Market failure: externalities and common pool resources

The area of lost well-being to society because output exceeds the socially optimal level. It is the triangle between MSC and MSB, from Q* (social optimum) to Qm (market output). Each unit beyond Q* costs society more than it benefits.

A tax set equal to the external cost per unit. It "internalises the externality" by making the polluter pay the full social cost. Ideally, S shifts up to MSC, and the market produces at the socially optimal quantity (Q*).

A cost from production or consumption that is imposed on a third party NOT involved in the transaction. The third party bears the cost without being compensated. Examples: factory pollution harming local residents, passive smoking.

Draw D (= MPB = MSB), S (= MPC), and MSC above MPC. The gap between MSC and MPC is the external cost per unit. Market equilibrium at MPC ∩ D (Qm). Social optimum at MSC ∩ D (Q*). Shade the welfare loss triangle between Q* and Qm.

Production: MSC > MPC — the firm does not pay the full social cost (e.g. factory pollution). Consumption: MSB < MPB — the consumer does not account for costs imposed on others (e.g. smoking causing passive smoke, driving causing congestion).

A government sets a total cap on emissions and issues permits. Firms can trade them — those cutting pollution cheaply sell excess permits; those with high abatement costs buy permits. This creates a market price for pollution and incentivises efficiency.

Draw S (= MPC = MSC), D (= MPB), and MSB below MPB. The gap between MPB and MSB is the external cost per unit. Market equilibrium at S ∩ MPB (Qm). Social optimum at S ∩ MSB (Q*). Shade welfare loss triangle between Q* and Qm.

MSC = MPC + external cost. The marginal social cost is higher than the marginal private cost because the external cost (e.g. pollution damage) is not included in the firm's decision-making. The gap between MSC and MPC equals the external cost per unit.

Carbon tax: fixes the PRICE of pollution (predictable cost, uncertain quantity). Permits: fix the QUANTITY (certain emission level, unpredictable price). Tax is simpler to administer; permits guarantee the environmental target. Both internalise the externality.

1) Regulation (bans, emission standards, speed limits). 2) Education campaigns (anti-smoking, recycling). 3) Direct provision of alternatives (public transport to reduce car use). 4) International agreements (Paris Climate Agreement).

The market equilibrium only considers private costs and benefits (MPC = MPB). It ignores external costs. The social optimum is where MSC = MSB, which occurs at a LOWER quantity. The difference (Qm − Q*) represents over-production.

The market over-produces/over-consumes relative to the socially optimal quantity. Firms base decisions on MPC (not MSC), so they produce where MPC = MPB instead of MSC = MSB. The result: too much output, too much pollution/harm.

Axes (Price/Cost, Quantity), all curves labelled (MPC/S, MSC, MPB/D, MSB if consumption), Qm (market quantity), Q* (social optimum), Pm and P*, external cost per unit (gap), welfare loss triangle shaded and labelled.

1) A coal power plant emitting CO₂ — climate change costs are borne by the whole world. 2) A factory discharging chemicals into a river — fishing communities downstream bear the cost of contaminated water.

The EU Emissions Trading System (EU ETS), the world's largest carbon market. It covers about 40% of EU greenhouse gas emissions. Companies must surrender permits for each tonne of CO₂ emitted. The cap is reduced over time to drive reductions.

The welfare loss triangle is between Qm and Q* — to the LEFT of the social optimum. For each unit between Qm and Q*, MSB > MSC but the units are not produced/consumed. Society misses out on net benefits.

A subsidy equal to the external benefit per unit shifts supply right (or reduces cost to consumers). This moves output from Qm to Q* (social optimum). On the diagram, S shifts down to align MPC with MSC (production) or effectively lowers the price to consumers (consumption).

A benefit from production or consumption that is received by a third party NOT involved in the transaction. The third party gains without paying. Examples: flu vaccination protecting the unvaccinated, beekeeper's bees pollinating nearby crops.

Production: MSC < MPC — the firm produces benefits it isn't rewarded for (e.g. R&D creating knowledge spillovers). Consumption: MSB > MPB — the individual doesn't capture all the benefits (e.g. education benefits employers and society too).

The government provides the good or service itself (free or below cost) instead of leaving it to the market. Examples: public schools, NHS healthcare, public parks. This ensures consumption at or near the socially optimal level regardless of ability to pay.

Draw S (= MPC = MSC), D (= MPB), and MSB above MPB. The gap between MSB and MPB is the external benefit. Market equilibrium at S ∩ MPB (Qm). Social optimum at S ∩ MSB (Q*). Shade welfare loss triangle between Qm and Q*.

Laws can mandate consumption of goods with positive externalities. Examples: compulsory education (most countries require schooling until 16-18), compulsory vaccinations for school entry, building regulations requiring energy efficiency.

MSB = MPB + external benefit. The marginal social benefit is higher than the private benefit because third parties gain. The gap between MSB and MPB equals the external benefit per unit.

