Market Failures

EXTERNALITIES & COMMON POOL/ACCESS RESOURCES

2.8

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 Review
Define Market Failure

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 Review
Why do market failures exist?

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 Optimal Social Quantity
New terms to know
MPC (Marginal Private Cost)
The cost for firms to produce an additional unit of a good or service

MSC (Marginal Social Cost)

The total cost to society is when an additional unit of a good or service is produced. MSC includes
MPC.

MPB (Marginal Private Benefit)

The benefit to consumers of consuming an additional unit of a good or service.

MSB (Marginal Social Benefit)

The total benefit to society when an additional unit of a good or service is consumed.

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 Optimal Social Quantity
Equilibirum
MSB = MSC

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 Optimal Social Quantity

New terms to know

Merit Goods
Goods that are beneficial to the individual and society as a whole and are usually, under-provided.

Demerit Goods
Goods that are harmful to the individual and society as a whole and are usually, over-provided.

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 Externalities

When third parties, who are uninvolved, are affected by the benefits and
costs involved in producing or consuming a particular good.

Brainstorm with a partner or small

group a list of 5 externalities in the
real world

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 Four Types of Externalities
Negative Positive
externalities of externalities of
production
MSC > MSB
production
MSC < MSB

Negative Positive
externalities of externalities of
consumption
MSC > MSB
consumption
MSC < MSB

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 Negative Externality of
Production
The production process of a good or service generates a
negative effect on a third party or on society as a whole.
Private firms do not take the additional costs on society into
consideration during production.
Examples
Air Pollution
Water Pollution
Loud noises generated.

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 Negative Externality of
Production
In the graph below, a typical company is making coal and is a significant
contributor to air pollution in the area.
The firm will only take into consideration their private benefit and costs
when determining how much to produce. The cost to society is much
higher.

ATTENTION:
Notice that the negative
externality only affects production
(supply curve).
The demand curve represents
both MSB + MPB.
Production externalities ALWAYS
affect Cost/Supply

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 Government Responses
The goal is to limit or decrease the production.

Legislation
Pass laws regarding environmental standards that firms must comply with. (Machinery upgrades, air
filters, disposal requirements)
Pros: Easy to Apply
Cons: Cost of production increases -> unemployment potential, cost of enforcing policy
Carbon Tax
Impose a tax on the firm per unit of output produced.
Pros: Government Revenue, Easy to Apply
Cons: Difficult to measure, Difficult to calculate tax
Tradable Emission Permits
Permission to pollute permits that enforce a quota of emissions. An eco-friendly firm can sell its permit
for profit.
Pros: Encourages firms to lower cost, free-market sets price of a permit, cooperation among businesses
Cons: Difficult to set an acceptable level of pollution, Difficult to measure pollution

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 Positive Externality of
Production
The production process of a good or service generates a
positive effect on a third party or on society as a whole.
Examples
Research and Development of New Tech (BlockChain)
Bee Keeping
Flood Defence Systems

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 Positive Externality of
Production
Due to it's a positive effect on society, MSC is less than than
MPC.

Please note: This is still an

inefficient allocation of
resources but, a potential
welfare gain.
Once again, production
externalities ALWAYS
affect costs/supply.

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 Government Responses
The goal is to increase the production for the benefit of
society.
Subsidizing Firms
Pros: Encourages promotion of the industry and lowers costs for firms.
Cons: The opportunity cost of using government funds, (may have to give up other things
such as healthcare)
Direct Government Provision
Pros: Government is in full control
Cons: High costs and opportunity cost, lack of expertise by the government, private
firms discouraged from joining market

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 Negative Externality of
Consumption
The consumption of a good or service generates a negative
effect on a third party or on society as a whole.
Examples
Smoking cigarettes around others
Dog Ownership in Apartments
Driving Vehicles with High Emissions

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 Negative Externality of
Consumption
Due to its negative effect on society, MSB is lower than MPB. Consumption is
greater than what it SHOULD BE. The good is over-allocated.

ATTENTION
Externalities of
consumption focus on
Demand/Benefits.
Therefore, MSC and MPC
will always be equal.

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 Government Responses
The goal is to decrease consumption for the benefit of
society.
Indirect Taxes
Taxes designed to correct negative externalities are called Pigouvian Taxes
Pros: Increases the cost of the good quickly, Government Revenue
Cons: Addictive goods are demand price inelastic, creates black markets
Regulation or Ban
A regulation or full ban to make the product illegal. (Non-smoking Areas)
Pros: Reduce Demand, low cost
Cons: Slow to implement, Government Spending, Enforcing regulations, anger from consumers
regarding free-will.
Negative Advertising
Government could fund negative advertising such as images on packs of cigarettes.
Pros: Aims to reduce demand naturally
Cons: High cost and opportunity costs for the government, studies are unclear on how effective
advertising is especially on young adults and teenagers.

