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Externalities and Market Failure

Why government need to intervene

In our General Equilibrium lecture, we noted that that free competitive markets will lead to Pareto Optimality unless there are externalities or economies of scale.

Today’s lecture will show that if there are externalities:

(a) you will not have Pareto Optimality if the markets are left alone

(b) state intervention may bring about a better outcome

Here we will look at simple “mixed” public goods:

positive externalities: education or health (today’s lecture)

negative externalities: pollution.

EC302 takes these ideas further.

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General Equilibrium under perfect competition with externalities

Results in “market failure”, not Pareto Optimality.

Necessary conditions of Pareto Optimality for society is that

Px/Py = MUx/MUy

i.e. ratio of prices reflect ratio of benefits to individuals (and society), and

and Px/Py = MCx/MCy

i.e. ratio of prices also reflect ratio of MCs to firms (and to society).

But if benefits to society > benefits to individuals (e.g. education)

Or if MC to society > MC to firm because of pollution produced by the firm, not taken into account in his pricing,

Then equilibrium prices, which may represent utility maximisation by the private consumers and profit maximisation by the private producers will not be Pareto Optimal for society.

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What are externalities?

Externalities come into being, when, as a result of a private transaction between 2 agents, economic effects flow to third parties, not involved in the private market transaction.

Externalities are also called

neighbourhood effects

spill-over effects

third party effects

Externalities can be positive: "external economies“ ie

ie social benefits > private benefits

Externalities can be negative: "external diseconomies".

i.e. social costs > private costs

(Do not confuse with “economies of scale” or “diseconomies of scale”)

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This lecture: Positive Externality: “external economy”

Many examples of positive externalities associated with some private action by

an agent: health, education ...

An individual may pay a price for inoculation against measles, or education,

according to his own assessment of the private benefit to be derived.

There will be a normal private demand curve explicit in the market.

Suppliers will provide the service according to their own cost structure: normal

supply curve.

And left to its own devices, the market will establish an equilibrium price Pp

and there will be an equilibrium output Qp.

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Equilibrium price will be Pp and output will be Qp.

But society gains as well, because

sick people pass on the germs to others and make others sick, unable to work

too many sick people could lead to economic disaster: eg AIDS in Africa.

In tutorials: give the arguments for wider social benefits of education.

Pp

E

$

S

Qp O

Dp

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Suppose for every healthy person ,

there is an “external benefit” De to society.

Just as you have a private Demand curve Dp, you can have a demand curve

representing the external benefits to society De.

If the externalities were the same from person to person then it would be a

horizontal line

Pp

E

$

S

Qp O

Dp

De

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But could also have declining external benefits or increasing external benefits

For declining external benefits- red line

For increasing external benefits you would have an upward sloping line (green)

Or some other kinds of curves? U-shaped? Upside down U?

Which is more appropriate for health? For education?

Discuss the possibilities in tutorials.

Pp

E

$

S

Qp O

Dp

De

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Assume that the De is constant per unit of output

Total Social Benefit = Private Benefit + External Social Benefit i.e. Ds = Dp + De

ie. the social demand curve Ds is a curve parallel to the the Dp curve,

Moved up by the amount represented by De.

Pp

E

$

S

Qp O

Dp

De

Ds

Ps

Qs

Pe

Pe

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From society’s point of view

The desirable equilibrium output should be Qs > than Qp.

And the suppliers should be receiving total price Ps.

Pp

E

$

S

Qp O

Dp

De

Ds

Ps

Qs

Pe

Pe

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How can society achieve output level Qs and price Ps?

Government has to give unit subsidy = value of the externality. But note what happens.

At equilibrium output Qs (point F), the equilibrium price = Ps, subsidy = GF

But all consumers now pay a lower price Pn including those previously paying Pp.

With the subsidy, (Qs-Qp) extra people are now inoculated.

Pp

E

$

S

Qp O

Dp

Ds

Ps

Qs

F

G Pn

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Where does the total subsidy PnPsGF go to?

PnPpEG is the increase in private consumer surplus.

