Market failure: externalities

1
Market failure externalities
Sediment in the street in Des Moines, Iowa, after
rains. Measures were not taken to protect the
soil from erosion during development.
2
External costs

• Marginal private costs to producers, MPC do not
  include all relevant costs
• Costs borne by others are external costs
• Efficiency requires that all costs be accounted
  for

3
External costs

• Marginal social cost, MSC is the sum of the
  Marginal private costs to producers and any
  associated external costs to others, MEC
• MSC MPC MEC
• Note the difference between definitions for MSC
  and MEC, these are often confused with each other.

4
External cost example - graph
5
External cost and economic efficiency

• Private producer chooses to produce quantity at
  which MPC MSB
• Socially efficiency dictates producing quantity
  at which MSC MSB
• Thus,
• Private producers produce too much
• Market price is too low as it does not cover
  all the costs of production
• Loss of net benefits, welfare loss compared to
  maximum net benefits

6
Solved problem 1

• For the following relationships
• Create a table of values for MSB, MSC, MPC and
  MEC for quantities from 0 to 500 in increments of
  100
• Plot the values in a graph
• Identify the quantity a private producer would
  choose when ignoring external costs and the
  market price in the graph and the table
• Identify the efficient quantity and price in the
  graph and the table
• Calculate the welfare loss if the market ignores
  the external cost

7
Solved problem 1

• MPC .075q 10
• MSC .4q 10
• MSB 140 - .25q

8
Solved problem 1

• MPC .075q 10
• MSC .4q 10
• MSB 140 - .25q

9
Solved problem 1
10
Solved problem 1

• Welfare loss .5(extra quantity)(MEC)
• .5(400-200)(170-40)
• 13,000

11
External benefits

• Willingness to pay of consumers do not include
  all relevant benefits
• WTP MPB, Marginal Private Benefits
• Other benefits not received by consumers are
  external benefits
• Marginal external benefits, MEB

12
External benefits graphical analysis

Quantity of trees
13
External benefits and economic efficiency

• Consumers maximizing own utility will choose
  quantity at which MPB MSC
• Efficiency requires that for the quantity
  produced
• MSB MPB MEB MSC
• Thus,
• Buyers will buy too little
• The market price will be too high
• Loss of net benefits, welfare loss compared to
  maximum net benefits