Externalities

In this chapter, we will delve into market failure, focusing particularly on externalities. Market failure happens when the free market cannot efficiently allocate resources, leading to a loss of social welfare. Externalities are one of the primary causes of this inefficiency. We will explore what externalities are, different types of externalities, and how government policies can address these market failures. Throughout this chapter, we’ll use real-world examples to demonstrate how externalities impact society and how policies can help mitigate these effects.

1. Introduction to Market Failure

Definition of Market Failure

Market failure occurs when the allocation of resources in a free market leads to an inefficient outcome, which harms social welfare. This means that the market does not work in the best interest of society, leading to overproduction or underproduction of goods and services.

One of the main causes of market failure is externalities. Externalities occur when the actions of individuals or firms affect others who are not involved in the transaction. This results in costs or benefits that are not reflected in the market price of a good or service.

Relevance of Externalities in Market Failure

Externalities can cause significant inefficiency in markets. In the case of negative externalities, the social costs exceed the private costs, while for positive externalities, the social benefits exceed the private benefits. This imbalance often leads to market outcomes that are less than optimal, prompting the need for government intervention to correct these market failures.

2. Understanding Externalities

Definition and Characteristics of Externalities

An externality is defined as a side effect of an economic transaction that affects third parties who are not directly involved in the transaction. Externalities can be both positive and negative, depending on whether the side effect benefits or harms others.

Positive Externalities occur when a third party benefits from a transaction.
Negative Externalities occur when a third party suffers from a transaction.

Externalities typically arise when property rights are not well-defined, or when the market price does not include the full costs or benefits of an activity. This often leads to market inefficiencies, where society as a whole is not better off due to these unaccounted effects.

3. Types of Externalities

3.1 Positive Externalities

Positive externalities occur when an economic activity benefits others beyond the individual or firm involved in the transaction. These benefits are not reflected in the market price of the good or service.

Examples of Positive Externalities

Education: Education is a classic example of a positive externality. The benefits of education extend beyond the individual learner, improving society as a whole. Educated individuals contribute to the economy by being more productive, have lower crime rates, and make informed voting decisions. The government often steps in to provide public education, ensuring that society benefits from a well-educated workforce.
Vaccinations: When someone gets vaccinated, they not only protect themselves from disease but also reduce the spread of infections to others. This is a positive externality because the vaccinated person’s action helps protect the health of the broader community. Public health campaigns and subsidized vaccination programs, such as those offered by governments globally, ensure that more people benefit from this positive externality.
Public Parks: The creation of public parks is another example. By providing green spaces in urban areas, everyone in the community benefits from improved air quality, recreational spaces, and enhanced mental health. Even though only the government or private entity may fund the parks, the entire community enjoys the benefits.

Positive Production Externality

Positive production externalities exist when the marginal social benefit of production exceeds the marginal private benefits i.e. production of the good generates external benefits that are under-valued by the free market. For instance, something that generates positive externalities from its production is honey. When a beekeeper produces honey, he/she incurs his/her own cost (marginal private cost) which includes the cost of breeding bees and labour needed to extract honey from beehives, as well as enjoys his/her own benefits (marginal private benefit) which includes revenue generated from the sale of honey. However, the production of honey also benefits third parties who are neither consumers nor producers of honey. Farmers nearby benefit from plant pollination by honey bees which increases their yield in orchards. Nevertheless, producers do not enjoy these additional benefits brought about by society and hence do not account for this in their decision-making process. As such, honey production results in a positive externality that is unpriced by the free market. This implies that a positive externality occurs when the social benefit is greater than the private benefit. Hence, as seen in the diagram below, the marginal social benefit lies above the marginal private benefit, since MSB = MPB + MEB. If the two values were the same, then there would not be a positive externality.

The externality is created because the marginal social benefit (MSB) is greater than the marginal private benefit (MPB). However, since the free market does not price in the marginal external benefit of producing an additional unit of honey, the equilibrium price and output are set at where MPC=MPB, which are Pm and Qm respectively. On the other hand, the socially optimum output is actually Qs, where MSC=MSB. Therefore, while society would like production levels kept at Qs, there is an underproduction and hence underconsumption of Qs-Qm units and an inefficient allocation of resources.

Refer to the video for diagrams

Other examples of economic activities that can generate positive externalities include:

Industrial training by firms: This does not only benefit the firms carrying out the training but also society as a whole. With the growth in labour productivity, more output can be produced with the same amount of resources, increasing the quantity and quality of the goods available for consumption, hence improving living standards throughout the economy.

Research into new technologies: This does not only benefit the firms carrying out the research but also society as a whole. The research can be disseminated for use by other producers not involved in the research process. These technology spill-over effects are able to lower the cost of production for many producers, which leads to lower prices for consumers, benefiting them and hence improving living standards throughout the economy. (You can read more about how research into space technology has resulted in many spillover technologies used in consumer electronics today)

Education: Education does not only benefit the people getting an education but everyone else as well. An educated person is able to share what he/she learnt with the people around him/her. With a more educated workforce, its productivity will increase and hence improving the state of the economy. Besides just improving the living standards throughout the economy, these efficiencies can help in the attainment of many macroeconomic goals.

3.2 Negative Externalities

Negative externalities occur when an economic activity imposes a cost on others who are not involved in the transaction. These costs are not accounted for in the market price of the product or service.

