Study Notes: Market Failure—Externalities and Common Pool Resources

Hello future economists! This chapter is incredibly important because it takes the perfect market model (which assumes nobody affects anybody else) and throws it into the messy real world. We are studying Market Failure—situations where the free market fails to allocate resources efficiently, leading to outcomes that are bad for society as a whole.

Don't worry if the diagrams look intimidating; we will break them down step-by-step. Mastering this chapter means understanding how economic decisions hurt or help third parties, and what governments can do to fix the problem!

1. The Concept of Market Failure

In Microeconomics, we aim for Allocative Efficiency. This occurs when resources are distributed in a way that maximizes overall social welfare.

What is Market Failure?

Market failure happens when the price mechanism (the forces of supply and demand) results in an inefficient allocation of resources. The market produces the "wrong" quantity of goods.

  • The Goal: Socially Optimal Output (where marginal social benefit equals marginal social cost: MSB = MSC).
  • The Failure: The market reaches equilibrium where Private Benefit equals Private Cost (MPB = MPC). If private costs/benefits do not equal social costs/benefits, market failure exists.

Key Term: Welfare Loss
This is the total net benefit (or welfare) lost to society because the quantity produced is not the socially optimal quantity.

2. Externalities: The Unpaid Side Effects

An Externality is a cost or benefit that is suffered or enjoyed by a third party who is not involved in the transaction (production or consumption) of a good or service.

Analogy: Imagine buying a very loud stereo (the transaction). The private benefit is the music you enjoy. The private cost is the price you paid. But if your neighbour can hear it, they suffer an external cost (lost sleep), even though they bought nothing and sold nothing. This external cost is the externality!

2.1 Private vs. Social Costs and Benefits

To understand externalities, we must distinguish between:

  • Private Costs (MPC): Costs borne solely by the producer (e.g., wages, raw materials) or the consumer (the price paid).
  • External Costs (MEC): Costs borne by third parties (e.g., pollution, traffic congestion).
  • Social Costs (MSC): The total cost to society. \(MSC = MPC + MEC\).

Similarly, for benefits:

  • Private Benefits (MPB): Benefits received by the consumer (utility) or the producer (revenue).
  • External Benefits (MEB): Benefits enjoyed by third parties (e.g., beautiful garden, herd immunity from vaccines).
  • Social Benefits (MSB): The total benefit to society. \(MSB = MPB + MEB\).

Memory Aid: Always remember the 'S' stands for Society. If it involves 'S' (MSC or MSB), it includes the external effects.

2.2 Negative Externalities (MSC > MPC or MSB > MPB)

Negative externalities lead to overproduction and overallocation of resources because the price does not reflect the true social cost.

A. Negative Externalities of Production (Pollution)

The firm only considers its private costs (MPC) and ignores the external cost (MEC) imposed on society (MSC).

  • Problem: \(MSC > MPC\). The social cost curve is above the private cost curve.
  • Outcome: The market produces too much (\(Q_{market}\)) at too low a price (\(P_{market}\)).
  • Real-World Example: A coal power plant dumps waste into a river. The cost of cleaning up the river is borne by the public, not the power plant.

B. Negative Externalities of Consumption (Traffic Congestion)

The consumer only considers their private benefit (MPB) and ignores the external cost (MEC) imposed on others (e.g., congestion, noise).

  • Problem: \(MSB < MPB\). The social benefit curve is below the private benefit curve.
  • Outcome: Consumers buy too much (\(Q_{market}\)) because they underestimate the true social cost of their consumption.
  • Real-World Example: Driving a gasoline car in a crowded city. The driver receives a high private benefit, but contributes to air pollution and traffic delays for others.
2.3 Positive Externalities (MSB > MPB or MSC < MPC)

Positive externalities lead to underproduction and underallocation of resources because the market only captures the private benefits, ignoring the wider social gains.

A. Positive Externalities of Consumption (Education or Vaccines)

The consumer only considers their private benefit (MPB, like getting a better job after graduating) but ignores the external benefit (MEB) to society (e.g., a more productive, healthier workforce).

  • Problem: \(MSB > MPB\). The social benefit curve is above the private benefit curve.
  • Outcome: The market provides too little (\(Q_{market}\)) because consumers don't fully value the social gain.
  • Real-World Example: A well-educated population benefits everyone through higher productivity and lower crime rates.

B. Positive Externalities of Production (Research and Development)

The firm only considers its private costs (MPC) and ignores the external benefit (MEB) that its innovation grants to other industries or competitors who can use the new knowledge.

  • Problem: \(MSC < MPC\). The social cost curve is below the private cost curve.
  • Outcome: Firms invest too little in R&D because they cannot capture all the benefits.
  • Real-World Example: A company develops a new technology that subsequently becomes cheaper for all other businesses to adopt (spillover benefits).

QUICK REVIEW: DIAGRAMS

In all diagrams (whether production or consumption):

  • The Socially Optimal point is always at the intersection of MSC and MSB.
  • The Market Equilibrium is always at the intersection of MPC and MPB.
  • If it's a Negative externality, the market produces too much (quantity is to the right of optimum).
  • If it's a Positive externality, the market produces too little (quantity is to the left of optimum).

3. Common Pool or Common Access Resources (CARs)

Another major source of market failure relates to goods that are non-excludable but rivalrous.

3.1 Defining Characteristics

Goods are classified based on two features:

  1. Excludability: Can people be prevented from using the good? (e.g., you can exclude someone from using a phone by locking it).
  2. Rivalry: Does one person’s use of the good reduce its availability for others? (e.g., if I eat an apple, you cannot eat that specific apple).

Common Access Resources (CARs) are characterized by:

  • Non-Excludable: It is difficult or costly to prevent people from using them.
  • Rivalrous: One person’s consumption reduces the quantity/quality available for others.

