Market Failure: Externalities and their Remedies

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1 Microeconomics study guide part III Definitions: Market failure Market Failure: Externalities and their Remedies Externality Negative externality Demerit good Diagrams of negative externalities: Neg. ext. of production Neg. ext. of consumption Positive externality Merit good Diagram of positive externality: Pos. ext. of production Pos. ext. of consumption

2 Some goods and resources are, meaning that it is possible to own them and prevent others from using them. Others are not excludable, meaning that anyone can use them Non-excludable resources and goods often give rise to externalities. These include and. Common resources: These are resources, often land, that anyone can use. They are also rival, meaning they can be used up, preventing others from enjoying them. Examples: Common resources often give rise to negative externalities because sellers can deplete them free of cost. In this case, the social cost is higher than private cost, or supply. In other words, the price society pays is higher than the market price. When negative externalities arise in the production of certain goods, these products are known as. Sellers supply too many of them than is socially optimal. Examples: Public goods: These are products that anyone can enjoy. Unlike common resources, they are not and thus cannot be used up. Examples: Public goods often give rise to positive externalities because consumers can enjoy them free of cost. In this case, the social value is greater than the private value, or demand. In other words, relatively few people will want to pay the price of what they can get for free. When positive externalities arise in the production of certain goods, these products are known as. Buyers purchase too few of these goods because they assume someone else will pay the cost. Examples of costs for merit goods:

3 When negative externalities arise, the government has various options for dealing with the problem: 1. : It can forbid the activity that leads to a negative externality or require all producers to reduce the externality by a certain amount. This can be a blunt tool, however, reducing production/consumption too much. Benefits: Direct control over producers, can be effective if enforced Drawbacks: Can be too punitive or too costly to enforce. 2. : (a.k.a. Pigovian taxes) It can impose a tax on either the sellers in order to reduce the equilibrium quantity of demerit goods to a socially optimal level. Benefits: Raises money for the government, rewards good firms with lower taxes Drawbacks: Hard to tell just how high tax should be to reach optimal quantity 3. : It can issue or sell a limited number of permission slips to create negative externalities, thus imposing a cost on the socially undesirable behavior and capping the maximum amount allowed. Diagrams: Benefits: Easier to set limit exactly at optimal quantity. Can raise money for the government if permits auctioned, rewards good firms who don t need expensive permits Drawbacks: Less incentive to reduce negative externality below cap set by government, puts a money price on common resources. Bad firms just pay to keep on polluting.

4 4. : It can give individuals or firms ownership of common resources, thus attaching a cost to the production demerit goods. Benefit: Could avert the tragedy of the commons Drawback: Greater inequality, not always possible to divide common resources 5. : It could discourage people from purchasing demerit goods. Benefit: Allows individuals to choose Drawback: Can take a long time, costs government money, may not be effective When positive externalities arise, the government has various options for dealing with the underprovision of merit goods: 1. : It could use taxpayer money to supply the goods free of charge. This might have large opportunity costs, however. Benefit: Free to the consumer Drawback: Not free to the taxpayer

5 2. : It could offer sellers a certain amount of money to help them increase the equilibrium quantity of merit goods to a socially optimal level. Diagrams: Benefit: Makes merit goods more affordable to everyone Drawback: Hard to determine effective amount of subsidy, costly to taxpayers 3. : It can give individuals or firms ownership over public or merit goods, thus creating an incentive to increase their production. Example: Patents for inventions. Mostly applies to creation and ownership of intellectual property. Benefit: Rewards innovation Drawback: Can restrict use of certain ideas, ultimately stifling innovation 4. : It could encourage people to purchase more merit goods Benefit: Allows individual consumers to choose Drawback: Costly for government, may not be effective : The governments of multiple countries can also work together and use any combination of the methods described above to internalize externalities. Examples:

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