Market Failure and Functions of Government: Externalities

1. Concept of Market Failure and Functions of Government
2. Market Failure and Functions of Government: Decreasing Costs
3. Market Failure and Functions of Government: Externalities
4. Market Failure and Functions of Government: Public Goods

Introduction

Market failure is said to occur when the resources are not allocated efficiently. There are many reasons for market failure, such as the presence of externalities, imperfect markets, incomplete markets, public goods, etc.

All such situations lead to inefficient allocation of resources and calls for the need to correct the allocation. The government plays an important regulatory and prohibitive role in such situations.

Externalities occur when the actions of one individual affect another person’s well-being, and the relevant costs and benefits are not reflected in the market prices. In the case of a negative externality, a producer or consumer does not bear the actual cost and imposes costs on those who are not directly involved in the exchange.

A positive externality, on the other hand, confers benefits to those who do not pay for it. It is desirable for society to discourage negative externalities and encourage positive externalities. For this, the government’s role is crucial.

Let us analyse in detail the market failure arising due to the presence of externalities and the function of government in eliminating it.

Market Failure and Functions of Government

Market Failure occurs when there is an inefficient allocation of resources in a free market. In more general terms, these are those situations where market forces do not serve the perceived public interest.

Market failure can occur due to a variety of reasons, such as monopoly (higher prices and less output), negative externalities (over-consumption), positive externalities (under-consumption), public goods (usually not provided in a free market), etc. These reasons can be broadly grouped as:-

• (i) Sub-optimal Market Structures and
• (ii) Lack of Internalisation of Costs or Benefits in Prices.

This makes for the role of government to allocate resources in accordance with social desirability. The government is expected to perform various regulatory, allocative and stabilising functions in pursuit of achieving macroeconomic goals.

In the event of market failure, the government comes into focus and influences the market outcome through its regulatory policy framework and actions. This results in the elimination of market failure, and efficient allocation is achieved in the market and economy.

Negative Externalities and Market Failure

Externalities are common in virtually every area of economic activity. They are defined as third-party (or spill-over) effects arising from the production and/or consumption of goods and services for which no appropriate compensation is paid.

Externalities occur when one person’s action affects another person’s well-being, and the relevant costs and benefits are not reflected in market prices. Externalities can cause market failure because the price mechanism does not take into account the full social costs and social benefits of production and consumption.

A negative externality occurs when the action of one party imposes a cost on another party. In the case of negative externality, a divergence between private and social costs of consumption and/or production is created.

Social cost includes all the costs of production of the output of a particular good or service. This includes all third-party (external) costs arising out of the act of consumption and/or production.

Social Cost = Private Cost + Externality

An example of a negative production externality is pollution by a firm in the course of its production, which causes nuisance and harm to others as well as the environment.

The market failure occurs in this case because, with production externality, marginal social cost is greater than private marginal cost. The negative externalities impose higher social costs on other firms, consumers and the environment, e.g. clean up costs, health costs, and environmental degradation.

The effects of negative externality created by this producer have been shown in Fig 1.

In Fig 1, it can be clearly seen that the marginal social cost of production exceeds the private costs faced by the producer. This is due to the inclusion of full cost, including external cost caused by pollution of the environment, into the private cost.

Assuming that the producer is interested in maximising profits – he will only take into account the private costs and private benefits arising from their supply of the product. In Fig 1, this corresponds to point A, where the profit-maximising level of output is at QP, and the price charged is PP.

However, the socially efficient level of production would consider the external costs, too. The social optimum output level is lower at QS. This leads to the private optimum output being greater than the social optimum level of production. The producer creating the externality does not take the effects of externalities into his cost calculations because producers are only concerned with their own self-interest.

In Fig 1, the private optimum output is where the private marginal benefit (which corresponds to the points on the demand curve) equals the private marginal cost, giving an output of QP. For society as a whole, the social optimum is where social marginal benefit is equal to social marginal cost at output QS.