Draw D (= MPB = MSB), S (= MPC), and MSC below MPC. The gap between MPC and MSC is the external benefit. Market equilibrium at MPC ∩ D (Qm). Social optimum at MSC ∩ D (Q*). Shade welfare loss triangle between Qm and Q*.

Negative externality: market over-produces (Qm > Q*). Positive externality: market under-produces (Qm < Q*). In both cases, the market quantity differs from the social optimum, creating a welfare loss triangle.

The market UNDER-produces/under-consumes relative to the socially optimal quantity. Consumers only consider MPB, not MSB, so they buy less than is socially optimal (Qm < Q*). Society misses out on the external benefits.

Government subsidies for solar panel installation. Private benefit (lower electricity bills) alone does not justify the cost for many households. The subsidy compensates for the external benefit (lower carbon emissions for society), increasing adoption toward the socially optimal level.

External benefits (e.g. from education, vaccination) are hard to measure in monetary terms, are spread across many people over long time periods, and vary with each unit consumed. This makes it difficult to set a precisely correct subsidy.

1) Vaccination — the vaccinated person is protected (private benefit) AND others are less likely to catch the disease (external benefit, herd immunity). 2) Education — the student gains skills (private benefit) AND society benefits from a more productive, innovative workforce.

Subsidies: opportunity cost, may not reach target group, hard to set correct amount. Direct provision: government failure (inefficiency, poor quality), high tax cost. Legislation: enforcement costs, may be unpopular, inflexible. All: difficulty measuring exact external benefit.

A concept described by Garrett Hardin (1968): when a resource is shared and unregulated, each individual has an incentive to over-use it. The private benefit of taking more exceeds the private cost (shared among all users), leading to depletion.

Resources that are RIVALROUS (one person's use reduces availability for others) but NON-EXCLUDABLE (impossible or very costly to prevent access). Examples: ocean fish stocks, clean air, groundwater, forests, grazing land.

1) Regulation — quotas (fishing limits), bans (moratoriums), emission standards. 2) Taxation — carbon/pollution taxes to raise MPC toward MSC. 3) Tradable permits — cap and trade. 4) Assigning property rights — private ownership creates incentive to conserve.

The full benefit of taking extra goes to the individual, but the cost of depletion is spread across ALL users. So the private marginal benefit > individual share of marginal cost. Rational self-interest leads everyone to take more than is sustainable.

Because they are non-excludable, no one can be prevented from using them. Because they are rivalrous, each user depletes the stock. The private marginal cost (free access) is less than the social cost (depletion), so usage exceeds the sustainable level.

Assigning ownership gives the owner an incentive to conserve the resource for future use (and future profit). If a fishery is privately owned, the owner limits catches to maintain the stock. Without property rights, no one has this long-term incentive.

Ostrom (Nobel Prize 2009) showed that communities CAN manage CPRs without government or privatisation. Small groups with clear rules, monitoring, and graduated sanctions can sustainably manage shared resources. Examples: irrigation systems, community forests.

1) Private goods: excludable + rivalrous (chocolate bar). 2) Public goods: non-excludable + non-rivalrous (street lighting). 3) Common pool resources: non-excludable + rivalrous (fish in the ocean). 4) Club goods: excludable + non-rivalrous (Netflix).

Over-exploitation can be modelled with MSC > MPC. Each fisher/farmer faces low MPC (free access) but the MSC includes depletion of the resource. The market outcome (where MPC = D) produces Qm > Q*. The welfare loss is the triangle between Qm and Q*.

Herders share a common grazing field. Each herder gains full benefit from adding one more cow (more milk, more meat), but the overgrazing cost is shared among all herders. So each adds more cows until the field is stripped bare and no one can graze.

Each user imposes a negative externality on others: their consumption depletes the resource, increasing scarcity for everyone. MSC > MPC because users don't account for the depletion cost. This leads to the same over-use problem as a standard negative externality.

The atmosphere, oceans, and climate are global CPRs — no single government has jurisdiction. Free-riding is a problem: each country benefits if others cut emissions. International agreements (Paris, Kyoto) set collective targets, but enforcement is weak without a global authority.

For each solution, discuss: effectiveness (does it reduce over-use?), enforcement (can it be monitored?), equity (who bears the cost?), and feasibility (political will, international cooperation). Note that no single solution is perfect — combinations often work best.

North Atlantic cod fisheries collapsed in 1992 — decades of unrestricted fishing depleted stocks to near zero. Canada imposed a fishing moratorium that put 40,000 people out of work. Stocks have still not fully recovered over 30 years later.

The atmosphere is a common pool resource (non-excludable, rivalrous in capacity to absorb CO₂). Each country benefits from burning fossil fuels (economic growth) while the cost (climate change) is borne globally. No single country has sufficient incentive to cut emissions alone.