1.3.1 and 1.3.2 Market failure and externalities

Contents

What is market failure?

Market failure is when the free market leads to a misallocation of resources.

There are three key types of market failure:

• Externalities (covered below);
• Under-provision of public goods;
• Information gaps.

Externalities are effects on third parties not involved in the transaction.

• There are “positive externalities” – positive effects on third parties not involved in the transaction.
• There are also “negative externalities” – negative effects on third parties not involved in the transaction.

Private and external costs

There are two types of costs:

• Private costs – costs to those in the market e.g. producers and consumers of a good.
  • If a firm produces chocolate, the firm pays for the workers’ wages and inputs such as cocoa and energy. These are all private costs.
• External costs – negative effects on third parties as a result of production.
  • The production process may produce waste products, including pollution. This can cause breathing problems for those with asthma. Those with breathing problems are a third party here, not directly involved in the production decision.

Private costs + external costs = social costs.

• Social costs refer to all costs to all members of society.

Private and external benefits

Similarly, there are two types of benefits:

• Private benefit – benefit to those in the market e.g. consumers and producers of a good.
  • For example, eating a chocolate bar may give the consumer satisfaction.
• External benefit – benefit for a third party not involved in the transaction.
  • Suppose a worker ‘consumes’ healthcare and becomes healthier and more productive as a result. Later on, other firms (third parties) may benefit from having a healthier, more productive worker.

Private benefit + external benefit = social benefit.

• Social benefit refer to the benefits to all members of society.

Market failures related to externalities

There are four types of market failures relating to externalities:

• Negative externality of production – the act of producing a good has a negative effect on a third party (e.g. firm pollution).
• Positive externality of production – the act of producing of a good has a positive effect on a third party (e.g. worker training)
• Negative externality of consumption – the act of consuming a good has a negative effect a third party (e.g cars and traffic).
• Positive externality of consumption – the act of consuming a good benefits a third party (healthcare).

These are explained in this table below:

	Production	Consumption
Negative	Negative externality of production Production causes harmful effects to third parties. Example: firm causes pollution as part of the production process, which damages local fish supplies and causes breathing problems for locals. Firms may not take into account the external costs when deciding the level of production. Production in the free market exceeds the socially optimal outcome.	Negative externality of consumption Consumption causes harmful effects to third parties. Example: the pollution from driving a car leads to breathing problems for others. Consumers may not take the externality into account when deciding how much to consume. Consumption in the free market exceeds the socially optimal outcome.
Positive	Positive externality of production Production causes beneficial effects to third parties. Example: firm A supplies training for its workers. If those workers later move to firm B, then firm B saves on training costs. Firms may not take into account the externality when deciding the level of production. This can lead to too little production in the free market relative to the socially optimal outcome.	Positive externality of consumption Consumption causes beneficial effects to third parties. Example: consuming healthcare means fewer sick days from work in the future, benefitting companies who may have higher productivity and revenue as a result. Consumers may not take the externality into account when deciding how much to consume. This can lead to too little consumption in the free market relative to the socially optimal outcome

Externality diagrams

For Edexcel A, you need to know:

• The negative externality of production diagram and
• The positive externality of consumption diagram.

For these diagrams, note the following principles:

• Marginal cost curves are assumed upward sloping.
  • This means the production of each extra unit comes at a higher extra cost, as the number of units produced increases. This is similar to a supply curve.
• Marginal benefit curves are assumed downward sloping.
  • This means the consumption of each extra unit comes with less additional benefit (such as utility), as the number of units consumed increases. This is similar to a demand curve.
• An externality will create a divergence between the private and social curves.
  • For example, a negative externality of production can be shown with marginal social cost exceeding marginal private cost. So MSC > MPC.
  • Likewise, a positive externality of consumption can be shown with marginal social benefit exceeding marginal private benefit. So MSB > MPB.
• We assume that free market participants only take into account private costs and private benefits.
  • This means the free market sets the marginal private benefit equal to marginal private cost. In other words, MPB=MPC.
  • If MPB > MPC, this means the private benefit of one more unit exceeds the private cost of one more unit. So the free market would increase production until MPB = MPC.
  • The opposite applies if MPB < MPC. This would mean the private benefit of an extra unit is lower than the private cost of one more unit. So the free market would decrease production until MPB = MPC.
• However the socially optimal outcome takes into account all (social) costs and benefits.
  • This means the socially optimal outcome sets the marginal social benefit equal to marginal social cost. In other words, MSB = MSC.
  • Suppose MSB > MSC. This means that the social benefit of one more unit is greater than the social cost of one more unit. In other words, increasing the quantity by one unit increases social welfare until MSB = MSC.
  • Suppose instead that MSB < MSC. This means that the social benefit of one more unit is less than the social cost of one more unit. In other words, decreasing the quantity by one unit increases social welfare until MSB = MSC.