Examples of CARs: Clean air, fish stocks in the ocean, shared forests, public grazing lands, Earth's atmosphere.

3.2 The Tragedy of the Commons

The failure associated with CARs is called the Tragedy of the Commons (coined by Garrett Hardin).

Step-by-Step Breakdown of the Failure:

  1. Individual Incentive: Each user of the common resource acts in their own self-interest to maximize their private benefit (e.g., catching as many fish as possible).
  2. Lack of Price Signal: Because the resource is non-excludable (often free), there is no price mechanism to internalize the cost of use.
  3. External Cost Imposed: Every additional unit consumed by one user (e.g., one more boat fishing) imposes a cost (depletion/reduced yield) on all other users. This is a negative externality.
  4. Overuse and Depletion: Since individuals do not bear the full social cost of their actions, the resource is rapidly overused, depleted, and eventually destroyed or degraded.

Did you know? The concept applies not just to pastures, but globally! Climate change is often seen as a Tragedy of the Commons, where individual countries pollute (private benefit) but share the global cost (clean air/atmosphere depletion).

4. Government Intervention and Solutions

Governments intervene to "internalize the externality"—meaning they force the parties involved to account for the social costs or benefits they impose on others, moving the market towards the socially optimal quantity (MSB=MSC).

4.1 Policy Responses to Negative Externalities (To Reduce Output)

The goal is to shift the MPC curve up until it equals the MSC curve, or directly reduce the quantity supplied.

A. Indirect Taxes (Pigouvian Taxes)

  • Mechanism: The government imposes a tax equal to the external cost (MEC) at the socially optimal output level.
  • Effect: This increases the firm's private costs, shifting the MPC curve upwards, reducing output and raising the price.
  • Advantage: Generates tax revenue that can be used to clean up the pollution.
  • Limitation: It is very hard to accurately measure the monetary value of the MEC (the ideal tax amount).

B. Regulations (Command and Control)

  • Mechanism: The government sets laws, rules, or standards (e.g., maximum limits on pollutants, mandatory safety checks).
  • Effect: Directly forces firms to reduce harmful activities.
  • Advantage: Simple and easy to understand.
  • Limitation: Does not provide incentive for firms to reduce pollution beyond the legal minimum. Can be costly to monitor and enforce.

C. Market-Based Solutions: Tradable Pollution Permits (Cap and Trade)

  • Mechanism: The government sets a total limit (cap) on pollution allowed. It then issues permits (rights to pollute) that firms can buy and sell (trade).
  • Effect: Creates a market for pollution rights. Firms with low costs of abatement (reducing pollution) will sell their permits, while firms with high abatement costs will buy them.
  • Advantage: Ensures the overall cap is met efficiently, as pollution reduction occurs where it is cheapest.
  • Limitation: Setting the initial cap level is difficult. Permits can be vulnerable to price manipulation.
4.2 Policy Responses to Positive Externalities (To Increase Output)

The goal is to shift the MPB curve up towards the MSB curve, or directly provide the good.

A. Subsidies

  • Mechanism: Government grants financial aid to consumers or producers of the beneficial good (e.g., subsidies for solar panels, grants for college students).
  • Effect: Lowers the effective price for consumers or reduces the cost of production for firms, leading to increased output towards \(Q_{socially optimal}\).
  • Advantage: Encourages consumption and production of socially desirable goods.
  • Limitation: Opportunity cost (the government funds must come from somewhere); difficult to determine the appropriate size of the subsidy.

B. Government Provision/Legislation

  • Mechanism: The government directly provides the good (e.g., public education, public healthcare, mandatory vaccinations).
  • Effect: Ensures universal access and supply at the optimal level.
4.3 Policy Responses to Common Access Resources (CARs)

The primary goal is to address the non-excludability and rivalry aspects simultaneously, ensuring sustainability.

A. Establishment of Property Rights

  • Mechanism: Clearly defining who owns the resource. If someone owns a forest, they have an incentive to manage it sustainably because they bear the full cost of depletion and enjoy the full benefit of preservation.
  • Effect: Makes the resource excludable, allowing the price mechanism to work.
  • Limitation: Often impractical for global resources like the atmosphere or the high seas.

B. Regulation

  • Mechanism: Implementing quotas (maximum harvest limits), banning certain harmful practices (e.g., dynamite fishing), or setting specific fishing seasons.
  • Effect: Limits usage to a sustainable level.

C. Taxation/Charges

  • Mechanism: Charging a license fee or tax for using the resource (e.g., fees for drilling or logging).
  • Effect: Internalizes the cost of depletion to the user.

5. Evaluation and Challenges of Policy Intervention

While intervention is necessary, it is rarely perfect. Evaluation is key, especially for HL students!

A. Challenges in Implementation
  • Measurement Problems: It is extremely difficult to calculate the exact size of the external cost (MEC) or external benefit (MEB). Without accurate data, governments risk setting the tax too high or the subsidy too low, leading to new inefficiencies (a new welfare loss).
  • Political Resistance: Taxes on polluters are often met with powerful lobbying from affected industries, who argue it will harm jobs and competitiveness.
  • Information Failure: The government may lack the perfect information needed to allocate tradable permits efficiently or set effective regulations.
  • Enforcement and Monitoring: Regulations on pollution or resource depletion require costly monitoring systems, especially in developing countries or concerning trans-boundary issues (like fishing in international waters).

Key Takeaway: Governments use intervention tools (Taxes, Subsidies, Regulation, Permits, and Property Rights) to shift the private incentives (MPC/MPB) so that they align with the social incentives (MSC/MSB), correcting the inefficiency caused by market failure.