Economics

Q. Critically discuss the issue of externalities, its implications and how it causes market failure in the economy. What should be the government’s role in mitigating this problem?

“The word externalities were created by Arthur Cecil Pigou (1877-1959), which was developed earlier by fellow English economists Henry Sidgwick (1838-1900) and Alfred Marshall (1842-1924) into an important feature of modern economic theory.” (1)

In a market economy this generally means that an externality occurs where there is a direct effect of the actions of one person or firm on the welfare of another person or firm in a way which is not transmitted by market prices. This externality can arise from the effects that consumption of an item by one consumer may have on the welfare of others or from the effects that the production of one product may have on the production possibilities of others. As a result, in a competitive market too much or too little of the good will be consumed from the point of view of society.

Two types of externalities exist, positive externalities and negative externalities.

“Positive externalities exist when the marginal social benefit (MSB) of production and or consumption exceeds the marginal private benefit (MPB) i.e. production and/or consumption generate external benefits that may go under-valued by the market. Examples include industrial training by firms, research by companies into new technologies, education and etc.” (2)

For instance on 16 Jun 2004, entomologists have described and named over 1,000,000 species of insect. In the UK it was estimated that the value of the pollination services provided by honey bees and bumble bees was around Ј170 million for outdoor crops (fruit, oil seed rape etc.) and Ј30 million for greenhouse crops (tomatoes, peppers etc). However, the populations of bees in the UK are in decline. Commercial bee operations have been hit by infestations of a tiny arachnid called the varroa mite. This mite has resulted in some bee keepers losing 90% of their hives. It's not good news for Britain's wild bees either. The decline of bee populations is so dramatic that the public are being asked to help, as part of National Insect Week.” (3)

At places where substantial positive externalities exist, the good is under consumed or under provided as the free market fails to take into account their effects. This is because marginal social benefit of consuming the good is greater then marginal private benefit. In case of external benefits from production, the marginal social cost would be marginal private costs. For instance if the example of health care is considered, good quality health care brings positive spillover effects not only for the recipient but also their family and associates. We can see in the diagram below that the provision and consumption of health care services results in an increase in social benefits and a reduction in social costs, hence the people should be encouraged to increase their consumption of health care services.

FIGURE 1: This figure illustrates the implications for the optimality rules of a positive externality. The market equilibrium in this situation occurs at quantity Qp and price Pm where the MPB equals MC. However this item produces an external benefit (b) which the market does not take into account by the market. The socially optimal quantity of this item actually occurs where the marginal social benefit (MSB) curve derived by summing the private marginal benefit and the external benefit, equals the marginal cost of producing the item. This analysis suggests that the allocatively efficient situation occurs at quantity Q* and price P*.

Negative externalities exist when the marginal social cost (MSC) of production exceeds the marginal private cost (MPC) or when marginal private benefit (MPB) is greater then marginal social benefit (MSB). Externalities in the market based economy suggests that the optimality rules normally assumed to lead to allocative efficiency may not in fact lead to the most socially efficient outcome. This concept can further be explained by the following diagram:

FIGURE 2: In a free market with optimality rules being followed the quantity produced will occur at Xp and Pm, the point where D equals PMC. However where a negative externality exists the market fails to produce the socially optimal level of production. This is because the marginal damage (d), generated by the negative externality, is a cost not taken in to account in the market. When SMC curve is generated it is possible to see that socially optimal level of production is in fact X* and that the product should be sold at a higher price P* to reflect the fact that the true social