1. Market Failure

2. Definitions & Terminology
Allocative efficiency (Pareto Optimality) is where
MARGINAL SOCIAL BENEFIT
= MARGINAL SOCIAL COST
(draw on a diagram)
If there is allocative inefficiency, too much or too little of goods or services are produced and consumed from the point of view of what is socially most desirable. Overprovision of a good means too many resources are allocated to its production (overallocation); underprovision means that too few resources are allocated to its production (underallocation)

3. Market Failure Imperfect competition Externalities
In the real world, free markets often “fail” to achieve allocative efficiency
The causes of “market failure”
Imperfect competition
Externalities
Collectively consumed (“public” )goods
Common access resources
Asymmetric/Imperfect information e.g. case of insurance and/or Irrational buyers: case of financial crisis
Inequitable distribution of income?
When a market fails, it justifies
government intervention
e.g. taxes, subsidies, regulation, price controls, government provision of the good

4. Introducing Externalities
the state or quality of being external (outward, outside); often unforeseen or unintended (dictionary.com)

5. More formally..
An externality occurs when the actions of consumers or producers give rise to negative or positive side-effects on other people (third-parties) who are not part of these actions, and whose interests are not taken into consideration
When a consumer buys a good, she or he derives some benefits and when a firm produces and sells a good, it incurs costs. But sometimes the benefits or costs spillover onto other consumers or producers who have nothing to do with consuming or producing the good.
When this happens, there is an externality

6. Types of Externality:
If the side effects on third parties involve benefits, there is a positive externality also known as an external benefit
If the side effects on third parties involve costs, there is a negative externality also known as an external cost

7. Examples of goods with externalities
MERIT GOODS
have
EXTERNAL
BENEFITS
Positive Externality of Consumption
Positive Externality of Production
DEMERIT GOODS
COSTS
Negative Externality of Consumption
Negative Externality of Production

8. Real Life Examples Negative production externalities
Environmental pollution
Negative consumption externalities
Due to smoking in public places, cars
Positive production externalities
If there is research and development e.g. hybrid technology, IPS cells and Stem cell research; spin-offs from NASA
From orchards and bee farms
Positive consumption externalities
Arising from education and health care, leading to increase in productivity, learning from each other, less crimes ..

9.  SOCIAL COST = Private Cost + External Cost = TOTAL Cost
If a Negative Externality : (due to Demerit Goods)
 SOCIAL COST = Private Cost + External Cost = TOTAL Cost
If a Positive Externality: (due to Merit Goods)
 SOCIAL BENEFIT = Private Benefit + External Benefit
= TOTAL Benefit (or utility)

10. Modeling and Analysis of Externalities
To model and analyze externalities, consider the definition of demand and supply
Demand curve is also the consumer’s marginal benefit of consumption
Supply curve is also the firm’s marginal cost of production. (The cost to producers for producing one more unit of the good, the minimum revenue needed to stay in business)
Since the benefits received by consumers go to the private individuals, we can refer to the demand curve as the marginal private benefits (MPB)
Similarly, since the costs incurred by producers go to the private firms, we can refer to the supply curve as the marginal private costs (MPC)

11. Modelling Externalities
1) Model the existence of a
Positive Externality of Consumption
2) Model the existence of a
Negative Externality of
Consumption
3) Model the existence of a
Positive Externality of Production
4) Model the existence of a
Negative Externality of Production

12. REVIEW
If there are externalities (benefits or costs) on the rest of the society full benefits or costs to society differ from private ones
 the concepts of marginal social benefits (MSB) and marginal social cost (MSC)
Marginal social benefit = benefits to society from consuming one more unit of a good
Marginal social cost = costs to society of producing one more unit of a good
(Both equal the PRIVATE cost/benefit + / − EXTERNAL cost/benefit)
When this occurs, the equilibrium price and quantity determined by the intersection of MPB and MPC (demand and supply in the private market) are not equal to the ones determined by the MSB and MSC (social optimum or efficient outcome)

13. From the societal perspective (the entire society), the social optimum or the “best” allocatively efficient outcome is where all benefits and costs are recognized
(Remember: Adam Smith assumed that when there are no externalities then the private equilibrium is the optimal allocative outcome… in other words, he assumed that MPB = MSB and MPC = MSC)
Thus, when externalities are present, the market equilibrium P and Q determined by MPB and MPC is NOT allocatively efficient… because social benefits or costs differ from private ones WELFARE LOSSES

14. Redefining Allocative Efficiency
Allocative efficiency is achieved when
MSC = MSB.
An externality creates a divergence between MPC and MSC or between MPB and MSB
Where there is an externality, the free market leads to an outcome where MPB = MPC, but where MSB is not equal to MSC, indicating allocative inefficiency
NEGATIVE EXTERNALITIES ………………. at too …………………. a price
POSITIVE EXTERNALITIES ………………. at too …………………. a price

