Market Failure:

Externalities and the

Role of Government

Ms. Frank
AP Microeconomics
 Market Failures: Externalities
• Recall that: Adam Smith’s “invisible hand” of the marketplace
leads self-interested buyers and sellers in a market to
maximize the total benefit that society can derive from a
market. But market failures can still happen.
• When a market outcome affects parties other than the buyers
and sellers in the market, side-effects are created called
externalities.
• Externalities cause markets to be inefficient, and thus fail to
maximize total surplus.
• However, if there is an externality and bystanders are affected
by this market, the market does not maximize the total benefit
to society as a whole.
• The market has failed when it results in either an over or an
under-allocation of resource towards a particular product.
Market Failures: Externalities

● When the impact on the

bystander is adverse, the
externality is called a
negative externality.
● When the impact on the
bystander is beneficial, the
externality is called a
positive externality.
 Examples of Negative Externalities

● Pollution, Chemical Waste

● Automobile exhaust, Cigarette
smoking, Barking dogs (loud pets),
Loud stereos in an apartment
building
 Examples of Positive Externalities
● Immunizations
● Restored historic
buildings
● Research into new
technologies
 OPTIMAL AMOUNT OF A GOOD
P
$9 S

1 D

0 1 2 3 4 5 Q
Market Equilibrium/Social
Equilibrium
● The Marginal Social Cost as shown by the
Supply Curve when equilibrium and
social equilibrium are at the same point.
The firm's Marginal Private Cost is equal
to society's Marginal Social Cost.
● The Marginal Social Benefit is shown by
the demand curve when equilibrium and
social equilibrium are at the same point.
The individual’s Marginal Private Benefit
equals the Marginal Social Benefit.
 OPTIMAL AMOUNT OF A GOOD
P
$9 S=MSC/MPC
The normal
7 equilibrium
graph assumes
5 that we are at
social
3 equilibrium as
well
1 D=MSB/MPB

0 1 2 3 4 5 Q
OPTIMAL AMOUNT OF A PUBLIC GOOD
P
$9 S=MSC
7 Yields the
optimum amount
5 of the public
good
3 MB = MC
1 D=MSB

0 1 2 3 4 5 Q
Cost-Benefit Analysis
Marginal Cost = Marginal Benefit Rule

Externalities

Spillover Costs = Overallocation

MC>MB Negative Externality

Spillover Benefits = Underallocation

MC<MB Positive Externality
Negative Externalities
Negative Externalities

● When the production or consumption of a

product places external costs on a third party
not involved in the market transaction, or
society as a whole.
● Government is needed to regulate the
production and consumption of these goods,
either through taxes, direct controls, bans, etc.
Overallocation of resources

√ when external costs are present and suppliers are

shifting some of their costs onto the community,
making their marginal costs lower.
√ The supply does not capture all the costs with the
MPC curve understating total production costs.
● supply=marginal private cost because the
producer is not calculating the costs that do not
directly influence their firms. The social cost curve
includes private costs and costs to society.
√ This means resources are overallocated to the
production of this product.
Spillover Costs
P
Spillover S=MSC
costs
S=MPC

DWL

D=MSB
Overallocation
0 Qoptimum QMarket Q
Negative externality in production
• If the production of a good generates an
externality (pollution), costs accrue to society
beyond those that accrue to the producing
firm. Thus, social cost exceeds private cost of
production and, graphically, the social cost
curve is above the supply curve.
• The intersection of the demand curve and the
social-cost curve determines the optimal
output level.
• Total surplus is the value to the consumers
minus the true cost of production. Therefore,
the optimal quantity is less than the
equilibrium quantity generated by the market.
 Example: The Market for Aluminum...
Price of
Aluminum
Supply
(private cost)

Equilibrium

Demand
(private value)

0 QMARKET Quantity of
Aluminum
 The Market for Aluminum and Welfare
Economics
● The quantity produced and consumed in the
market equilibrium is efficient in the sense that
it maximizes the sum of producer and
consumer surplus.
● If the aluminum factories emit pollution (a
negative externality), then the cost to society of
producing aluminum is larger than the cost to
aluminum producers.
 Pollution and the Social Optimum...
Price of Cost of Social cost
Aluminum pollution
Supply
(private cost)

