Market Failure and Externalities: Impact on Economy

1. Market Failure Positive and negative externalities in consumption and production

2. Definition When the free market mechanism leads to a misallocation of resources in the economy, either completely failing to provide a good or service or providing the wrong quantity.

3. Market failure • Negative externalities • Positive externalities • Merit & demerit goods • Public goods • Monopoly • Immobility of the factors of production • Unequal distribution of income and wealth

4. Negative externalities Also regarded as the external cost. When the consumption or production of a good or service causes costs to a third party, where the social cost is greater than the private cost.

5. Negative externalities 1 Costs that spill over to third parties of a market transaction.

6. Negative externalities in productionWhere the social cost of production exceeds the private cost The existence of negative externalities in production creates a divergence between the private and social costs of production. The private costs of any action are those incurred by the individual decision maker while the social costs of the corresponding action are ALL the conceivable costs associated with the action. Production needs to be reduced. Costs and benefits S2 (MSC) S1 (MPC) P2 E2 P1 E1 D (MSB) Q2 Q1 Quantity

7. Negative externalities in consumptionWhere the social cost of consumption exceeds the private cost The existence of negative externalities in consumption creates a divergence between the private and social costs of consumption. The private benefits of any action are those incurred by the individual decision maker while the social benefits of the corresponding action are ALL the conceivable benefits associated with the action. Consumption needs to be reduced. Costs and benefits S (MSC) E1 P1 D1 (MPB) P2 E2 D2 (MSB) Q2 Q1 Quantity

8. Positive externalities Also regarded as the external benefit. When the consumption or production of a good or service results in a third party benefit, where the social benefit is greater than the private benefit .

9. Positive externalities 2 Benefits that spill over to third parties of a market transaction.

10. Positive externalities in productionWhere the social benefit of production is greater than the private benefit The existence of positive externalities in productioncreates a divergence between the private and social costs of production. The private costs of any action are those incurred by the individual decision maker while the social costs of the corresponding action are ALL the conceivable costs associated with the action. Production needs to be increased. Costs and benefits S1 (MPC) S2 (MSC) P1 E1 P2 E2 D (MSB) Q1 Q2 Quantity

11. Positive externalities in consumptionWhere the social benefit of consumption is greater than the private benefit The existence of positive externalities in consumption creates a divergence between the private and social costs of consumption. The private benefits of any action are those incurred by the individual decision maker while the social benefits of the corresponding action are ALL the conceivable benefits associated with the action. Consumption needs to be increased Costs and benefits S (MSC) E2 P2 P1 E1 D2 (MSB) D1 (MPB) QDS1 QDS2 Quantity