations and lobbying groups
• Do not allow for the externality to be internalized because there is no
market-based incentive to get firms and industries to reduce their
pollution
• Difficult to determine what is harmful and in what quantities, and
how much harm is being caused
• Can be costly to implement and may require a large drain on
government resources (creation of an agency, oversight, legal battles,
etc.)
• Evaluate the effectiveness of a carbon tax in an economy of your
choice.
 Example
• The “fast fashion” industry is now seen as a major contributor to the global
waste problem and therefore a threat to sustainability.
a) Explain briefly what is meant by the “fast fashion industry”
b) What are the negative externalities associated with the consumption of clothing?
c) Inexpensive clothes create negative externalities, but they are not considered a
demerit good like cigarettes or unhealthy food. What is the difference?
d) What are the negative externalities associated with the production of clothing?
e) How are governments responding to this threat to sustainability?
f) Evaluate the success of government responses, considering the following
questions:
i. What barriers have governments faced in trying to implement policies?
ii. To what extent have they been successful in reducing consumption?
iii. Once the policies were implemented, what factors have limited their success?
Correcting Negative Externalities of
Consumption
1. Taxation
• Attempt to “internalize” the
externality
Advantages
• Reducing the size of the externality and move the output toward the
socially optimal level
• Makes those involved in the transaction (producers & consumers)
internalize the costs to society
• Consumers pay more and this serves as an incentive to buy less of the
good (change consumption habits)
Disadvantages
• Assessing the magnitude of the externality is extremely difficult and
costly
• If the tax is too high, it can cause significant economic harm
• If the tax is too low, it will have little impact on consumer behavior
• Demerit goods tend to be inelastic (either addictive like cigarettes or a
necessity like gas)
• Accordingly, taxes tend to generate revenue, but do little to decrease
consumption
• To decrease consumption, the taxes will have to be very high—which may
be politically unpopular
Legislation, Regulation, and Advertising
(Decrease Demand)
• Prevent certain people from buying
the good (i.e. age requirements)
• Limiting where and when the
product may be used (i.e. not
allowing smoking at bars, offices,
etc.)
• Negative advertising
Consumer Nudges- HL Extension
• Consumers do not always have perfect information and do not always
make rational choices.
• Governments and other organizations have to encourage people to make
better choices so society wellbeing increases
• Consumer Nudges encourage consumers to reduce their consumption
voluntarily
• i.e. cigarettes
Advantages
• Reduces the size of the externality and moves the output toward the
socially optimal level
• Simpler and can be more easily implemented than market-based
policies
• In combination, advertising and regulation can be effective at
changing the value that consumers place on a good
Disadvantages
• Changing attitudes through advertising can be expensive
• Hard to convince people who are addicted or dependent on the
product
• Regulations may not go far enough to completely resolve the
externality
Real World Examples
• There are many examples of products which create negative
externalities of consumption.
• Choose a product whose consumption creates negative externalities
and address the following questions to build up a case study.
1. Illustrate how the consumption of your product creates market failure. Be
sure to specify the external costs, and who “pays” these external costs
2. Investigate different policies that governments have used to reduce this
market failure. Try to identify three different policies, noting where these
have been implemented.
3. Evaluate the success of these policies, considering the following questions
a) What barriers did the governments face in trying to implement policies?
b) To what extent have they been successful in reducing consumption
Positive Externalities
Positive Externality of Consumption

DWL
Positive Externalities of Consumption
• An external benefit is created by the
consumption of a good or service

• MSB > MPB

• Merit Good: a good whose consumption

benefits 3rd parties—governments feel
that people will under-consume the good
and that it should be subsidized or
provided free at the point of use
Merit Goods
Merit Goods
Product Possible private benefits Possible benefits to society as a whole
A university education
in engineering The joys of pursuing a career in a More people educated in engineering
chosen field. at university may contribute to
Better job prospects important technological innovations.
Measles vaccines
Less risk of contracting measles. If a certain percentage of the
Better health population is immunized against
measles, then it reduces the risk of a
Sports facilities
measles outbreak
Enjoyment of physical activity. A “fitter” population is a more
Better health. productive population
Correcting Positive Externalities of
Consumption
1. Subsidies to producers or
consumers

2. Direct Government Provision

a) K-12 Education, Healthcare,
Vaccination Programs
b) Typically are merit goods that
provide great benefit to society
(and, as such, cannot be left to the
free market)
Correcting Positive Externalities of Consumption (cont.)
3. Legislation (increase demand)
a) Government enacts laws that compel individuals to consume them (i.e.
compulsory schooling)
b) Government must provide the resources to fulfill the demand created by the
legislation
c) Programs can be resource intensive to establish, monitor, and enforce (i.e.
compulsory vaccinations)
4. Advertising (increase demand)
d) Is more effective with some merit goods (i.e. sports and activities) than others
(i.e. health campaigns for men to see their doctors for regular prostate exams)
e) Advertising campaigns can be expensive and must reach the target audience
(many different media outlets)
Positive Externalities of Production
• Producing a good or service creates
an external benefit that spills over
and is enjoyed by 3rd parties

• MSC < MPC

• Third parties or individuals external

to the market are benefitting from
the production decision without
have to pay a cost (MSC < MPC)
Positive Externality of Production

DWL
Correcting Positive Externalities of
Production
1. Subsidy to Producers
2. Direct Government Provision of the Good
Advantages
• Both policies are highly effective in increasing the quantity of the
good or service being produced and consumed
• Reduces the price paid by consumers
• Reduces the size of the externality and moves the output closer to the
socially optimal level
Disadvantages
• Opportunity cost: government funding (tax revenue) is required and
could be used for something else (money spent on R & D could be
used for healthcare or education)
• Many goods provide positive externalities—how does the
government choose?
• It is difficult to measure the size of the spillover benefits that result
from production (often still underproduced)