This Economics HL talks about Externalities. An externality is a cost or benefit to a third party who has no control over how that cost or benefit was created. It tells us the definition and different types of externalities that can affect the government.
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Before discussing the economics of market failures and externalities, it is important to understand a few definitions:
In the ideal situation, the marginal social costs are equal to the marginal private costs and the marginal social benefits are equal to the marginal private benefits (so MPC = MSC, MPB = MSB). The price is determined at the intersection of the demand and supply curves, which also means that the marginal social costs are equal to the marginal social benefits (so MSC = MSB).
Figure 1.8: The ideal situation in which MPC = MSC and MPB = MSB.
In general we can, say the following so the ideal situation is reached when the externalities
are equal to zero:
MSC = MPC + externalities MSB = MPB + externalities
We will have a look at all four alternatives in the two sections that follow.
1.2.5 Other sources of market failure
In addition to the discussed sources of market failure, the following sources can also be
Lack of public goods
Public goods (e.g. dams) have the following two characteristics:
• They are non-rivalrous: more people can use the good at the same time e.g. a dam protects more people at the same time.
• They are non-excludable: people can’t be excluded from the use of the good e.g. in the case of a dam, people living in the protected area can’t be excluded from the protection by the dam.
In economics we also recognize private goods (e.g. tickets to a concert) which have the following characteristics:
• They are rivalrous: the good can’t be used by more people at the same time e.g. tickets to a concert can only be used by one person to enter.
• They are excludable: people can be excluded from the use of the good e.g. someone checking for tickets could deny people entry.
Private firms will not supply public goods because few people will pay for it if they can use it anyway; this is called the free-rider problem.
Governments can solve this by providing the public goods themselves paying for them using taxes.
Common access resources, a threat to sustainability
Common access resources are resources that everyone has access to so it is very hard to exclude people from using them (e.g. fishing grounds, fossil fuel reserves).
The lack of a pricing mechanism on these resources may cause overuse or depletion. This poses a threat to sustainability.
For example, poverty in developing nations often leads to overexploitation of agricultural land.
What can the government do to solve this problem?
• Legislation to forbid or limit the use of some common access resources.
• Carbon taxes to make sure companies will use less common access resources that eventually lead to the emission of carbon dioxides such as oil, coal, and natural gas.
• Cap and trading schemes for companies to trade rights to emit carbon dioxide. This has the same effect as carbon taxes but also limits the emission to a predetermined level because there is a certain maximum of rights to be traded.
• Funding for clean technologies so companies will use fewer resources.
But government responses are limited because:
• The problems have a global nature. They can only be solved if all countries and governments act against them, otherwise, companies will just move to countries where the laws are less strict.
• There’s a lack of ownership of the common access resources. Often no one feels responsible for solving the problem.
• Effective responses require international cooperation, see above.
One party in a transaction possesses more knowledge of the transacted product than the other party resulting in market failure because the price does not reflect the true value of the product. An example can be the difference in information between the seller of a house / the real estate agent and the buyer. The seller knows exactly where the shortcomings of the house lie but the buyer does not unless he inspects the property thoroughly.
The government can prevent this by providing:
• Legislation/regulation: how much information to include when selling a product.
• Information: the government can directly provide information on certain products or help consumers make the right choice by providing brochures etc.
Abuse of monopoly power
Abuse of monopoly power creates a welfare loss because often a higher price is asked for
the product than the true value.
The government can prevent this by providing:
• Legislation/regulation to prevent the monopolist from being able to set a higher price.
• Nationalisation of the company. The government can buy a company to make it part of the government so the government now decides what the price shall be.
• Trade liberalization. Allowing foreign competitors to enter the domestic market creates more competition, which usually lowers the price level.