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How can the presence of externalities cause market failure?

In general, an externality is something that is a by-product of a production process but affects a third party externally (the word from which ‘externality’ is derived).

There can be both positive and negative externalities, which can be split up into consumption externalities and production externalities. The table below shows some different externalities:

But why do these externalities occur and what effect can they have on the market?

The graph below shows the exist of net external costs, perfect market will over produce with too many resources allocated to this use, the welfare loss is shown by the area ABC.

Society will benefit from output reduction of cars with some resources leaving this use or other uses.

The car firm does not care about the pollution. The owner is simply interested in maximising profits. The equilibrium price for him is where demand equals his supply curve, at point B, so output will be Q₁ with price at P₁. Given that there is pollution, though, the optimal point for the whole of society is at C, where output is Q₂ and price P₂. Hence, if left to the free market, cars will be over-produced at a price, which, in terms of society, is too low.

Now we have looked at negative externalities that arise from the production process, I will move onto negative externalities that arise from consumption.

A good example of this type of negative externality is when private individuals cause congestion and pollution when they drive (or ‘consume’) their private cars. In this case, the social benefit will be less than the private benefit due to the negative externality of the exhaust fumes.

The graph below shows this well:

This diagram shows only one supply curve which is labelled MSC = MPC. I am assuming, for simplicity, that there are no negative externalities from the production process, so the marginal private cost is the same as the marginal social cost. Also, instead of demand curves we have the marginal private benefit (MPB) and marginal social benefit (MSB) curves.

The equilibrium in the diagram is a point D, where the supply curve (MSC = MPC) equals the demand curve (MPB). But this is not the socially optimal position. The MSB curve is below the MPB curve to represent the negative eternality of private driving. The best equilibrium for society, therefore, is at point E where MSC = MSB. Hence, again, too many cars are produced and the deadweight loss triangle is DEF (the area where MSC is greater than MSB)

A good example of negative externalities causing problems within a market can be seen in the development of the Glen Canyon and Bonneville dams. Many of these externalities were unknown at the time of their development; it was not until later that many of the ecological and social costs became explicit. The situation is now one in which these long term investments in infrastructure have generated large social and ecological costs as a result of economic short sightedness. The Bureau of Reclamation and the BPA do not internalise these costs. The costs of these externalities are eventually borne by the consumer in the form of higher taxes and increases in energy prices.

As stated earlier, although it is less obvious, there are examples of positive externalities. A good example is education. This includes training by firms as well as what goes on in schools and universities. If you get a good education, there are obvious private benefits; better career prospects and higher future earnings for instance. But there are external benefits as well. The obvious economic one is that a better-educated workforce is a more productive and efficient one, but there is also the fact that well educated people are less likely to resort to crime. This is almost like an avoidance of a negative externality.

In the diagram, the MSC = MPC curve and the MPB curve are only showed. This is the initial equilibrium where the quantity and price of education reflects only individuals’ private benefit.

Like the previous diagrams, there is a deadweight loss again (GHJ). This occurs because the amount of education consumed when only private interests are taken into account (Q₅) is less than the socially optimal amount when one allows for the external benefit to society (Q₆). It is the area where MSB > MSC. It is because education is a ‘good thing’ that the government do subsidise it and makes sure that all children go to school, free at the point of use, until the age of 16.

The fact that marginal social benefit is greater than marginal social cost might sound like a good thing, but it is still inefficient because it means more resources should be devoted to this area. It means that the MSC > MSB in a different market, which is a bad thing as well. A totally efficient economy would have MSB = MSC in all markets.