Introduction: The Hidden Costs and Benefits (Externalities)

Welcome to one of the most crucial topics in Market Failure! Don't worry if the names sound intimidating—this chapter simply explores the economic side effects that activities have on people who weren't involved in the original purchase or sale.

Markets work perfectly only if every cost and benefit is accounted for by the buyer and seller. But in the real world, this often isn't true. These uncounted side effects are called Externalities.

Why is this important? Externalities cause a misallocation of resources, meaning the market produces either too much or too little of a good, leading to a loss of overall social welfare. Understanding this is key to justifying government intervention.

1. Understanding Private vs. Social Economics

To understand externalities, we must distinguish between what affects the immediate actors (Private) and what affects everyone (Social).

1.1 Private Costs and Benefits

These are the costs and benefits directly experienced by the buyer or seller involved in the transaction.

  • Private Cost (PC): The cost paid by the producer (in production) or the consumer (in consumption). Example: The cost of sugar, labour, and rent for a fizzy drink factory.
  • Private Benefit (PB): The satisfaction or revenue received by the consumer or producer. Example: The enjoyment of drinking the fizzy drink (consumer), or the revenue generated by selling it (producer).

1.2 External Costs and External Benefits

These are the spillover costs or benefits that fall onto third parties (people not involved in the transaction).

  • External Cost (EC): A negative cost imposed on a third party. Example: The polluted river downstream from the factory.
  • External Benefit (EB): A positive benefit enjoyed by a third party. Example: The beautiful garden you plant makes the street look nicer for your neighbours.

1.3 Social Costs and Benefits (The Full Picture)

The social value is the total impact on society.

$$ \text{Social Cost (SC)} = \text{Private Cost (PC)} + \text{External Cost (EC)} $$

$$ \text{Social Benefit (SB)} = \text{Private Benefit (PB)} + \text{External Benefit (EB)} $$

Key Takeaway

Market Failure occurs when there is a divergence between the private costs/benefits and the social costs/benefits (i.e., SC $\neq$ PC or SB $\neq$ PB). When this happens, the market equilibrium ($Q_M$) does not equal the socially optimal equilibrium ($Q_{SOC}$).

2. Negative Externalities

Negative externalities occur when $SC > PC$ or $SB < PB$. The total cost to society is greater than the cost borne by the individual acting.

Analogy: Think of it as a debt that society has to pay because an individual or firm wasn't charged the full price for their action.

2.1 Negative Externalities in Production

This happens when the production process creates costs for third parties.

  • Situation: SC > PC (The external cost is ignored by the producer).
  • Example: A coal power plant emits CO2 and sulfur dioxide. The plant pays for coal and labour (PC), but society pays for higher healthcare costs, climate change damage, and cleaning acid rain damage (EC).
  • The Result: The market price is too low, and the quantity produced is too high (Overproduction).
The Misallocation (Using Demand and Supply)

In standard economic diagrams (as required by the syllabus):

The standard supply curve (S) represents Private Cost (PC). The demand curve (D) represents Private Benefit (PB).

  1. The market equilibrium occurs at the intersection of S(PC) and D(PB), giving quantity $Q_M$.
  2. Because SC > PC, the Socially Optimal Supply Curve (S$_{SOC}$) should be higher (shifted to the left) than the private supply curve.
  3. The socially optimal equilibrium occurs where D(PB) intersects S$_{SOC}$(SC), giving a lower quantity $Q_{SOC}$.

Conclusion: Since $Q_M > Q_{SOC}$, the market produces too much of the polluting good.

2.2 Negative Externalities in Consumption

This happens when the consumption of a good creates costs for third parties.

  • Situation: SC > PC (or more commonly, PB is greater than SB because consumption imposes an external cost).
  • Example: Smoking in public places or loud motorbikes. The consumer enjoys the benefit (PB), but bystanders suffer from passive smoke or noise pollution (EC).
  • The Result: The market quantity consumed is too high (Overconsumption).
The Misallocation (Using Demand and Supply)

The supply curve (S) represents Private Cost (PC). The demand curve (D) represents Private Benefit (PB).

  1. The market equilibrium is $Q_M$.
  2. Because of the external costs in consumption, the Socially Optimal Demand Curve (D$_{SOC}$) should be lower (shifted to the left) than the private demand curve.
  3. The socially optimal equilibrium occurs at the intersection of S(PC) and D$_{SOC}$(SB), giving a lower quantity $Q_{SOC}$.

Conclusion: Since $Q_M > Q_{SOC}$, the market consumes too much of the negative externality good.

🛑 Common Mistake Alert!

