Understanding market failure models – externalities
Markets fail if there is an efficiency loss (= deadweight loss [DWL]) at market equilibrium.
An efficiency loss occurs at market equilibrium (Qf) because the cost to society of moving from Qf to
Qs (the Pareto optimum) is less than the amount it benefits
ie society is better off moving to Qs because benefits > costs so Qf is economically inefficient.
Pareto optimum is the economically most efficient output as the costs of moving from it are greater
than any benefits of the move
ie it is inefficient to move from Pareto optimum output because the cost>benefits
On graphs the DWL area shows the amount society would gain if output moved to the most
economically efficient output level (ie Qs)
ie the amount society is worse off by operating at the current output
1. Negative externalities of consumption
- Area bhg (=DWL) is the evidence of market failure if this market produces at Qf (which it
will without government interference). This DWL occurs because the additional PS + CS
benefits are not sufficient to cover the additional spillover costs of increasing output from Qs
to Qf
- If govt uses a sales tax (set at a rate = to the gap between Ptax and Ppr per unit) in response
to the market failure the efficiency loss (DWL) of operating at Qf is removed.
ie society is better off at Qs by area bhg which is the amount by which the benefits from
moving to Qs exceeds the costs of the move.
Note diagram below identifies the areas of benefits and cost
If a ban was imposed (ie operate at Q= 0) to address the market failure (of operating at Qf)
this would result in a DWL (efficiency loss) of area egc
ie. It would be more efficient to operate Qs since if output moved from 0 to Qs the benefits
(area adgc [=CS+PS]) exceed the costs (area adge [=spillover costs]) by area egc
At Qf
CS
PS
Spillover cost
DWL
-VE EXTERNALITY OF CONSUMPTION
Costs/
benefits
a
Ptax
e
Pf
Ppr = Ps
MC
- DWL = efficiency loss of operating at Qf
(ie amount by which society would better off if it
moved to [the Pareto optimum] Qs)
d
b
f
g
h
abPf
Pfbc
abhe
bhg
At Qs (due to sales tax)
Costs if shift to QS (from Qf)
MB
dbg
= lost PS or CS
c
SMB
Benefits from shift to QS
dbhg
= reduced spillover costs
0
Qs
Qf
Output
Efficiency gain
bhg
= amount by which benefits > costs of move from Qf
to Qs
2. Positive externalities of consumption
- Area dbg (=DWL) is the evidence of market failure if this market produces at Qf (which it
will without government interference). It occurs as the additional spillover benefits are
greater than the MC>MB costs of increasing output from Qf to Qs
- If govt uses a subsidy (set at a rate = to gap between Psub and Ppr per unit) in response to
the market failure the efficiency loss (DWL) of operating at Qf is removed.
ie society is better off at Qs by area dbg which is the amount by which the benefits from
moving to Qs exceeds the costs of the move.
Note diagram below identifies the areas of benefits and costs
At Qf
CS
PS
Spillover benefit
DWL
+VE EXTERNALITY OF CONSUMPTION
Costs/
benefits
a
MC
d
Ppr = Ps e
Pf
Psub
g
- DWL = efficiency loss of operating at Qf
(ie amount by which society would better off if it
moved to [the Pareto optimum] Qs)
b
f
h
egPf
Pfgc
adge
dbg
At Qs (due to subsidy)
Costs of shift to QS (from Qf)
SMB
bhg
= MC > MB for output Qf to Qs
c
MB
Benefits from shift to QS
dbhg
= increased spillover benefits
0
Qf
Qs
Output
Efficiency gain
dbg
= amount by which benefits > costs of move from Qf
to Qs
3. Negative externalities of production
- Area edb (=DWL) is the evidence of market failure if this market produces at Qf (which it
will without government interference). This DWL occurs because the additional PS + CS
benefits are not sufficient to cover the additional spillover costs of increasing output from Qs
to Qf
- If govt uses a sales tax (set at a rate = to gap between Ptax and Ppr per unit) in response to
the market failure the efficiency loss (DWL) of operating at Qf is removed.
ie society is better off at Qs by area edb which is the amount by which the benefits from
moving to Qs exceeds the costs of the move.
Note diagram below identifies the areas of benefits and cost
If a ban was imposed (ie operate at Q= 0) to address the market failure (of operating at Qf)
this would result in a DWL (efficiency loss) of area adh
ie. It would be more efficient to operate Qs since if output moved from 0 to Qs the benefits
(area adgc [=CS+PS]) exceed the costs (area hdgc [=spillover costs]) by area adh
At Qf
CS
PS
Spillover cost
DWL
-VE EXTERNALITY OF PRODUCTION
Costs/
benefits
a
Ptax
Pf
Ppr
h
SMC
e
MC
d
- DWL = efficiency loss of operating at Qf
(ie amount by which society would better off if it
moved to [the Pareto optimum] Qs)
b
f
g
abPf
Pfbc
hebc
edb
At Qs (due to sales tax)
Cost if shift to QS (from Qf)
MB
dbg
= lost PS or CS
c
Benefits from shift to QS
debg
= reduced spillover costs
0
Qs
Qf
Output
Efficiency gain
ebd
= amount by which benefits > costs of move from Qf
to Qs
4. Positive externalities of production
- Area dbg (=DWL) is the evidence of market failure if this market produces at Qf (which it
will without government interference). It occurs as the additional spillover benefits are
greater than the MC>MB costs of increasing output from Qf to Qs
- If govt uses a subsidy (set at a rate = to gap between Psub and Ppr per unit) in response to
the market failure the efficiency loss (DWL) of operating at Qf is removed.
ie society is better off at Qs by area dbg which is the amount by which the benefits from
moving to Qs exceeds the costs of the move.
Note diagram below identifies the areas of benefits and costs
Costs/
benefits
a
Ppr
Pf
Psub
h
At Qf
CS
PS
Spillover benefits
DWL
+VE EXTERNALITY OF PRODUCTION
MC
e
SMC
d
- DWL = efficiency loss of operating at Qf
(ie amount by which society would better off if it
moved to [the Pareto optimum] Qs)
b
f
g
adPf
Pfdh
dhcg
dbg
At Qs (due to subsidy)
Cost to shift to QS (from Qf)
MB
edb
= MC > MB for output Qf to Qs
c
Benefits from shift to QS
debg
= increased spillover benefits
0
Qf
Qs
Output
Efficiency gain
dbg
= amount by which benefits > costs of move from Qf
to Qs