15. Graphically

16. Negative Production Externality
For each level of output , the social costs of producing the good are greater than the firm’s private costs
The vertical distance between MSC and MPC represents the (marginal) external cost
The free market outcome is determined by the intersection of MPB and MPC and is indicated with “m”. The social optimum (allocatively efficient) outcome is given by the intersection of MSB and MSC which is indicated with “opt”

17. Welfare Analysis
The welfare loss occurs where MSC > MSB for the output that is overproduced (Qm – Qopt)
It is the loss to society due to overproduction of the good caused by the externality. Society would be better of if less of the (harmful) good is produced.
There would be a WELFARE GAIN if less of the good was produced

18. 2. Positive production externalities
Positive externalities of production refer to external benefits (or “negative costs”) created by producers
Examples
Research and development and development of new technology that spreads throughout the economy (eg lasers)
Firms training workers who later switch jobs
Pharmaceutical firms or NASA developing new medication that can be used for other purposes
Fruit orchards and bee (honey) farms

19. (continued)
In the production, there are external benefits as the firm not only benefits but also the third party and society as a whole
This implies that the social costs of the production (with positive external benefits) are lower than the private costs incurred by the firm (the external benefits can be thought of as “negative costs”- production is more beneficial than expected)
The MSC curve lies below the MPC curve and the vertical difference between the two is the (marginal ) external benefit

20. Comparing the market outcome and the social outcome, it is evident that the market underallocates resources for the production of this good or underproduces it.
Society would have been better off if more of the good was produced (ie a WELFARE GAIN if more of the good)
For the shortage of quantity below Qopt, MSB > MSC. WL is the total loss calculated as the difference in the MSB and MSC

21. More specifically, theWL (DWL) due to the allocative inefficiency is…

22. 3. Negative Consumption Externalities
Negative externalities of consumption refer to external costs created by consumers
Examples
Consumers of cigarettes smoking in public places spilling over second hand smoke to other people
Heating homes and driving cars utilizing fossil fuels and gas that emit pollution to the atmosphere/cause noise pollution, congestion and accidents
Partying with loud music, construction work, alcohol etc.

23. (continued)
Perspective now is the consumer  expect the MB curve to change and not the MC curve
When there is a negative consumption externality, the marginal private benefit (MPB or demand curve) no longer reflects the social benefits (MSB)
The external costs to third parties (non-smokers) creates “negative benefits” to society and cause the MSB curve to lie below the MPB curve
The vertical distance between the MSB and MPB represents the (marginal) external cost
This is shown as follows…

24. Graphical Illustration
Note: since the externality involves consumption, the demand curve is unreliable but the MC curve is unaltered (assume no exterrnalities in production or MPC = MSC)
The market outcome is determined by the intersection of MPB and MPC but the social optimum is determined by the intersection of MSB and MSC
NOTE- MISTAKE in diagram. Popt should be HIGHER in order to reduce quantity demanded to Qopt

25. The welfare loss (due to the overproduction of the good in the market) is equal to the vertical difference between MSC and MSB curves (the external cost where MSB < MSC.) for the amount of output that is overproduced relative to the social optimum (Qm – Qopt)
For the excess amount of output produced beyond Qopt, the WL is the total difference of MSB and MSC for the extra output being produced
There would be a WELFARE GAIN if output was reduced to Qopt
NOTE- same MISTAKE in diagram Popt should be HIGHER

26. 4. Positive Consumption Externalities
Positive consumption externalities refer to external benefits created by consumers
Examples
Consumption of education benefits the person who receives it but also give rise to external benefits
Consumption of health care, immunization, HIV tests, etc., also benefits the society at large as healthier economy

27. (continued)
When there is a positive consumption externality, the marginal private benefit (MPB or demand curve) no longer reflects the social benefits (MSB)
The external benefits to third parties and society cause the MSB curve to lie above the MPB curve
The vertical distance between the MSB and MPB represents the (marginal) external benefit
This is shown as follows…

28. Graphical Illustration
Note: the MC curve is unaltered (MPC = MSC or NO production externalities)
The market outcome is determined by the intersection of MPB and MPC but the social optimum is determined by the intersection of MSB and MSC
NOTE- MISTAKE in diagram. Popt should be LOWER in order to reduce quantity demanded to Qopt

29. Welfare loss (due to the underproduction of the good) is equal to the vertical difference between MSC and MSB curves (the external benefit) for the amount of output that is underproduced relative to the social optimum (Qopt – Qm)
For the shortage of the output below the Qopt, MSB > MSC. WL is the sum of difference between MSB and MSC for the shortage of output
NOTE- MISTAKE in diagram. Popt should be HIGHER in order to reduce quantity demanded to Qopt