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 Positive Externality of
Consumption
The consumption of a good or service generates a positive
effect on a third party or on society as a whole.
Examples
Education
Healthcare
Vaccines

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 Positive Externality of
Consumption
Due to its positive effect on society, MSB is greater than MPB.
Consumption is SMALLER than it should be.

Please note: This is still an

inefficient allocation of
resources but, a potential
welfare gain.
Once again, consumption
externalities ALWAYS
affect Demand/Benefits.

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 Government Responses
The goal is to increase the consumption for the benefit of
Subsidizing Firms
society.
Pros: Encourages promotion of the industry and lowers costs for firms.
Cons: The opportunity cost of using government funds, (may have to give up other things
such as healthcare)
Direct Government Provision
Pros: Government is in full control
Cons: High costs and opportunity cost, lack of expertise by the government, private firms
discouraged from joining market
Positive Advertisements
Pros: Aim to increase Demand Naturally
Cons: High costs and opportunity cost
Compulsory Legislation
Pros: Shifts demand effectively
Cons: Government must provide for free, anger from residents, cost of enforcing law

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 Real World Connection
Vaccine Mandate

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 Vaccine Mandates
Read the following article or Listen and answer the
questions below with your group.

What are your initial thoughts on COVID vaccine mandates?

Explain the economic rationale for or against them
Do you think COVID vaccine mandate are legal? Would you support
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 Welfare Loss/Gain Calculation

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 Welfare Gain/Loss Calculation
Area of a Triangle = 1/2 (base x height)

Determine whether this is a welfare

gain or loss.
Calculate the amount in Euro. (note
the quantity units) Show all work.

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 Welfare Gain/Loss Calculation
Area of a Triangle = 1/2 (base x height)

Welfare Gain
Potential Welfare Gain =
1/2(base*height)
1/2((6-4)*5Million)
1/2( 2 * 5 Million)
1/2(10 Million)
Potential Welfare Gain = EUR 5 Million

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 Common Pool Resources

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 Common Pool Resources
Also known as Common Access Resources or Common Property Resources
Definition
Resources that are rivalrous but non-excludable.
Examples: Fish, Clean Air, Lakes/Rivers, Forest, Fertile Soil

Rivalrous Non-Excludable
A good when consumed, cannot be A good that someone cannot be
consumed by another person. excluded or prevented from using.
Example Example
When one uses fertile soil, there are Goods that have no price and are
fewer spots for others to farm. available to use without payment.
Clean Air
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 Common Pool Resources
Common Pool Resources are rivalrous and non-excludable.
It would be very difficult to charge a price for these items resulting in
overuse and over-consumption which could lead to severe environmental
impacts in the long run.

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 Sustainability
Issues surrounding Common Pool Resources lead to discussions about
Sustainability.
Definition
the ability of the present generation to meet its needs without
compromising the ability of future generations to meet their own needs.

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 Government Responses to
Sustainability Threats

Sustainability is of great importance on a national and global level. These resources

are not owned by one country, and therefore, international cooperation is key.
Some Examples

Carbon Emission Caps and Taxes

Subsidies for Clean and Renewable Technologies (Clean Technology)
Collective Self Governance
Participation of industries in the measures planned and taken to resolve
environmental sustainability issues. These industries are aware there is a
problem and strive to fix them.
Examples: Cruise Lines are aware they have a negative impact on the
environment. They chose to implement and market their sustainability.
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 International Cooperation

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 International Cooperation
Countries must cooperate to develop, set, and enforce policies designed to slow, halt,
and reverse climate change.
Example: Paris Climate Accord

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 International Cooperation Challenges
Lack of Shared Responsibility
Not all countries produce large CO2 Emissions. The countries most
affected are small islands with little/no C02 footprint while those
larger countries responsible for large emissions are slow to act.
Inequality of Resources
Not all countries have the ability to devote resources to combat
climate change. Developing countries find it much more difficult to
transition to clean technology and renewable energy
Political Disagreements
Some governments are more committed than others to reducing
environmental impacts and there are different views about which
methods are best.

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 Review

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 Diagrams and Rationale
Concepts of MSB, MPB, MSC, MPC
Over-production vs under-production
Socially Optimal Quantity
Negative Externalities of Production and Consumption
Draw Diagrams, explain welfare loss/gain, and government responses
Positive Externalities of Production and Consumption
Draw Diagrams, explain welfare loss/gain, and government responses

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 Practice Question

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 Paper 1

M13/3/ECONO/SP1/ENG/TZ1/XX

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 Check Answers

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