The failure to take into account the negative externality effects is an example of market failure. This leads to the good or service being over-produced relative to the social optimum. It must be noted that the price is higher at the socially optimum level of output because this considers the actual cost of production, which raises the price.

Apart from production, the negative externality can also occur due to the over-consumption of some goods and services, i.e. beyond their socially optimum level. The examples of negative consumption externalities which the consumers can create include:

• Pollution from cars and motorbikes
• Litter on streets and in public places
• Noise pollution from using loud music and ghetto blasters in streets and public places
• Negative externalities created by smoking and alcohol abuse
• Vandalism of public property
• Negative externalities arising from crime

In all such situations, the marginal social benefit of consumption is less than the marginal private benefit of consumption, i.e. SMB < PMB. This leads to the good or service being over-consumed relative to the social optimum.

Positive Externalities and Market Failure

Not all actions impose costs; rather, there are some actions in the economy by one individual which confer benefits to other individuals who do not pay for the benefits they enjoy. So, a positive externality occurs when the actions of one party benefit another party.

Positive externalities exist when the marginal social benefit of production and/or consumption exceeds the marginal private benefit, i.e. production and/or consumption generate external benefits that may go under-valued by the market.

There are many examples from day-to-day economic activities that generate positive externalities:

1. Imparting education leads to the creation of a well-educated labour force with increased efficiency, which can produce other important social benefits like lower unemployment, fewer crimes, a reduction in social unrest, etc.
2. The provision of improved healthcare services reduces absenteeism and creates a better quality of life and higher living standards.
3. An attractive garden maintained by an individual in front of his house will also confer benefits (in terms of the pleasure of watching beautiful flowers and plants) to passers-by and those living in the area.
4. Arts and sporting participation and enjoyment derived from historic buildings.
5. When a firm provides industrial training to its employees, this can reduce the costs faced by other firms and have important effects on labour productivity. Faster growth of productivity allows more output to be produced from a given amount of resources and helps improve living standards throughout the economy, thereby shifting the production possibility frontier outwards.
6. Research into new technologies can be disseminated for use by other producers, and these technology spill-over effects can help other producers reduce the costs of production, which can be passed on to consumers through lower prices.

Market failure occurs in the case of positive externalities on account of their under-production and under-consumption. When substantial positive externalities exist, the good or service may be under-consumed or under-provided since the free market may fail to take into account their effects. This is because the marginal social benefits of consuming the good are higher than the private marginal benefits.

Consider the example of health care. Good quality health care brings positive spill-over effects both for the recipient of the care but also for their families and associates. A healthy individual and family creates a healthy workforce which is more productive, and the scale of absenteeism from work due to sickness and illness would also be lesser.

This can be illustrated using Fig 2 below:

In Fig 2, the private demand curve shows the private benefit to an individual of availing quality health care services, while social demand shows the social marginal benefit. The vertical distance between these two curves represents the external marginal benefit or positive externality. The supply curve shows the marginal cost of providing health care.

As it can be seen from Fig 2, if the recipient of quality health care takes into account only his own private benefits from getting healthcare, the market will end up at price PP and quantity QP. However, the socially efficient price and output are PS and QS, respectively. This is because, at point B, corresponding to socially optimum output and prices, marginal social benefit is equal to marginal social cost.

Production and consumption should be increased as long as the marginal social benefit exceeds the marginal social cost. But, here, as inefficient output QP is produced, there is a case of market failure due to allocative inefficiency. Society as a whole would be better off if more have been consumed.

Just like negative externalities, positive externalities may also be involved with the act of production as well as consumption. Positive externalities arising from technological spill-overs are an example of a positive externality in production in form of a technology spill-over.

The use of new technology will bring down costs to other producers- social cost, in this case, will be below the private cost and output of the product (i.e. a new robot or piece of software). Thus, these should be encouraged to higher levels.

