1. ALLOCATIVE EFFICIENCY  Under the assumptions of perfect competition and no externalities, the economic well-being of a society is measured as: The sum of consumer and producer surplus.  The invisible hand is powerful but not omnipotent, which leads to market failure.

2. MARKET FAILURE  If a market system affects individuals other than buyers and sellers of that market, side-effects are created called Externalities. » Externalities cause markets to be inefficient, and thus fail.

3. MARKET FAILURE Due to externalities, market equilibrium is not the socially desirable equilibrium. Market price and quantity is not the same as socially desirable price and quantity. The market (invisible hand) does not allocate resources efficiently (allocatively)

4. EXTERNALITIES From Production and Consumption

6. EXTERNALITIES Unintended side effects or spillovers, both positive and negative, which affect a third party, caused by production or consumption. Externality = Side-Effect Spillover External cost/benefit

7. EXTERNALITIES Caused by production Positive or negative Caused by consumption Positive or negative

8. SOCIAL COST Social cost = total cost to society from production including any spillover effects. Private cost = cost to individual firm (MC) Social cost = MC + spillover cost or Social cost = MC – spillover benefit

9. SOCIAL BENEFIT Social benefit = total benefit to society from consumption including any spillover effects. Private benefit = benefit to individual consumer (MB) Social benefit = MB + spillover benefit or Social benefit= MB – spillover benefit

10. Negative externalities of production External costs experienced by a third party caused by production. For example; Air pollution – causes lung disorders, breathing discomfort and increased cleaning costs. Noise pollution – causes hearing problems and the discomfort of loud noise. Water pollution - causes unsafe drinking water, loss of fishing and recreational enjoyment.

11. Negative externalities of production Q Cost Benefit Price $ MC MSC The good is overproduced and underpriced in the market. Resources are mis-allocated. The market fails. Spillover Cost per unit MB Pm Ps Qm Qs

12. Positive externalities of production Firms planting trees or gardens create cleaner air and a more appealing look to the environment. A food shop might locate near a big firm and gain from the external benefits of more customers.

13. Positive externalities of production Q Cost Benefit Price $ MSC MC The good is underproduced and overpriced in the market. Resources are mis-allocated. The market fails. Spillover benefit per unit MB Pm Ps Qm Qs

14. Negative externalities of consumption Cigarette smoke exhaled affects the health of others. Driving cars in the city pollutes the air as well as adding to traffic congestion. Planting trees, or building a house might interfere with others’ views.

15. Negative externalities of consumption Q Cost Benefit Price $ MC The good is overproduced and underpriced in the market. Resources are mis-allocated. The market fails. MSB MB Spillover cost per unit Qm Qs Pm Ps

16. Positive externalities of consumption Going to an educational program such as defensive driving or first aid gives others a potential benefit in terms of fewer road accidents and urgent first aid when required. Using public transport means less air pollution for others and less traffic congestion.

17. Positive externalities of consumption Q Cost Benefit Price $ MC The good is underproduced and overpriced in the market. Resources are mis-allocated. The market fails. MB MSB Spillover benefit per unit Qm Qs Pm Ps