Externalities and market failure

An externality is when a public good (properties of public good: non-excludable and non-rival) is “dumped” on to third parties outside the market, see here for more. They occur from the consumption and production of goods and services. Those receiving the externalities are not compensated for in any way.

Externalities can be a form of market failure because market failure occurs when the wrong quantity of a good/service is provided at the wrong price.

A negative externality is when the…

marginal social cost  >  marginal private cost

The extra cost borne by society resulting from the last unit of output consumed/produced is greater than the extra cost to the individual/firm.

The socially optimum level of output (where MSB=MSC) is Q1, and price P1. The privately optimum level (where MPC=MPB) of output is Q2 and price P2.When there is a negative externality, the market produces at the privately optimum level at point X, therefore there is over-production. The shaded area represents the welfare loss and the MEC.

If a firm, a factory for example, produces electricity, they also create a negative externality which is pollution. If the firm fails to recognise and act against reducing the pollution, market failure occurs. The incentive function of price breaks down (see word of the day) because the firm is only charging consumers for the output of the good produced in the factory and not the output produced as a negative externality. Therefore the good is under-priced, over-consumed and over-produced.

A positive externality is when the…

marginal social benefit  >  marginal private benefit

The extra benefit borne to society resulting from the last unit of output consumed/produced is greater than the extra benefit to the individual/firm.

If a factory produces a positive externality, for example increased fish stocks in a lake that result from more warm water being discharged into it, fisherman are able to exploit the fish without having to pay the factory owner. The fisherman free rides. Market failure occurs because the good is under-priced and under-produced.

See here for more on public goods and the free rider problem.