Externalities | Causes of market failure

This is a comprehensive explanation of externalities, a crucial topic in economics that refers to the unintended consequences of economic activities on third parties. We will examine the distinction between positive and negative externalities, highlighting their significance in market efficiency. Through engaging examples and graphs, viewers will gain a deeper understanding of how externalities impact economic welfare.

1. EXTERNALITIES

2. What are externalities?
▪Externalities are the third-party effects of production
or consumption.
▪Externalities cause market failure because they are
not accounted for by those who take decisions in a
free market, i.e. the buyers and the sellers.
.

3. What is market failure?
▪Market failure occurs when the free market fails to
allocate resources in the best interest of the society.

4. Types of externalities?

5. Negative production externalities
▪Negative effects of production on third parties or
others, e.g. different kinds of pollution.

6. Positive production externalities
▪Benefits to third parties arising from production, e.g.
open-source software that other firms can replicate
to boost their productivity, new vaccines, etc.

7. Negative consumption externalities
▪Harm caused to one party when another party
consumes a product, e.g. second-hand smoke,
congestion from car use, road accidents from
alcohol use.

8. Positive consumption externalities
▪Positive third-party effects arising from
consumption, e.g. immunisation, education,
subsidised bike scheme, etc.

9. Private, External and Social Costs
▪Private Costs: Costs incurred by the decision
maker, e.g. rent.
▪External Costs: Costs incurred by third parties,
e.g. pollution, traffic congestion, etc.
▪Social Costs: Total costs of a decision.
Social Cost = Private Cost + External Cost

10. Private, External and Social Benefit
▪Private Benefit: Benefit from consuming/producing a
product.
▪External Benefit: Spill-over benefit from
consumption/production.
▪Social Benefit: Total benefit from
consumption/production.
Social Benefit = Private Benefit + External Benefit

11. Externality diagrams
▪We use supply curves to represent production
externalities. They are labelled marginal social cost
(MSC) and marginal private cost (MPC).
▪Consumption externalities are represented by
demand curves and are labelled marginal social
benefit (MSB) and marginal private benefit (MPB).

12. Externality diagrams
Production externalityConsumption externality

13. Negative production externality diagram
Benefits
and
Costs
Quantity
MSC
MPC
MPB = MSB
Q
f
P
f
Q
o
P
o
MEC
Social Cost = Private Cost + External Cost
External Cost = Social Cost – Private Cost
If there is an external cost (negative
externality),
Social Cost > (greater than) Private Cost
Social Cost = Private Cost + External Cost
Marginal Social Cost = Marginal Private Cost +
Marginal External Cost

14. Negative production externality diagram
Benefits
and
Costs
Quantity
MSC
MPC
MPB = MSB
Q
f
P
f
Q
o
P
o
A
B
C
Welfare
Loss
Free Market Equilibrium: MPC = MPB (C)
Free Market Equilibrium Quantity = Q
f
Social Optimum Equilibrium: MSC = MSB
Social Optimum Quantity: Q
O
Welfare Loss: Area of triangle ABC
Move up
Draw a
vertical line

15. Positive production externality diagram
Benefits
and
Costs
Quantity
MPC
MSC
MPB = MSB
Q
o
P
o
Q
f
P
f
Positive
externality
MSC = MPC+ MEC
If there is an external cost (negative
externality),
MSC will be greater than MPC.
If there is no external cost
MSC is equal to MPC.
If there is an external benefit from production,
MSC will be less than MPC.

16. Positive production externality diagram
Benefits
and
Costs
Quantity
MPC
MSC
MPB = MSB
Q
o
P
o
Q
f
P
f
D
F
E
Potential
welfare
gain
Free Market Equilibrium: MPC = MPB (D)
Free Market Equilibrium Quantity = Q
f
Social Optimum Equilibrium: MSC = MSB
Social Optimum Quantity: Q
O
Potential Welfare Gain: Area of triangle DEF
Move up

17. Positive consumption externality diagram
Benefits
and
Costs
Quantity
MPC=MSC
MSB
Q
o
P
f
Q
f
P
o
Positive
externality
MPB
Social Benefit = Private Benefit + External
Benefit
External Benefit = Social Benefit – Private
Benefit
If there is an external benefit (positive
externality),
Social Benefit > (greater than) Private Benefit
Social Benefit = Private Benefit + External
Benefit
Marginal Social Benefit = Marginal Private
Benefit + Marginal External Benefit

18. Positive consumption externality diagram
Benefits
and
Costs
Quantity
MPC=MSC
MSB
Q
o
P
f
Q
f
P
o
G
I
H
Potential
welfare
gain
MPB
Move up
Free Market Equilibrium: MPC = MPB (I)
Free Market Equilibrium Quantity = Q
f
Social Optimum Equilibrium: MSC = MSB
Social Optimum Quantity: Q
O
Potential Welfare Gain: Area of triangle GHI
Draw a
vertical line

19. Negative consumption externality diagram
Benefits
and
Costs
Quantity
MPC=MSC
MPB
Q
f
P
o
Q
o
P
f
MSB
MSB = MPB+ MEB
If there is an external benefit (positive
externality),
MSB will be greater than MPB.
If there is no external benefit,
MSB is equal to MPB.
If there is a negative consumption externality,
MSB will be less than MPB.

20. Benefits
and
Costs
Quantity
MPC=MSC
MPB
Q
f
P
o
Q
o
P
f
L
J
K
Welfare
loss
MSB
Negative consumption externality diagram
Move
up
Free Market Equilibrium: MPC = MPB (K)
Free Market Equilibrium Quantity = Q
f
Social Optimum Equilibrium: MSC = MSB
Social Optimum Quantity: Q
O
Welfare Loss: Area of triangle JKL