Market Failure

Externalities - Models

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Carys Brown

Learning Objectives

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Consumption Externalities
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Negative Consumption Externalities: 

In negative externalities, the social benefit – D (s), is less than the private benefit – D (p), this shows that externalities are present. The market fails because the product is overconsumed. The market equilibrium when the externality is present is set at (Q1, P1), and the efficient equilibrium is at (Qe, Pe). This shows that the externality is consumed more than is allocative efficient which is why market failure occurs, and produces Deadweight loss, shown by the DWL triangle.


Positive Consumption Externalities: 

In positive consumption externalities, the social benefit – D (s) is greater than the private benefit – D (p). The market fails because the product is under consumed. The market equilibrium when the externality exists is shown by (Q1, P1). When compared to the efficient equilibrium (Qe, Pe), it is clear that the product is not being consumed at the level that reflects the benefits of the product. For example, eating fruits and vegetables are good for your health and the healthcare system – however, are not consumed enough. Therefore, market failure occurs and produces deadweight loss, shown by the DWL triangle. 


(Tip: The deadweight loss triangle always acts as an arrow and points at the most efficient point of consumption.) 

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Production Externalities
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Negative Production  Externalities: 

For negative production externalities, the social costs - shown by S(s) - are greater than the private costs - S(p). The market fails because the product is over-produced. The market equilibrium when the externality is present is set at (Q1, P1), and the efficient equilibrium is at (Qe, Pe). This shows that the externality is produced more than is allocative efficient which is why market failure occurs, and produces Deadweight loss, shown by the DWL triangle.

Positive Production Externalities: 

For positive production externalities, the social costs - shown by S(s) - are less than the private costs - S(p). The market fails because the product is under-produced. The market equilibrium when the externality is present is set at (Q1, P1), and the efficient equilibrium is at (Qe, Pe). This shows that the externality is produced less than is allocative efficient which is why market failure occurs, and produces Deadweight loss, shown by the DWL triangle.


(Tip: The deadweight loss triangle always acts as an arrow and points at the most efficient point of production.) 

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Government Policies
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As externalities are examples of market failure, and therefore, must be corrected in order to be consumed and produced efficiently. This means that governments must introduce policies to correct the inefficiency. Examples of these policies are: 

Positive Externalities:

  • Reward consumers for socially correct behaviour. 

  • Educate people about benefits - helmets

  • Regulate good purchases  - buying fruit and veg

  • Provide a subsidy to producers - solar panals

  • Provide a subsidy to consumers - child-care 

  • Government provides the good for free or subsidised cost. - Covid Vaccine 

  • Reward producers for socially correct behaviour 

  • Educate producers - benefits of eco friendly business

Negative Externalities 

  • Make consumers pay for bad purchases 

  • Educate buyers about the harm caused - cigarettes 

  • Reward people for better substitutes - cheaper train faires opposed to cars 

  • Discourage bad choices for consumers and producers - drink driving 

  • Encourage eco-friendly businesses 

  • Tax producers for making bad decisions - pollution fines 

  • Tax consumers for making bad purchases - suagr tax

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Causes of Market Failure
Market power
Market Failure - Uncompetitive Markets
Externalities
Externalities - Models
Public Goods
Common Resources
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