Market Failure and Externalities

Working as designed, still wrong

You have spent this course watching markets do something rather clever: prices move, buyers and sellers respond, and resources end up where people want them. This topic is about the situation where all of that happens correctly and the outcome is still bad. That is what economists mean by market failure, and the name is slightly misleading, because nothing has broken. The reason is simple enough to state in a sentence. A price only carries the costs and benefits that land on the two people doing the deal, the buyer and the seller. If an activity also imposes a cost on somebody who is not part of the transaction, or gives a benefit to somebody who is not paying, none of that reaches the price. The market cannot respond to something it cannot see, so it produces too much of one thing and too little of another. Economists call that a misallocation of resources, and it is the reason governments intervene in markets at all. Hold that sentence, because the rest of this topic is it, said more precisely.

Words for costs that escape

Six terms, and the first four matter most because the last two are defined out of them.

Which cost is in the price

A firm produces something. Some of the cost falls on the firm; some falls on people who have nothing to do with the transaction. Which part does the market price reflect, and why does that matter?

• Only the private cost, because a price is set by the buyer and the seller and can carry nothing else
• The social cost, because society ultimately pays for everything
• Both, since firms are required to account for the harm they cause
• Neither, because prices are set by competition rather than by costs

Two directions the gap can run

An externality is a difference, so it has a direction. That is the only division your specification makes here, and it is worth keeping it that simple.

Match the situation to what it is

Which two are externalities

These are hypothetical situations used to illustrate the idea. Select the TWO that describe an externality.

• People living near a workshop are disturbed by noise from it, although they neither buy from it nor work there
• A firm plants trees around its site, and people walking past enjoy the shade without paying anything
• A firm pays more for raw materials than it did last year
• A customer enjoys the product they have bought

Why the market cannot see it

It is worth being precise about why a market does not simply correct this itself, because that is what the marks are usually for. A market allocates resources through prices, and a price emerges from what a buyer will pay and what a seller will accept. Both of those figures reflect what each of them personally gains and bears. Somebody who is neither buying nor selling has no way to enter that calculation, however much the activity affects them, because there is no mechanism through which their gain or loss becomes part of the price. So the market is not making a mistake in the ordinary sense: it is allocating resources efficiently with respect to the information it has, and that information is incomplete. The result is a misallocation, with real costs, and this is precisely where your specification says governments intervene: to change the price or the quantity so that it reflects the cost or benefit to society rather than only to the two parties. That is also the shape of a good exam answer. Say what falls outside the transaction, say which way the gap runs, say what the market therefore does too much or too little of, and then say what an intervention would be trying to correct.

Putting the difference into words

An externality is the difference between _____ and private costs, or between social and private _____. Where a cost falls on somebody outside the transaction, the social cost is _____ than the private cost, and the market produces _____ of the activity than is efficient. Either way the outcome is a _____ of resources, which is what economists mean by market failure.

The claim that calls it a fault

Four sentences about market failure. Select the ONE that misunderstands what the term means.

• A price reflects only the costs falling on the buyer and the seller.
• Market failure means the market has stopped working properly and prices no longer respond to demand.
• Where social costs exceed private costs, the market produces more of the activity than is efficient.
• The result of market failure is a misallocation of resources, which carries costs of its own.

Say what the price misses

Assemble a sentence defining a negative externality in the terms your specification uses.

Advising on a decision

A hypothetical activity imposes a cost on people who are neither buying nor selling. You are asked to analyse it. Take the decisions in order.

• What is the first thing to establish?
• It falls outside. What follows about the two costs?
• What does the market therefore do?
• What would government intervention be trying to achieve?

Explain market failure

Explain what market failure is and how externalities cause it, using the terms from this topic and an example of your own.

• Explain what market failure means, and why the market is not simply broken
• Explain what a price does and does not reflect
• Define an externality as the difference between social and private costs or benefits
• Explain a negative externality, and say what the market does too much of as a result
• Explain a positive externality, and say what the market does too little of
• Explain what a misallocation of resources is and why it carries costs
• Explain what government intervention would be trying to correct
• Use one example of your own, and be clear that it is an illustration rather than a definition