Government Policy to Correct Negative Externality

When externalities are present, the individual pursuit of self-interest rarely results in maximum social welfare, and the result is an outcome that is inefficient. This implies that a rearrangement could make at least some people better off without harming others in the process. Thus, there is an economic rationale for some form of government intervention in markets where externalities are prevalent.

The need for government intervention arises because without government intervention, the good or service (producing negative externality) will be under-priced as well as under-produced, and the negative externalities will not be taken into account.

Similarly, in case of a negative externality in consumption, there will always be over-consumption compared to what is considered socially optimum.

One such example of a negative externality in consumption is smoking. There are potential negative effects of people consuming cigarettes on other consumers. The disutility (dissatisfaction) created leads to a reduction in the overall social benefit of consumption. If the cigarette consumer only considers their own private costs and benefits, then there will be overconsumption of the product.

In the case of a negative externality in consumption, the optimum consumption is always less than the private consumption level. In this example, the socially efficient level of cigarette consumption will be lower than the level being consumed by private individuals who are not considering the negative impact of their consumption on others.

In all such cases, there arises the need for the government to formulate appropriate policies/strategies that lead to those levels of production and consumption where marginal social benefit is equal to marginal social cost, thereby resulting in allocative efficiency.

There are many ways in which the Government can Eliminate Negative Externalities:

1. Internalising the Externalities

Negative externality occurs because the private entities do not pay the full cost of their actions and, therefore, over-produce. One way to eliminate externalities is to internalise the externalities so that producers have to pay the external cost, which will then encourage producers to produce socially optimum output. The internalisation can be through the imposition of certain taxes on production and consumption, like:

(a) Pollution tax, which is a classic way to adjust for externalities, is a tax on those who create negative externalities. Apart from pollution, there can be other adverse effects of a production or consumption activity, which can be corrected by imposing taxes on undesirable production or consumption.

However, this taxation approach is accompanied by some problems, such as reduced output and higher prices, which might reduce consumer surplus. Consumer surplus will also be affected when the demand for the product is inelastic, and producers pass on the tax to consumers in the form of higher prices, this may also have a regressive effect on low-income households when taxes are imposed on demerit goods.

(b) Along with emission and affluent taxes, specific purpose levies are announced by the government which are levied for a specific purpose. For example, the introduction of the climate change levy.

2. Regulation Through Policies

The government can also eliminate negative externalities by issuing policy regulations which seek to guide the actions of producers and consumers in a socially desirable manner.

For example, by setting minimum standards for health and safety at the workplace, stricter penalties for firms and consumers who break regulations, banning cigarette smoking in public places and advertisements of these dangerous products and making workplaces no-smoking environments.

All such policies aim at regulating the behaviour of all those entities which are producing negative externalities.

3. Enforcement of Property Rights

Externalities arise because property rights are not fully allocated. For example, the atmosphere or environment or oceans are nobody’s private property. Extension and enforcement of property rights to private individuals and firms is an alternative to government regulation.

For example, if property rights are assigned to a fishery to enjoy a clean river, then a factory upstream polluting the river could not ignore the cost of polluting the river, but it will have to trade with the fishery if it can allow the factory to pollute river to a certain extent and for which it compensates the fishery. It, therefore, gives the fishery the right to charge factories or companies who pollute the rivers.

Extending property rights is one of the methods of internalising the externality. The advantages of extending property rights are many, including the lesser need for government intervention as the owners of the property will better be able to handle their property themselves, facilitation of direct transfer of resources from the polluters to those who suffer, achieving efficient outcomes, etc.

In spite of these advantages, a number of disadvantages also come in the way of extending property rights, like the inability of the government to extend property rights; this is because it may be difficult to link between pollution and the problem. Another problem arises in assessing the value of the property for which rights need to be extended and then the compensation charged thereafter.

4. Marketable Pollution Permits

These are something which are extensively used in the global world in order to minimize global pollution. Different countries are granted permits for a certain level of use of harmful greenhouse gases so that the overall global effect does not exceed the permissible levels. These permits are tradable, and the countries can trade among themselves if one under-produces and the other over-produces.