PpPsFE is the increase in producer surplus

HEG are the net benefit due to the new consumers coming in.

and EFG is the dead-weight loss that the economy would have sustained if the subsidy

had not been given. (=area EJF = where social benefits are > costs of producing (Qs-Qp)

Pp E

$

S

Qp O

Dp

Ds

Ps

Qs

F

G Pn

H

J

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Benefits to consumers can be broken into 2 pieces

PnPpEG is the increase in private consumer surplus.

= PnPpEH is the lowered costs to the previous consumers +

HEG is the net private benefit due to the new consumers coming in.

Pp E

$

S

Qp O

Dp

Ds

Ps

Qs

F

G Pn

H

J

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Negative Externality: Pollution: but need new Social Supply curve

Everywhere, economies have been growing, rising incomes have been enjoyed

But firms and consumers have not been paying for

* pesticides and fertiliser pollution of land and sea

* chemical waste dumping

* forest, land and sea degradation through logging and mining

* atmospheric pollution rising because of industries, cars

* ozone layer depletion, global warming and ocean levels rising (and

putting Tuvalu, Kiribati, all the atoll countries of the world under

ocean within fifty years)

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Without taking account of the externalities

The Demand Curve gives the Private Benefits;

The Supply curve gives the Private costs

Equilibrium output would be Qp and price of the product would be Pp.

Pp

E

$

Sp

Qp O

Dp

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But for society, must include the cost of externalities (pollution)

Pollution costs could be the same per unit at every level of output (horizontal line) or be

increasing, or decreasing (interesting question): assume same, = Se

Total Social Cost = Private Cost + External Cost Ss = Sp + Se

i.e Sp shifts upwards by the amount of the negative externality.

Pp

E

$

Sp

Qp O

D

Se

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From society’s point of view, output shd be lower, price higher

Socially optimal equilibrium output should be a lower Qs

The equilibrium price should be higher (Ps) the “socially efficient price”.

How achieve this result?

Pp E

$

Sp

Qp O

D

Se

Ss

Qs

Ps

F

G Pn

H

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One approach: unit tax on output: “Pigouvian” Tax

FG is the unit pollution tax or “Pigouvian Tax” paid by the consumer.

Total tax paid = PsFGPn.

FGE is the dead-weight loss that has been removed: because the economy was previously

not taking account of the external damages they were doing.

Pp E

$

Sp

Qp O

D

Se

Ss

Qs

Ps

F

G Pn

H

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Who bears the burden of the total tax PsFGPn revenue?

As with previous analysis: one part falls on consumers; one part on producers.

What determines the relative shares of this tax burden? As before.

Pp E

$

Sp

Qp O

D

Se

Ss

Qs

Ps

F

G Pn

H

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Does a Pigouvian tax solve all the externality problems?

eg Sugar mills or cement factory?

Those who buy the sugar or cement do not pay for:

* damage to households from the polluting smoke (SO2, H2S, HCl, ..)

- household costs to clothes hung out,

- rust to buildings, cars, etc roofing iron,

- polluted air breathed in, causing health problems

- dust deposited on the forests, creeks etc

* mill waste (currently dumped in the nearby river or mangroves)

- physical unpleasantness for those living nearby

- destruction of river environment (unique species?)

- loss of fishing benefits to resource owners

- wider ecological damage through the marine food chain- loss

of fishing benefits to Suva, Loomi Bay and surrounding areas

P1

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What are the effects of the tax? Is it fair to all?

Consumers of sugar pay more than what they were paying under free markets:

Ps = marginal private cost + marginal external cost (good)

They are now consuming less: good.

Profits of the milling company must go down.

Government (society) gets tax revenue.

Does the pollution end? No. What is the $ cost of the pollution now? (bonus mark).

Q: why should the Government (and taxpayers in general) benefit while the polluting factory continues to hurt the local residents?

For real equity, who should receive the benefits of the Pigouvian taxes?

How practical would that be?

Note: in neoclassical economics, compensation of victims is not necessary for economic efficiency?

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Next lecture

How control pollution?

“by command or decree”

or market mechanism such as “carbon prices” and “emissions trading”

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