Market Failure Positive and negative externalities in consumption

Market Failure Positive and negative externalities in consumption and production

Definition When the free market mechanism leads to a misallocation of resources in the economy, either completely failing to provide a good or service or providing the wrong quantity.

Market failure 1. 2. 3. 4. 5. 6. 7. Negative externalities Positive externalities Merit & demerit goods Public goods Monopoly Immobility of the factors of production Unequal distribution of income and wealth

Negative externalities Also regarded as the external cost. When the consumption or production of a good or service causes costs to a third party, where the social cost is greater than the private cost.

Negative externalities 1 Costs that spill over to third parties of a market transaction.

Negative externalities in production Where the social cost of production exceeds the private cost Costs and benefits S 2 (MSC) S 1 (MPC) P 2 E 2 P 1 E 1 The existence of negative externalities in production creates a divergence between the private and social costs of production. The private costs of any action are those incurred by the individual decision maker while the social costs of the corresponding action are ALL the conceivable costs associated with the action. D (MSB) Q 2 Q 1 Quantity Production needs to be reduced.

Negative externalities in consumption Where the social cost of consumption exceeds the private cost Costs and benefits S (MSC) E 1 P 1 D 1 (MPB) P 2 E 2 D 2 (MSB) Q 2 Q 1 Quantity The existence of negative externalities in consumption creates a divergence between the private and social costs of consumption. The private benefits of any action are those incurred by the individual decision maker while the social benefits of the corresponding action are ALL the conceivable benefits associated with the action. Consumption needs to be reduced.

Positive externalities Also regarded as the external benefit. When the consumption or production of a good or service results in a third party benefit, where the social benefit is greater than the private benefit.

Positive externalities 2 Benefits that spill over to third parties of a market transaction.

Positive externalities in production Where the social benefit of production is greater than the private benefit Costs and benefits S 1 (MPC) P 1 S 2 (MSC) E 1 P 2 E 2 The existence of positive externalities in production creates a divergence between the private and social costs of production. The private costs of any action are those incurred by the individual decision maker while the social costs of the corresponding action are ALL the conceivable costs associated with the action. D (MSB) Q 1 Q 2 Quantity Production needs to be increased.

Positive externalities in consumption Where the social benefit of consumption is greater than the private benefit Costs and benefits S (MSC) E 2 P 1 E 1 D 2 (MSB) The existence of positive externalities in consumption creates a divergence between the private and social costs of consumption. The private benefits of any action are those incurred by the individual decision maker while the social benefits of the corresponding action are ALL the conceivable benefits associated with the action. D 1 (MPB) QDS 1 QDS 2 Quantity Consumption needs to be increased