Question

Consider the case of a power plant that, in the process of generating electricity, it also emits noxious pollutants. It has been argued that this situation represents a market failure.

a. Briefly explain, using a graph, what are the economic foundations of this argument?

b. Using the graph in (a) show what are the economic implications of this case

c. What economic mechanism would you suggest to correct for this market failure?

d. In general, why market forces, do not provide an efficient solution in such cases?

Answer 1

a)

Here, the power plant generates electricity but in order to do so it also emits noxious pollutants. Thus, it creates a negative externality where the social costs are higher than the private costs.The marginal benefit for such externality is same for the private and social levels. The following diagram depicts the situation,

Here, SMB : Social Marginal Benefit

PMB : Private Marginal Benefit

SMC: Social Marginal Cost

PMC : Private Marginal Cost

The economically optimum output will be at that point where the demand equals to the Private social cost.

b)

Since, a negative externality is observed here. So, the demand is equal to Social Marginal Benefit and Private Marginal Benefit i.e SMB=PMB

Here, the Social Marginal Cost is greater than the Private Marginal Cost i.e SMC>PMC. Since the production of electricity bears a social cost with pollution which is not beared by the Private Electricity producing companies.

The Private companies will produce to that point where D=PMC. At this point, the output is not socially optimum.

The social optimum output is upto that point where D=SMC. And in this case . So, there involves a deadweight loss.This creates a market failure.

c)

To correct such market failure I would suggest to implement some neccessary regulations in the factories to control pollution such as installation of pollution control filters . This will increase the private cost of the firm upto that point where PMC = SMC . Thus, SMC and PMC curve will ultimately coincide with each other. And the output obtained by such interaction of Demand and Marginal cost(SMC=PMC) will be economically and socially optimum.

d)

In general, the market mechanism fails under the presence of externality. In the presence of externality, there is either underutilisation of resources or overutilisation of resources. In this case, there is overutilisation of resources. In the presence of externality, the economically optimum output is never equal to social optimum output and the output is never efficient. There is always a deadweight loss associated with such mechanism. Hence, market always fails under such mechanism.