This is based on the belief amongst economists that the free market mechanism offers a better solution. Pollution permits are a combination of command and control (regulations) and market-based approaches to the task of limiting pollution emissions.

Government Policy to Correct Positive Externality

It is generally seen that consumption and production activities which generate positive externalities are generally under-produced or under-consumed. This means that society as a whole can benefit if there is more production and consumption.

For example, the provision and consumption of health care services leads to an increase in social benefits and a reduction in social costs, so in society, people should be encouraged to increase their consumption of health care services. Similarly, through education, the wider community can benefit in terms of skills acquired and knowledge learnt, which can further raise society’s productivity.

Here, the role of government is important in subsidising the consumption of such merit goods, in promoting and advertising such products, etc. There are the following options for government intervention to encourage the production and consumption of positive externalities:

1. Increasing Supply

The supply of goods and services that generate external benefits can be raised if the government provides grants and subsidies to producers, which will reduce the costs of production and encourage more supply. This is a common remedy to encourage the supply of merit goods such as healthcare, education, and social housing.

Such merit goods can be funded out of tax revenues of central and local government. Public goods, such as roads, bridges and airports, also generate significant positive externalities, and these can also be built and maintained out of tax revenue.

2. Increasing Demand

Demand for goods is inversely related to their prices. The government can encourage consumption of those goods and services which generate positive externalities by reducing the price paid by consumers.

For example, subsidising the educational loans of university students will encourage more young people to go to university, which will generate a positive externality for future generations.

The government can also provide certain merit goods like hospital treatment for contagious diseases, completely free to protect others in the society. The government can also provide free information to consumers through promotional advertisements to compensate for the information failure that discourages consumption.

These can be in the form of public information broadcasts, such as aid awareness programmes, which can reduce ignorance and encourage the use of safety measures.

3. Command and Control Techniques

An additional option is to compel individuals to consume the good or service that generates the external benefit by issuing directions for the same. For example, if suspected of having a contagious disease, an individual may be forced into hospital to receive treatment, even against their will.

Coase Theorem and Externalities

Ronald Coase suggested a solution to a well-known problem of market externalities. He argues that if property rights are well-defined, there are a small number of individuals, and the costs of bargaining are not significant, and then these bargains can bring about an efficient outcome and eliminate externalities from the market without government intervention. This is widely known as the Coase Theorem.

The government in such a situation should restrict its role to facilitating bargaining among the affected groups or individuals and to enforcing any contracts that result. This individual bargaining among people would result in an efficient outcome in the market. This has implications for both positive and negative spillover effects.

The main implication of the theorem is that all that is needed to achieve efficient allocation is a common law or statutory rule, which assigns rights over the externality to one party or another. After the assignment of rights, the market mechanism will function on its own in the same way as it does for the ordinary goods and services over which rights are clearly defined.

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2. Role of Government in Economy
3. Role of Government in Mixed Economy: Public & Private Sector
4. Role of Government under Cooperation and Competition
5. Role of Government in Economic Development and Planning
6. Concept of Public Goods, Private Goods, and Merit Goods
7. Concept of Market Failure and Functions of Government
8. Market Failure and Functions of Government: Decreasing Costs
9. Market Failure and Functions of Government: Externalities
10. Market Failure and Functions of Government: Public Goods
11. Future Market: Meaning, Role & Uncertainty
12. Concept of Information Asymmetry
13. Theory of Second Best: Concept & Explanation
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27. Demand Revealing Schemes for Public Goods
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37. Diamond-Dybvig Banking Model
38. Preference Shocks, Adverse Selection & Central Bank
39. Equilibrium Deposit Contract
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43. Effect of Regional Imbalances on Stabilization Policy
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67. Concept of Public Debt or Public Borrowings
68. Need for Public Debt or Public Borrowing
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70. Classification of Public Debt
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74. Crowding Out of Private Investment and Activity
75. Principle of Public Debt Management and Debt Repayment