How can the presence of externalities cause market failure?
...point B, so output will be Q1 with price at P1. Given that there is pollution, though, the optimal point for the whole of society is at C, where output is Q2 and price P2. Hence, if left to the free market, cars will be over-produced at a price, which, in terms of society, is too low. Now we have looked at negative externalities that arise from the production process, I will move onto negative externalities that arise from consumption. A good example of this type of negative externality is when private individuals cause congestion and pollution when they drive (or ‘consume’) their private cars. In this case, the social benefit will be less than the private benefit due to the negative externality of the exhaust fumes. The graph below shows this well: This diagram shows only one supply curve which is labelled MSC = MPC. I am assuming, for simplicity, that there are no negative externalities from the production process, so the marginal private cost is the same as the marginal social cost. Also, instead of demand curves we have the marginal private benefit (MPB) and marginal social benefit (MSB) curves. The equilibrium in the diagram is a point D, where the supply curve (MSC = MPC) equals the demand curve (MPB). But this is not the socially optimal position. The MSB curve is below the MPB curve to represent the negative eternality of private driving. The best equilibrium for society, therefore, is at point E where MSC = MSB. Hence, again, too many cars are produced and the deadweight loss triangle is DEF (the area where MSC is greater than MSB) A good example of negative externalities causing problems within a market can be seen in the development of the Glen Canyon and Bonneville dams. Many of these externalities were unknown at the time of their development; it was not until later that many of the ecological and social costs became explicit. The situation is now one in which these long term investments in infrastructure have generated large social and ecological costs as a result of economic short sightedness. The Bureau of Reclamation and the BPA do not internalise these costs. The costs of these externalities are eventually borne by the consumer in the form of higher taxes and increases in energy prices. As stated earlier, although it is less obvious, there are examples of positive externalities. A good example is education. This includes training by firms as well as what goes on in schools and universities. If you get a good education, there are obvious private benefits; better career prospects and higher future earnings for instance. But there are...