Economics note : Externalities

Government intervention corrects market failure and solves the problem of income inequality. Market failure means the market fails to allocate resource efficiently.

Reasons for market failure

1)       Lack of competition: Monopoly and oligopoly under cartel can rise P and decrease Q to earn more. Government can impose relegations to restrict them (promote competition).

2)       Provision of public goods makes the goods are consumed by all individuals concurrently, so that it's to costly to exclude non-payers from consuming, causing market failure.

Public goods refer to non-rival and non-excludable goods while private goods refer to rival and excludable goods.

Rivalry refers to one's consumption reduce availability in amount for other's consumption.

Excludability refers to difficulty to exclude specific individuals (non-payers) to consume it.

For Public goods, MC for an additional unit/serving additional consumer is zero, and it's too costly to exclude others to consume it.

Pure public goods refer to completely non-rival and non-excludable, which can be consumer by all individuals at the same time.

Impure public goods has a certain degree of rivalry and excludability but not compete at all.

Note that public goods provided by the government may be more efficient since it's too costly for private firms to exclude non-payers to use those goods, and it can bring greatest benefits to the society. However, goods provided by government may not be public good (e.g. water supply) and public good is not necessarily provided by the government.

3)       Externalities: when a party's action affect third party without any compensation or receiving payment.

Harmful (detrimental) and beneficial externalities refers to negative and positive externalities.

Private cost/benefit (PC/PB) is the cost/benefit of the economic agent taking that action.

External cost/benefit (EC/EB) refers to someone's action cause cost/benefit to third party without any compensation or payment.

Social cost/benefit (SC/SB) is the cost/benefit of the whole society by that action.

Mathematically SC = PC + EC, MSC = MPC + MEC, same as benefit.

Note that PB/SB is also called private/social product.

When external cost exists, the equilibrium quantity (ideal for individual considerations) is more than the efficient quantity, which is overproduced (or overconsumed). Deadweight loss is denoted by the bolded black lines. Note that MSC=MPC at Q=0.

When external benefit exists, the equilibrium quantity is less than the efficient quantity, which is underproduced. Deadweight loss is denoted by the bolded black lines.

 Since problem of externalities leads to inefficiency due to underproduction / overproduction which producers produces to MPB = MPC (equilibrium quantity) which maximizes his own gain, but the society's gain maximizes as MSC = MSB (efficient quantity), which differs from equilibrium quantity, taxation and subsidization shifts the MPC curve such that efficient quantity is equal to equilibrium quantity.

When there's divergence between MSC and MPC, we apply a unit tax of MEC at efficient quantity. As a result, MSC, new MPC, MB curve are concurrent at efficient quantity. The producers produce until MPB=MPC, but under taxation MSB=MPB=MPC=MSC, therefore producer's equilibrium quantity is equivalent to society's efficient quantity, and efficiency is attained.

When there's divergence between MSB and MPB, we apply a unit subsidy of MEB at efficient quantity, the MPC curve shifts downward (note that originally it was MC curve, but only MPC curve shifts only while MSC curve stays still), then the point of intersection of MPC'=MPB and MSC=MSB are both on efficient quantity. Therefore producers produce until MPC' = MPB, but at that equilibrium quantity, MSC = MSB is also attained, hence efficiency is attained.

-          Restriction or even removal on harmful externalities can be imposed by government.

-          When government takeover the firm, it concerns the gain of the whole society, then it'll produce to efficient quantity.

-          Defining and granting rights to scarce resources may emerge them to solve the problem of externalities. e.g., they can trade their polluting permission. (Coase's theorem)

-          Internalization or self-restraint (maybe engaged by government).

-          Integration between the firm and third party solve the externalities.

Note that if the transaction costs is larger than the benefit brought, or cost > benefit, we better not to do anything in the interests of the society. Also, the precondition for solutions to take place is the well-defined private property rights.

Government intervention is appropriate only if it's least costly and benefit > cost. The restriction of government intervention are imperfect information, lack of incentives (less efficient than private firm's solution), government official concern their own interests (corruption), and cost consideration.