Do not confuse the source of the externality with the type of shift. Negative externalities (in both consumption and production) always result in overproduction/overconsumption because the market price doesn't reflect the true cost. This means $Q_M > Q_{SOC}$.

3. Positive Externalities

Positive externalities occur when $SB > PB$ or $SC < PC$. The total benefit to society is greater than the benefit received by the individual actor.

Analogy: Think of it as a free gift that society receives, but for which the producer or consumer is not compensated.

3.1 Positive Externalities in Production

This happens when the production process creates benefits for third parties.

  • Situation: SC < PC (The producer's actions inadvertently lower society's overall cost or provide a benefit).
  • Example: A company invests heavily in research and development (R&D) for a new, efficient energy source. The company bears the huge R&D cost (PC), but once the information is published or "leaks," other firms and society benefit freely from the new knowledge (EB). The social cost of that knowledge generation is therefore lower than the private cost.
  • The Result: The market quantity produced is too low (Underproduction).
The Misallocation (Using Demand and Supply)

The standard supply curve (S) represents Private Cost (PC). The demand curve (D) represents Private Benefit (PB).

  1. The market equilibrium is $Q_M$.
  2. Because SC < PC (society's true cost is lower due to spillovers), the Socially Optimal Supply Curve (S$_{SOC}$) should be lower (shifted to the right) than the private supply curve.
  3. The socially optimal equilibrium occurs where D(PB) intersects S$_{SOC}$(SC), giving a higher quantity $Q_{SOC}$.

Conclusion: Since $Q_M < Q_{SOC}$, the market produces too little of the beneficial good.

3.2 Positive Externalities in Consumption

This happens when the consumption of a good creates benefits for third parties.

  • Situation: SB > PB (The external benefit is ignored by the consumer).
  • Example: Healthcare (like vaccination) or education. When you get vaccinated (PB), you also prevent others from getting sick (EB). When you get an education (PB), society benefits from a more productive, skilled, and engaged workforce (EB).
  • The Result: The market quantity consumed is too low (Underconsumption).
The Misallocation (Using Demand and Supply)

The supply curve (S) represents Private Cost (PC). The demand curve (D) represents Private Benefit (PB).

  1. The market equilibrium is $Q_M$.
  2. Because SB > PB, the Socially Optimal Demand Curve (D$_{SOC}$) should be higher (shifted to the right) than the private demand curve.
  3. The socially optimal equilibrium occurs at the intersection of S(PC) and D$_{SOC}$(SB), giving a higher quantity $Q_{SOC}$.

Conclusion: Since $Q_M < Q_{SOC}$, the market consumes too little of the beneficial good.

🧠 Memory Aid: The Market Outcome

If you forget which way the market error goes, remember:

  • Negative = Too much of a bad thing $\rightarrow$ Overproduction/Overconsumption ($Q_M > Q_{SOC}$)
  • Positive = Too little of a good thing $\rightarrow$ Underproduction/Underconsumption ($Q_M < Q_{SOC}$)

4. The Importance of Property Rights

A key reason why externalities exist and cause market failure is the absence of Property Rights.

What are Property Rights?

Property Rights are the legal rights of ownership that allow individuals or firms to own, use, and transfer resources.

When you own a good, you have the right to exclude others from using it, and you can charge them if they damage it.

The Problem of Missing Property Rights

Externalities typically arise concerning resources that are unowned or difficult to enforce ownership over, such as clean air, public seas, and quiet environments.

  • If a factory pollutes a river, and nobody owns the river, who can sue the factory or demand compensation? No one can, so the factory treats the river's capacity to absorb waste as a free resource (a zero price).
  • Because the factory pays a price of zero for pollution, the external cost is never factored into its production decisions.
  • This failure to assign legal rights to the affected party means the external cost persists, leading directly to the market failure of overproduction.

Did you know? This issue is often linked to the concept of the "Tragedy of the Commons," where shared, unowned resources (like public fishing grounds or pasture) are overexploited because individuals act in their own self-interest, ignoring the total social cost.

Quick Review Summary: Externalities and Misallocation

Type Divergence Market Outcome (Error) Real-World Example
Negative (Production) SC > PC Overproduction ($Q_M > Q_{SOC}$) Factory pollution
Negative (Consumption) SB < PB Overconsumption ($Q_M > Q_{SOC}$) Noise pollution from loud music
Positive (Production) SC < PC Underproduction ($Q_M < Q_{SOC}$) Innovation/R&D spillover
Positive (Consumption) SB > PB Underconsumption ($Q_M < Q_{SOC}$) Vaccinations or public education

Understanding these four cases is fundamental. They form the basis for why governments decide to tax (to reduce negative externalities) or subsidise (to increase positive externalities), which we will explore in later chapters!