Unit 6: Market Failure and the Role of Government
An externality is a third-person side effect of an economic decision that impacts someone other than the original decision-maker.
There are two types of externalities within our society, positive and negative. A negative externality is a situation that results in external costs to others, causing the marginal social cost to be higher than the marginal private cost. When the government needs to correct this situation, they will put a per unit tax in place that can help mitigate the effects of the negative externality and force the firm to produce the socially optimal quantity.
A positive externality is a situation that results in external benefits for others, causing the marginal social benefit to be higher than the marginal private benefit. When the government needs to correct this situation, they will put a per-unit subsidy in place that can help mitigate the effects of the positive externality and force the firm to produce the socially optimal quantity.
A negative externality exists when there is an external cost separate from the internal costs to the firm. A common example of a negative externality is smoking, which contributes to pollution and harm others through secondhand smoke exposure. 🚬
Another example is a factory that produces pollution, which can have negative effects on society, such as diminishing the quality of the water supply and atmosphere. 🏭
The graph for a typical negative externality looks like:
When a firm chooses to produce a good or service, it does not take into effect the external costs to society. It just looks at its own production costs. Looking back at the previous example, a cigarette company only looks at the costs associated with producing a pack of cigarettes, but it does not take into consideration the societal costs that come along from exposure to second-hand smoke.
The other example mentioned was a factory; when a good is produced in a factory, it can lead to a byproduct of pollution that will affect society. This pollution may enter the water supply or air, but the firm is only looking at their own costs, which are known as private costs.
In the graph above we can see that at the free market quantity, the marginal social cost (MSC) is greater than the marginal private cost (MPC). This is marked by point C on the graph above. This essentially means that society is experiencing more costs than the firm at that quantity. A private firm will produce at the point where marginal social benefit (MSB) equals marginal private cost (MPC). In the graph above, this is point A.
Society would like the firm to produce at the socially optimal quantity, which is where marginal social benefit (MSB) = marginal social cost (MSC). This is point B on the graph above. In a negative externality, there are spillover costs (which shows inefficiency) and deadweight loss is created (on the graph this is the area ABC).
To correct this inefficiency and produce the quantity best for society, the government places a per-unit tax on the good or service. In an effort to avoid the per unit tax, the firm will reduce the quantity of good they are producing, which shifts the S=MPC curve left to the MSC curve, and brings them to where marginal social benefit (MSB) equals marginal social cost (MSC).
A positive externality is where there is an external benefit to society other than the consumer who has purchased the good or service. One common example of a good with a positive externality is the flu vaccine. When a consumer receives a flu shot, they are only considering the benefit to themselves, but society also benefits because they will be contributing to herd immunity and protecting others in the community. 💉
Another example of a good with a positive externality is education. The more educated our society is, the less we will have issues like crime. 👨🏽🏫 We will be a more productive society as well. 📈
A typical positive externality graph looks like:
You can see in the graph above that at the free market quantity (QFM), marginal social benefit (MSB) is greater than marginal private benefit (MPB). This is marked by point C on the graph above. This essentially means that society is experiencing more benefits than the firm at that quantity. Society would like the firm to produce at point B, which is where marginal social benefit (MSB) equals marginal social cost (MSC). By producing at the free market quantity, a deadweight loss is created. This is marked by the triangle ABC on the graph.
Consumers only consider the marginal private benefit (MPB) of consumption, so consumers will consume until MPB = MSC, and that is where the good will be supplied. To account for the spillover benefits, the government provides a per-unit subsidy to consumers for each unit of the good. When this is done, it makes the good less expensive to buyers which increases the demand for the good. Firms will increase the production of the good to the socially optimal quantity to meet the increased demand.