Understanding Public Goods, Externalities, and Market Failures

PART 1 : THEORY 2 Public Goods and their characteristics Free Rider Problem and Market Failure Externalities vis-a vis Public Goods

Externalities vis-a vis Public Goods Public goods and externalities are two important concepts in economics that relate to market failures and the role of government intervention in addressing these failures. Public goods include clean air, street lighting, national defense, and public parks. These goods tend to be underprovided in a purely market-driven economy because private firms have no incentive to produce them. If a firm were to produce a public good and charge a price for it, they wouldn't be able to exclude non- payers from using it, and the non-rivalrous nature of the good would make it impossible to charge each user their marginal cost.

Consequently, public goods are often provided by the government, which can raise funds through taxation to finance their production. Externalities: Externalities, also known as spillover effects or third-party effects, occur when the production or consumption of a good or service has an unintended impact on third parties who are not directly involved in the transaction. Externalities can be positive or negative:

Negative externalities: These occur when the actions of one party impose costs on others. For example, air pollution from a factory can harm the health of people living nearby, and the cost of healthcare is borne by those affected, not the factory owners. Negative externalities overproduction of the harmful activity in the absence of government intervention. tend to result in

Positive externalities: These occur when the actions of one party create benefits for others. For example, education benefits not only the individual receiving it but also society as a whole through increased productivity and reduced crime rates. Positive externalities underinvestment in the beneficial activity in a purely market-driven economy. tend to lead to

Negative Externalities and Inefficiency MSC MC MEC P1 Q

Let us assume a steel plant dumping waste in a river First figure explains the negative externality of single steel plant and second figure explains the negative externality of all steel plants. First figure shows the production decision of the steel plant in a competitive market second figure explains the market demand and market supply . They generate similar externalities. The firm has fixed proportion production function and it cannot alter its input combination. Waste and be reduced only by lowering output.

DD is the market demand and MC1 is the market supply curve MEC is the Marginal External Cost (dumping) curve which is upward slopping because as the firm produces additional output it dumps additional waste in the river. It will harm the fish industry increasingly. MSC is the Marginal Social Cost Curve which is obtained by adding MC with MEC i.e. MSC = MC + MEC By the intersection of DD and MC 1 , P1 Market Price of the steel is determined . A single firm takes the price determined in the industry and maximizes its profit by equalizing the price with the marginal cost. In first figure at Q 1 output the firm maximizes profit. From social point of view the efficient output is the level at which price is equal to the marginal social cost of production (MSC). MSC intersects the price curve at e where Q output is produced. Here Q 1 > Q

Case of all steel plants together Here MC1 is the industry supply curve and MEC1 is the industry s marginal external cost curve . The DD curve represents the marginal benefits to the consumers. The competitive industry s output is OQ 1 at the intersection of MC1 and DD . The market price is P 1 . It is incorrect pricing of the product . It does not considers MEC . This industry s output is too large from social point of view as. It is not efficient situation. Thus there is market failure. MSC1= MC1 + MEC1 The DD intersects MSC1 at E* and OP* price and OQ* output will be determined. OQ* output is efficient output as marginal benefit of an additional of output (DD) is equal to Marginal Social Cost (MSC1).

The cost to the society of the inefficiency ? When output exceeds OQ* MSC exceeds DD (the marginal benefits to the consumers). The aggregate social cost will the lateral summation of the difference between MSC1 and DD for all units of output that exceeds the efficient level OQ*. The shaded area in figure 2 represents this.

Externalities generate long run as well as short run inefficiencies. A firm enters into industry when price of the product is above the average cost of production and exists when price falls below the average cost of production. In long run price is equal to long run average cost. When there is negative externalities average cost of production is less than average social cost. As a result some firms remain in the industry even when it would be efficient to leave it. Thus negative externalities encourage too many firms to remain in the industry.