Question

In regards to externalities, why do free markets tend to over allocate resources (or produce more) to the production of goods that generate external costs?

Answer 1

An externality occurs if a person’s activity, such as consumption or production, affects the well-being of an uninvolved person. (The term externality comes from the fact that someone external to the action or transaction is affected by the production of consumption of the good.)

A negative externality occurs if an activity creates costs (harm or discomfort) for uninvolved people. Examples of negative externalities: Cars and factories generate air pollution that affects people’s health. Cars entering congested freeways impose time costs on other drivers, as all cars slow down as a result.

A positive externality occurs if an activity creates benefits for uninvolved people. Examples of positive externalities: People who get vaccinations against a communicable disease reduce other people’s chances of getting the disease. People who improve their property may create benefits for their neighbors by creating a more pleasing neighborhood and increasing property values.

Externalities affect resource allocation because the market fails to fully price the external effects generated by some economic activities. This is because market prices tend to reflect the cost sellers charge buyers of a commodity, a price based on the personal utility derived, while ignoring the costs/benefits imposed on third parties. Thus the pricing mechanism fails to reflect the true or social costs of economic activity so private costs may diverge from social costs. Resources will be allocated on the basis of private consumption and/or production decisions and not on social welfare maximising ones and for this reason resources will be allocated inefficiently.

The failure of all relevant effects to make their impact on the pricing system will result in a sub-Pareto optimum allocation of resources as the social marginal cost (MSC) of an activity will not equal its marginal private cost (MPC) which equals its price, The real price of the commodity does not fully determine its allocation so the function of the market to efficiently allocate resources based on their true prices breaks down resulting in a misallocation. The existence of externalities will thus lead to a sub-optimal allocation as either too many resources are used in processes conferring uncompensated social costs or too few are used in processes conferring uncompensated social benefits as the profit maximising output is less than the socially optimal output. This misallocation of resources is best seen by an example.

Let a firm be in perfect competition with a given market price, p, and a profit maximising output of xl and a marginal cost curve as in figure 1. Suppose now that the production of x creates air pollution which imposes a cost on local residents of [[sterling]]1 per unit of x produced. To obtain the MSC of x [[sterling]]1 must be added to the MPC of x. As a consequence of the negative externality the profit maximising output xl, exceeds the socially optimal level x* where the MSC=MPC=P.

If the firm is permitted to pollute, the firm produces too much of x, the reason being that part of the real cost of production, [[sterling]]1 per unit, is not recognised as a cost by the firm (Johansson, 1991). Therefore the existence of uncorrected externalities implies that resource allocation is inefficient as a Pareto improvement is possible. Thus externalities, which tend to be mostly negative, result in an inefficient resource allocation as commodities are not allocated on the basis of their true economic price.

Competitive markets are efficient; they produce the goods and services that people value the highest. However, we have already seen that problems such as monopoly and oligopoly can lead to inefficiency. In this chapter, we look further at problems that relate to market failure. We are particularly concerned with the problems of external costs and external benefits. External costs occur when costs are imposed upon third parties that are not through the market. Pollution is a prime example of an external cost. Smoke from a factory or loud noise from airplanes landing at airports impose costs upon individuals near those areas. Parties that cause external costs tend to ignore them in making decisions concerning how much to produce. As a result there is a tendency for resources to be overallocated to the production of goods that involve external costs.

External benefits occur when third parties benefit from the actions of others. If someone receives a flu shot, s/he will not spread the flu to anyone else, which benefits other individuals. When making decisions concerning goods that involve external benefits, people tend to ignore the external benefits that others receive. Therefore, there is a tendency for goods that involve external benefits to be underproduced.