Market Failures: Understanding Externalities and Public Goods
Item 7: Market Failures: Externalities
We classify market failures into three types:
- Imperfect competition
- Externalities
- Imperfect information
Externalities
Negative Externalities
A negative externality in production occurs when the social cost of producing a quantity (q) exceeds the private cost. For example, if a company is polluting, the amount of pollution it is releasing is greater than the socially optimal amount.
Positive Externalities
A positive externality in production occurs when the social cost of producing a quantity (q) is less than the private cost. The amount produced in the market is below the socially optimal amount.
An externality exists when the production or consumption of a good directly affects consumers or businesses not participating in the purchase or sale of this good, and when these effects are not reflected in market prices.
Externalities create a difference between private and social costs and valuations. The external effects are not reflected in market prices, which prevents the achievement of economic efficiency.
Social and Private Valuations
We distinguish between social and private valuations:
- Social valuations: Include private benefits or costs that the market has not taken into account and are due to the externality.
- Private costs: Are those costs that are actually incurred to produce or consume a good.
- External costs: Are those costs that are not incurred by the producer or consumer, but are generated by other economic agents.
Negative externalities (pollution) are due to pollution. Externalities create inefficiency, causing markets to produce a larger quantity than is socially desirable.
Addressing Externalities
A possible strategy to address the problem is for the state to impose a tax on pollution. The tax on pollution internalizes the externality of pollution: the costs related to the chemical waste generated by the company (for example) are no longer external to the company that has produced the pollution, but internal.
Internalizing an externality: Consists of altering the prices paid if one pollutes (incentives) so that people take into account the external effects of their actions. The state internalizes the externality by making those who generate negative externalities pay for them (the goods that pollute).
Permits to Pollute
The use of transferable permits or licenses to pollute is a decentralized solution. It is a solution based on the market, not one that requires authorities to impose taxes (a government-imposed solution). Paying for pollution allows for the desired objectives of reducing pollution at relatively lower costs than direct control. Authorities determine the maximum level of total pollution and issue adequate permits. The price of these permits is set according to the demand and supply of permits. This method allows companies to reduce emissions and sell their permits to other companies. It is advisable to buy permits rather than installing expensive equipment to reduce pollution.
Positive Externalities
Positive externalities occur when a product or service activity benefits third parties.
Markets make it possible to produce a smaller quantity than is socially desirable. A market in which there is a positive externality associated with the production or consumption of a good will be inefficient. In a market equilibrium situation, the benefit to all parties is greater than the cost to all parties. Examples include the production of new technologies and higher education. The social value of education is higher than the private value (more value than what students pay at the end of their career – social value – than what is paid in enrollment, residence, etc. – private value). Improving education benefits other members of society, making it easier to live with people. University graduates are better prepared to introduce innovations that are more valuable to the market. Higher education generates a positive externality.
The intervention of public authorities can correct the error caused by a positive externality in the market.
A positive externality is corrected using trade as a stimulus to account for the difference between social value and private value, in order to make the market efficient.
Public Goods
Public goods are considered an extreme case of positive externality. The market failure is an insufficient quantity offered. Public goods benefit an entire community, regardless of who wants to buy them or not.
Public goods can be enjoyed by everyone, where the cost of extending the service to an additional person is zero. One of the main tasks of the state is the provision of public goods.
The goods that private companies offer have two characteristics: rivalry and exclusion.
- Rivalry: When one person consumes a good, another person cannot consume it. For example, an airline seat or a hotel room.
- Exclusion: The ability to prevent those who do not pay from consuming the good.
In some situations, companies cannot prevent those who do not pay from consuming the service.