AS Market FailureNegative Externalities |
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In this note we consider some of the external costs that can result from people consuming goods and services and businesses supplying products. Externalities are common everywhere in everyday life and the key issue is whether the market, left to its own devices, will take these externalities into account. If not, then market failure can occur and there is a justification for some form of government intervention. What are externalities? Externalities are third party effects arising from production and consumption of goods and services for which no appropriate compensation is paid. Externalities cause market failure if the price mechanism does not take account of the social costs and benefits of production and consumption.
Externalities can and do result in the market mechanism producing the wrong quantity of goods and services so that there is a loss of social welfare Externalities occur outside of the market i.e. they affect economic agents not directly involved in the production and/or consumption of a particular good or service. They are also known as spin-over or spill-over effects. Externalities and the importance of property rights External costs and benefits are around us every day – the key point is that the market may fail to take them into account when pricing goods and services. Often this is because of the absence of clearly defined property rights – for example, who owns the air we breathe, or the natural resources available for extraction from seas and oceans around the world? A question of property rights I paint a picture on the side of your house – who owns the picture? Property rights confer legal control or ownership of a good. For markets to operate efficiently, property rights must be clearly defined and protected – perhaps through government legislation and regulation. If an asset is un-owned no one has an economic incentive to protect it from abuse. This can lead to what is known as the Tragedy of the Commons i.e. the over use of common land, fish stocks etc which leads to long term permanent damage to the stock of natural resources. Negative Externalities Negative externalities occur when production and/or consumption impose external costs on third parties outside of the market for which no appropriate compensation is paid. Some examples are given below, many of them are environmental.
US pollution may damage UK health Private Costs and Social Costs The existence of production and consumption externalities creates a divergence between private and social costs of production and also the private and social benefits of consumption. Social Cost = Private Cost + External Cost Social Benefit = Private Benefit + External Benefit When negative production externalities exist, social costs exceed private cost. This leads to the private optimum level of output being greater than the social optimum level of production. The individual consumer or producer does not take the effects of externalities into their calculations. External costs from production Production externalities are generated and received in production - examples include noise pollution and atmospheric pollution from factories and the long-term environmental damage caused by depletion of our stock of natural resources External costs from consumption Consumption externalities are generated and received in consumption - examples include pollution from cars and motorbikes and externalities created by smoking and alcohol abuse and also the noise pollution created by loud music being played in built-up areas. Negative consumption externalities lead to a situation where the social benefit of consumption is less than the private benefit. Positive consumption externalities lead to a situation where the social benefit of consumption is greater than the private benefit. In both cases externalities can lead to market failure. Consider this example of the estimated social costs arising from drug addiction in the UK. External Costs of Drug Dependency Heroin and crack cocaine addicts are costing the country up to £19 billion a year, according to a study from experts at York University. A hard core of problem drug abusers is running up a bill of £600 a week each in crime, police and court time, health care and unemployment benefits. Last year, the NHS spent about £235 million on GP services, accident and emergency admissions and treatment linked to drug abuse. When social costs are added, the bill rises to between £10.9 billion and £18.8 billion. There are at least 1.5 million recreational and regular users of Class A drugs. The average cost to society of all Class A drug users is £2,030 each a year, says the study. Externalities from alcohol use and misuse For most adults drinking alcohol is part of a pleasurable social experience, which causes no harm to themselves or others. For some people though, alcohol misuse is responsible for causing serious damage to themselves, their family and friends and to the community as a whole. In this context, alcohol has significant costs not only for the individual but also for the whole economy. Per capita alcohol consumption in the UK has risen by more than half in the part thirty years to 8.5 litres of pure alcohol in 2001. However obtaining reliable information about drinking behaviour is difficult and social surveys consistently under-record consumption of alcohol for two reasons.In 2001, over nine million people were estimated to be drinking above government weekly guidelines. Around eight percent of the English population or around 2.8 million people in England aged 16 and over are estimated by government figures to have some form of alcohol dependency. Britons are paying the penalty for the soaring rate of alcohol consumption, a report by doctors shows. According to the report, deaths from liver cirrhosis are rising faster in Britain than anywhere else in Europe. The rise has been especially sharp in men and women aged fewer than 45, where death rates now exceed the European average. Sources: Adapted from government reports and newspaper reports, November 2005 Private and external costs and benefits of alcohol Private costs: Expenditure on alcohol Private benefits: Pleasure / satisfaction from consumption External costs: Injuries / damage done to 3rd parties External benefits: Alcohol as a social lubricant
Government policy on alcohol – is this an example of government failure? A leading alcohol campaigning charity has heavily criticised the Government after a major new report revealed Britons are drinking themselves to death at a faster rate than people anywhere else in Western Europe. A new study published in The Lancet medical journal shows liver cirrhosis deaths are soaring in the UK while falling in other European countries. National charity Alcohol Concern today said the trend is an indictment of Britain's drinking culture and accused the Government of failing to tackle alcohol abuse and binge drinking. According to the pressure group, excessive drinking kills around 22,000 people every year. The Wanless Report on Health (2004) The value of some externalities can vary depending on the situation in which a good is consumed. For example, the externality of alcohol consumption depends critically on the amount consumed – small amounts of alcohol can be beneficial, while large amounts damage health. Ideally when introducing a tax, it should be set at the value of the last unit of the good consumed – called the marginal cost. Therefore, for example, the tax on a heavy drinker could be greater than someone only having a glass of wine during a meal.
The private costs of dumping waste are close to zero – but the external costs are often very high Illustrating the market failure from negative externalities The diagram below provides a way of illustrating the effects of negative externalities arising from production on the private and social costs and benefits to producers and consumers. The key is to understand the difference between private and social costs.
In the absence of externalities, the private costs of the supplier are the same as the costs for society. But if there are negative externalities, we must add the external costs to the firm’s supply curve to find the social cost curve. This is shown in the diagram above. If the market fails to include these external costs, then the equilibrium output will be Q2 and the price P2. From a social welfare viewpoint, we want less output from production activities that create an “economic-bad” such as pollution and other forms of environmental damage. A socially-efficient output would be Q1 with a higher price P1. At this price level, the external costs have been taken into account. We have not eliminated the pollution (we cannot do this) – but at least the market has recognised them and priced them into the price of the product. |
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| Author: Geoff Riley, Eton College, September 2006 | |||||||||||||||||||||||||||||||
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