Externalities & Market Failure

What is an externality? This arises when a person or firm engages in an activity that influences the well-being of others and yet neither pays nor receives compensation for that effect Factoring in externalities shows the true costs and benefits to society Negative Externality Positive Externality The activity causes a negative impact on the well-being of society The activity causes a positive impact on the well-being of society

Negative or Positive?

Externality Terms Marginal private benefit The benefit derived by the private consumer

Carla’s MPB when planting one flower is her enjoyment of gardening.

Externality Terms Marginal private benefit Marginal private cost The benefit derived by the private consumer Marginal private cost The private cost to the producers of a good associated with the good’s production

The MPC of Carla planting one flower could be $10 (for the seed, soil, etc.)

Externality Terms Marginal private benefit Marginal private cost The benefit derived by the private consumer Marginal private cost The private cost to the producers of a good associated with the good’s production Marginal social benefit The private benefit plus any external benefits placed on society

The MSB of Carla planting one flower is her enjoyment of gardening AND the beautiful scent it emits that the neighbors love

Externality Terms Marginal private benefit Marginal private cost The benefit derived by the private consumer Marginal private cost The private cost to the producers of a good associated with the good’s production Marginal social benefit The private benefit plus any external benefits placed on society Marginal social cost The private cost plus any external costs placed on society

The MSC of Carla planting one plant is $10 AND the extra space that was taken away for the neighborhood kids to play

Graphing the impact of externalities

A market graph

A market graph when describing externalities

Lets look at the car market Lets look at the car market. Lets assume that there are NO government regulations on car production…

The externalities of car production would create MARKET FAILURE!

Sometimes the production of the good produces a cost that is NOT included in the marginal private cost of production

For example, when a firm pollutes the air during production, this cost of pollution to society is NOT included in the MPC of production

The pollution cost is a negative externality

When the pollution cost is added to the MPC of production, you then get the marginal social cost to society

So, the marginal social cost is the TRUE cost of producing a car.

Let’s look at this graphically…

Externalities and their affects Causes market failure Creates deadweight loss (Total surplus not maximized) Causes either an over-allocation or under-allocation of resources. Producing at the socially efficient equilibrium will offset the impact of externalities. (Where demand=supply)

Public Policy Towards Externalities Governments can attempt to make markets impact by externalities more efficient by doing many things: Corrective taxes Production regulations Grants and subsidies Etc…

Higher Education Practice Higher education causes society to be more productive Graph the market failure Is it over or under allocation of resources? Describe what the government can do to correct the market failure.