Externalities

    A second important source of market failure is externalities or ‘spillover effects’.

These arise when an economic activity affects a third party directly rather than

through the market. The competition model assumes that both producers and

consumers bear the entire cost and enjoy the entire benefit created by their economic actions. This assumption is frequently breached in practice. The resulting

spillover effects reflect an inefficiency of the free-market system.

    Externalities can be either positive or negative. Positive externalities, also called

external benefits, bestow a benefit on a third party.Correspondingly, a negative externality,also referred to as an external cost, imposes a cost on a third party, involving a loss of utility.A further distinction can be made between producers and

consumers. Externalities can result either from the consumption activities of

some individuals or from the production process of firms.

    The different types of externalities are summarised in Figure 8.1. Examples are

given for each of the four categories. All four types of externalities lead to inefficiencies when the market system is left to operate freely. The free market

provides too little of the activities providing positive externalities and too much

of those with negative externalities. In that sense, ‘positive’ externalities are just

as ‘inefficient’ as ‘negative’ externalities.

    To illustrate the efficiency loss from spillover effects, we begin with the

example of a negative production externality. Imagine a chemical plant which channels its polluted effluents into the nearest river. Imagine also that, downstream,

there is a factory which needs clean water, and, therefore, must incur costs

in cleaning the water. Finally, assume that the resulting loss in profits for the

downstream factory can be measured in money terms and is a constant fraction

of the factory’s output. This situation is represented in Figure 8.2.

    Assume for simplicity that the chemical factory can sell at a given price OP, i.e.

it faces a horizontal demand curve and thus price # marginal revenue. Its

marginal costs increase with output. The production costs borne by the firm are

denoted by PMC, which stands for private marginal cost. Profit maximisation

drives the firm to produce up to OP # PMC, hence the amount OQ_1 of chemicals

is produced. However, the factory’s operating costs do not encompass the totality

of costs created by the manufacture of its output. Costs borne by the downstream

factory in cleaning the water need to be accounted for. Suppose these amount to

EF per unit of chemical output. In order to represent total production costs perunit, we add EF to PMC to obtain SMC, the social marginal cost. In the case of a

negative production externality, the social cost is greater than the private cost of

production. From society’s point of view, the costs to the downstream factory

should be added to the outlays of the chemical company. Hence, the optimality

condition is that OP # SMC. It would be socially optimal to produce OQ_2 rather

than OQ_1._11

    This example shows that, in the presence of negative externalities, the free

market leads to an over-provision of the goods concerned. In the opposite scenario

– where the production or consumption of a certain good creates external

benefits – a free market results in too low a level of production or consumption.

   

    Note that economics tends to resist any absolutist approach to the pollution

problem. The existence of external costs such as pollution does not generally

provide an economic justification for the total suppression of the underlying

activity. In our example, the closure of the chemicals plant is not required for

efficiency, merely a reduction in output to the level OQ_2. There is a trade-off between the utility lost by the sufferers of pollution and the utility gained by the producers and consumers of the good whose production gave rise to the externality. In this sense some pollution is, for this reason, usually better than no pollution. Only if the negative spillover EF were so large as to push up SMC beyond the demand curve over the whole range of output would it be most efficient to shut down the factory completely. This is not just a theoretical possibility – several polluting plants of Central Europe were closed down during the 1990s for this reason.