Question

Question 6. Externalities, market failure and climate change

1. Explain briefly the economic view of market failure and apart from monopolies, what else can lead markets to fall?
2. Explain using a graph how a carbon tax would correct for the negative externality created by carbon emissions from coal fired power stations in the electricity market?
3. Flu vaccinations create positive externalities for society. How does the Government intervene in the flu vaccine market to ensure maximum benefits are received? Demonstrate using a graph.

Answer 1

A.

Perfectly competitive market ensures Pareto optimality or what is called economic efficiency. This implies that competitive market system helps to achieve the state of maximum social welfare such that any reallocation of resources cannot make some people better off without reducing the welfare of someone else.

However, under some circumstances the market system cannot lead to this optimum situation of Pareto efficiency ( i.e. the state of maximum social welfare ). These circumstances due to which market fails to achieve economic efficiency have been called market failures.

There are three main causes of market failure.

1. the existence of monopoly or imperfect competition;

2. the presence of externalities, i.e., external economies and diseconomies in production and consumption; and

3. the consumption of public goods.

B.

When there is CO2 emission by coal fired power plant it leads to creation of negative externalities. The government can impose per unit tax so that private marginal cost ( PMC ) curve inclusive of per unit tax shifts above to the level of social marginal cost ( SMC ) so that equilibrium of the firm is at optimum level of output.

C.

To promote social well-being and achieve Pareto optimum level of output the government provides subsidies to those activities which are believed to generate external benefits. That is, positive externalities. Thus Flu Vaccinations are subsidized by the government not only because it creates equal opportunities for all people of a country but also because it generates positive externalities.