See the example diagrams below.

Negative externality of production diagram

The free market produces where MPB = MPC (it does not account for external costs and benefits). This occurs at point E.

The socially optimal outcome is where MSC=MSB. This occurs at point B. This creates a welfare loss due to overproduction of the good. The welfare loss is of size ABE.

Example: firm pollution of air and water.

How do you identify the welfare loss area?

• For welfare loss, we need to look at all the costs and benefits to society. This means using the marginal social benefit (MSB) and marginal social cost (MSC) lines.
• Dotting up from the free market quantity q where MPB = MPC, a triangle forms between the MSB and MSC curves, as well as the dotted line. This gives the welfare loss.
• Note that at the free market quantity q, MSC > MSB. This means producing this last unit offers more additional cost to society than additional social benefit, measured by the vertical distance between the MSC and MSB curves. Social welfare would increase from a small reduction in the quantity.

Note you can only use this diagram above to show a negative externality of production. Do not use this diagram to show a negative externality of consumption – you will not receive credit for doing so.

Positive externality of consumption diagram

The free market outcome occurs where MPB=MPC. This is at point E on the diagram below.

However the socially optimal outcome is where MSB=MSC, at point B.

This means in the free market, there is underconsumption of q1-q. This leads to a welfare loss of area ABE.

Examples of positive externalities in consumption include consuming healthcare. This benefits the rest of society as healthier individuals are more productive, benefitting firms. Also a healthier population reduces the length of waiting lists for treatments, making it easier for others to access healthcare.

Note you can only use this diagram to show a positive externality of consumption. Do not use this diagram to show a positive externality of production – you will not receive credit for doing so.

Externality evaluation points

The economic theory above tells us that the free market does not take into account externalities. This creates a market failure.

However externalities may not always lead to welfare loss:

• The government may lack information about the size of the externality. For example, estimating the size of a negative externality of production from firm pollution requires measuring: the amount of pollution, the private costs and benefits of the polluting activity and the effect on others of pollution. All of these also have to be converted into a monetary value. This requires a lot of assumptions which may lead the government to overestimate (or underestimate) the size of any externality.
• Consumers can account for externalities to some degree. Environmentally conscious consumers may reduce their consumption of goods that cause pollution voluntarily. For instance, some consumers may reduce their car use and switch to public transport to reduce pollution.
• Producers can account for externalities to some degree, without government intervention. Firms may have other objectives apart from profit maximisation. This may include environmental objectives to reduce the pollution in their production processes. Firms may invest in new technologies or more efficient production methods to reduce pollution.
• Government intervention can reduce the welfare loss from market failure. For example subsidies can increase the quantity of merit goods. Meanwhile, taxes can decrease the quantity of demerit goods.

Externality examples in various markets

Above, I have mentioned a few externality examples, such as healthcare and pollution from cars.

I have covered externality examples in more detail in my real world micro examples list here.

Which externality diagrams do you need to know?

For Edexcel Economics A, you only need to know the positive externality in consumption and the negative externality in production diagrams.

You do not need to know the negative externality of consumption and the positive externality of production diagrams.

However I recommend learning how to explain all four types of externalities in words.

Example when explaining a negative consumption externality

For example, suppose the question discusses a negative externality of consumption coming from car use creating pollution and traffic.

• You can explain this in words, for instance that the free market does not account for the external harm caused. In this case, the external harm may be breathing problems or the traffic slowing other car users down.
• This leads to the free market quantity of cars exceeding the socially optimal quantity of cars.
• Note it would be a mistake to draw a negative externality of production diagram in this case [unless you are talking about emissions from the process of car production instead of consumption].
• If you know the negative externality of consumption diagram, this could be drawn but this is not part of the Edexcel A course.

For more information on what Edexcel expects on externalities, I recommend reading the 2019 Paper 3 Edexcel A examiner’s report, pages 33 and 37.

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