Examples of Negative Externalities

Pollution: Industrial pollution is a significant negative externality. For example, a factory that emits harmful chemicals into the air or water causes health problems for nearby residents and damages the environment. These costs are not reflected in the price of the product produced by the factory, leading to overproduction and excessive pollution. A carbon tax is one government policy used to internalize these externalities and reduce pollution.
Smoking: Smoking also creates negative externalities through second-hand smoke. Non-smokers who are exposed to second-hand smoke suffer health consequences, while the smoker does not bear the full cost of their actions. Governments have addressed this externality through policies such as public smoking bans and tobacco taxes, helping to reduce smoking rates and protect public health.
Traffic Congestion: When too many people drive cars on the same roads, traffic congestion leads to wasted time, increased pollution, and higher accident rates. The costs of these effects are borne by others, not the drivers themselves. Governments often use measures like road pricing and public transportation subsidies to mitigate traffic congestion and reduce these negative externalities.

Negative Consumption Externality

A negative consumption externality occurs when the by-product from the consumption of a good is viewed to have a social cost. For instance, a good that generates negative externalities from its consumption would be cigarettes. When a person smokes, while he/she incurs his/her own cost (marginal private cost) which includes the cost of cigarettes and the damage to their health, the general public also inhales second-hand smoke. However, even though 2nd hand smoke can have very harmful effects on other people, individuals generally do not account for this in the costs of smoking, such as the medical fees of the third parties who contract lung diseases. Instead, society, in general, has to pay for the costs of dealing with 2nd hand smoke, including the loss in labour efficiency due to absenteeism. Therefore, smoking results in a negative externality that is unpriced by the free market.

This implies that a negative externality occurs when the social cost is greater than the private cost. Hence, as seen in the diagram below, the marginal social cost lies above the marginal private cost, since MSC = MPC + MEC. If the two values were the same, then there would not be a negative externality.

The externality is created because the marginal social cost (MSC) is greater than the marginal private cost (MSC). However, since the free market does not price in the marginal external cost of consuming an additional unit of cigarettes, the equilibrium price and output are set at where MPC=MPB, which is Pm and Qm respectively. On the other hand, the socially optimum output is actually Qs, where MSC=MSB. Therefore, while society would like consumption levels kept at Qs, there is an overconsumption of Qm-Qs units of cigarettes and an inefficient allocation of resources. With the overconsumption of Qm-Qs units of cigarettes, the total social costs incurred outweighs the total social benefits gained, hence resulting in a deadweight welfare loss of area ABC.

Refer to the video for diagrams

4. Government Policies to Address Externalities

4.1 Policies to Correct Positive Externalities

Subsidies for Beneficial Activities: Governments can offer subsidies to encourage activities that generate positive externalities. For example, subsidies for education make it more affordable for individuals to pursue schooling, benefiting society by creating a more educated workforce. Government support for public health programs also increases the number of vaccinated individuals, helping to prevent widespread disease.
Provision of Public Goods: Governments can directly provide goods that generate positive externalities. For example, funding public parks or investing in renewable energy helps society at large by improving public welfare, promoting sustainability, and increasing overall well-being.
Tax Incentives: Governments can provide tax incentives to encourage positive behavior. For example, tax deductions for companies investing in clean energy promote environmental sustainability and reduce societal costs associated with climate change.

4.2 Policies to Correct Negative Externalities

Imposing Taxes (Pigovian Taxes): One of the most common tools to address negative externalities is imposing taxes that reflect the social cost of a good or activity. For instance, a carbon tax on carbon emissions forces companies to account for the environmental harm they cause, reducing pollution and encouraging cleaner alternatives.
Regulations and Bans: Governments can create laws to limit or ban activities that result in negative externalities. For example, smoking bans in public places protect non-smokers from second-hand smoke, and environmental regulations limit harmful emissions from factories.
Cap-and-Trade Systems: A cap-and-trade system places a cap on the total level of a negative externality (e.g., carbon emissions) and allows firms to trade the right to pollute. This market-based solution provides an economic incentive for firms to reduce their emissions. The EU Emissions Trading System is a prime example of this policy in action.

5. Market-Based Solutions to Externalities

5.1 Tradable Permits and Cap-and-Trade Systems

Cap-and-trade systems involve setting a limit (cap) on the amount of pollution allowed and allowing firms to buy and sell pollution permits. This system provides financial incentives for firms to reduce pollution in the most cost-effective manner. For example, the EU ETS helps reduce overall emissions by creating a market for trading pollution permits.

5.2 Coase Theorem and Bargaining Solutions

The Coase Theorem suggests that if property rights are well-defined and transaction costs are low, parties involved in an externality can negotiate to reach an efficient outcome without government intervention. For example, if two neighbors experience noise pollution, they can reach an agreement on an acceptable noise level. This can work effectively when transaction costs are low and property rights are clear.

6. Real-World Examples of Externality Policies

Pollution Control in China: The Chinese government has implemented strict environmental regulations and pollution taxes to tackle severe air and water pollution. For example, cities like Beijing have introduced pollution reduction programs, including emission standards for factories and vehicles.
Public Health Campaigns in the UK: The UK government’s public smoking ban, tobacco taxes, and anti-smoking education campaigns have effectively reduced smoking rates and second-hand smoke exposure, improving public health.

7. Conclusion

Externalities are a critical cause of market failure, both positive and negative. Understanding externalities and their impact on society is essential for designing effective economic policies. Whether addressing negative externalities through taxes and regulations or encouraging positive externalities through subsidies and public goods, government intervention plays a pivotal role in correcting these market failures and improving social welfare.

Discussion Questions

How can the Coase Theorem be applied to reduce traffic congestion or other types of externalities?
What are the advantages and disadvantages of using Pigovian taxes to address negative externalities like pollution?
Can you think of other real-world examples of externalities that have not been discussed in this chapter?

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