In the field of microeconomics, a significant area of study is that concerning market failure, it’s causes, effects and it’s remedies.
Market failure occurs when a price mechanism leads to an inefficient allocation of resources; resulting in outcomes which fail to maximise social welfare. Although there are several causes of market failure, this essay will focus on market failure caused by negative externalities. Initially theorised by Henry Sidgwick, externalities – or “spillover effects” – are the costs/benefits of an economic transaction inflicted upon a third party who did not participate in the trade. Negative externalities, specifically, refers to cases in which detrimental cost is inflicted and social welfare is diminished. These externalities can be categorised into either consumption (such as obesity) or production (such as pollution) externalities; both of which can be addressed via government intervention. This intervention occurs in the form of regulation, taxation or compensation. Alternatively, however, some economists such as Coase argue the best way to prevent market failure is private negotiation.
Socially optimal outcomes, otherwise known as ‘Pareto efficient’ outcomes are trades in which there is no feasible alternative in which one party is better off and no party worse off. However, in unregulated, free market conditions, the private agent often over produces/consumes goods; leading to a Pareto inefficient allocation of goods and welfare. This is because personal profits are maximised at the point at which marginal private benefit; that is, the benefit increase from consuming or producing one extra unit of a good for the person who consumes/produces said good (MPB) = marginal private costs (MPC), which is the cost for the producer of producing an additional unit of a good. At this point, the actor is not considering negative externalities as they have no incentive to. However, should the actor take negative externalities into account, the outcome will be a Pareto efficient allocation of goods.
This is the point at which he marginal social cost (MSC) = MPB. The marginal social cost (MSC) is the sum of MPC and the marginal external cost (MEC), which is the cost of producing another unit of a good incurred by any third parties. A futher result of market failure is a deadweight loss of welfare at the equilibrium level of output delivered by a free market. Since, beyond the socially optimum level of output, MSC > MPB there is a net loss of social welfare. The higlighted region in the third diagram shows the overall social welfare loss at the equilibrium level of output delivered by a free market.
There are three main actions a government can take to prevent, or correct, market failure. The first is regulation. To mitigate social welfare loss, the government may regulate levels of production or consumption – ideally to pareto efficient quantities. Firstly, considering the sheer diversity of the free market, it may be difficult to determine socially optimal quotas and even harder to enforce them. Furthermore, regulation provides no compensation to the producer/consumer despite them having diminished private benefit. An example of government regulation could be in relation to the negative production externality that is air pollution.
Air pollution has a demonstrable affect on third parties; often on a vast scale. The most common welfare loss from air pollution is health related, for example, in 2013 air pollution is predicted to have caused 5.5 million premature deaths; mostly from nations with high industrial output and high urbanisation, such as China. This shows that over production (above socially optimal levels) is contributing towards deadly pollution levels, resulting in significant welfare loss. The loss of economic welfare can bee seen in medical costs and lost working hours. One reason for this welfare loss is because the cost of this air pollution is not compensated for by either producers or consumers of polluting products – for example, factory owners or car drivers.
An example of regulation against air pollution is ‘EU regulation number 443/2009’, which sets an emissions target of 130g of CO2 per kilometre for all new passenger cars. However, as previously mentioned, this has proven hard to regualte. This was demonstrated by the 2015 Volkswagen emissions scandal, in which all 37 VW car tested proved to have COx emissions higher than EU regulation stipulates; some being 14 times higher.A second form of government intervention used to adress market failure is taxation. Known as a Pigouvian tax, any market producing negative externalitites should be taxed equal to the cost of the social welfare loss; therefore correcting the market inefficiency.