Optimum DWL

Equilibrium

Demand
(private value)

0 Qoptimum QMARKET Quantity of

Aluminum
 The Market for Aluminum and Welfare
Economics
● For each unit of aluminum
produced, the social cost
includes the private costs of
the producers plus the cost to
those bystanders adversely
affected by the pollution.
Government solution to negative externality
of consumption: corrective tax
● Corrective tax shifts the
market supply to the left,
increasing the equilibrium
price, and reducing the
quantity demanded by
consumers to the socially
optimal level.
Government Solution: Corrective Tax

$ S = MSC

S = MPC

TAX
Pb The Tax shifts the
Private Supply line
Pe
to the left to meet
Ps the societal supply
line.
D = MSB

Qso Qe Q
Positive Externalities
 Positive Externalities

● Goods which create positive

externalities of consumption represent
a market failure because resources will
be UNDER-allocated towards these
goods if the free market is left to itself.
Underallocation of resources
√ when external benefits are
present and the MPB curve reflects
only the private benefits understating
the total benefits, at Qe.
√ The output at Qo is optimum and
reflects the MSB curve and the S
curve.
√ External positive benefits will
accrue to society from the
consumption of this product.
Spillover Costs And Benefits
P
S=MC

Spillover
DWL
Benefits

D=MSB

D=MPB
Underallocation
0 Qe Q0 Q
Solutions to Externalities
Internalizing Production Externalities

● Taxes are the primary tools

used to internalize negative
externalities.
● Subsidies are the primary
tools used to internalize
positive externalities.
 Private Solutions to Externalities
● Government action is not
always needed to solve the
problem of externalities.
● Moral codes and social sanctions
● Charitable organizations
● Integrating different types of
businesses
● Contracting between parties
 The Coase Theorem
● The Coase Theorem states that if private
parties can bargain without cost over the
allocation of resources, then the private
market will always solve the problem of
externalities on its own and allocate resources
efficiently.
● Transaction costs are the costs that parties
incur in the process of agreeing to and
following through on a bargain.
If the private solution doesnʼt work…

Sometimes the private solution

approach fails because transaction costs
can be so high that private agreement is
not possible.
Correcting for Spillover Benefits
P Correcting by Subsidy to Consumers

S=MC

Subsidy to
consumer
increases
demand
D=MSB

Underallocation D=MPB
Corrected
0 Qe Q0 Q
 Correcting for Spillover Benefits
P Correcting by Subsidy to Producers

S=MPC
S=MSC

Subsidy to
producers
increases
supply
D=MB
Underallocation
Corrected
0 Qe Q0 Q
 Public Policy Toward Externalities
● When externalities are
significant and private
solutions are not found,
government may attempt to
solve the problem through
… command-and-control
policies.
… market-based policies.
 Command-and-Control Policies
● Usually take the form of regulations:
● Forbid certain behaviors.
● Require certain behaviors.
● Examples:
● Requirements that all students be
immunized.
● Stipulations on pollution emission
levels set by the Environmental
Protection Agency (EPA).
 Market-Based Policies
● Government uses taxes and
subsidies to align private
incentives with social
efficiency.

● Pigovian taxes are taxes

enacted to correct the effects of
a negative externality.
 Examples of Regulation versus Pigovian tax
● If the EPA decides it wants to
reduce the amount of pollution
coming from a specific plant. The
EPA could…
… tell the firm to reduce its pollution
by a specific amount (i.e.
regulation).
… levy a tax of a given amount for
each unit of pollution the firm
emits (i.e. Pigovian tax).
 Market-Based Policies
● Tradable pollution permits allow the
voluntary transfer of the right to
pollute from one firm to another.
● A market for these permits will
eventually develop.
● A firm that can reduce pollution at a
low cost may prefer to sell its
permit to a firm that can reduce
pollution only at a high cost.