Question

1. List and explain the three ways in which there can be market failure.

2. Define externality and distinguish between positive and negative externality and their impact on production, using examples where possible.

3. How can a government correct for positive and negative externalities ?

Answer 1

1) The three major ways in which a market failure arises are due to:

• Public Goods: Public goods are the goods that have two main features of non-exclusivity i.e, no one can be excluded from use of a public good/ Second feature is Non-Rival i.e, the use of a public good by one person does not reduce its availability to the other. Due to the public nature of certain goods, there arises the problem of "Tragedy of the Commons' under which the excessive use of a public good leads to its deterioration as individual acts in their private-interest neglecting the overall social welfare.
• Externality: An externality is a situation under which an action by an individual or a party causes harm or benefit to the third party for which that individual or party is neither paid nor rewarded and the cost or benefit of that action is not reflected in the market price.
• Asymmetric Information: Asymmetric information arises when one party in a transaction has more information than the other party. Asymmetric information can take place both pre and post the transaction such that the party with more information can take unfair advantage in the transaction leading to inefficient outcomes.

2) Externality as defined is a kind of a cost imposed or benefit acquired to a party due to the activity of a third party for which the third party is not accountable. An externality can be both positive or negative. A negative externality arises when an action by a third party imposes extra cost to an individual leading to high costs of production and thus increased market price.and to market inefficiencies. For example: The industrial waste that is dumped into a river leading to heavy water pollution and damage to marine life and a loss to the nearby fishery in which case, the pollution by the factory is a negative externality for the fishery, which reduces the supply of fishes and thus price of fishes in the market rises. As a result the Social cost of pollution is more than the private cost of pollution to the factory. Thus in case of a negative externality, the marginal social cost is greater than the private marginal cost. Thus, a negative externality leads to overproduction of goods as the producer is not accounted for the cost of externality (pollution in this case)

A positive externality arises when a party receives a benefit for which it makes no payment, as a result of an economic activity of a third party. For example: Development of a new technology by a company that can later be accessed by other companies too in order to increase production at lower cost. In case of a positive externality, the social benefit is more than the private benefit and it leads to under-production of goods.

3) In order to deal with the market failure arising because of externalities, the government can deal in the following ways:

• The government can impose tax on the activities causing negative externality as a result the party causing such an action will take the required actions to reduce the externality. Such a tax is called a Pigouvian Tax.
• To deal with the positive externality, the government can provide subsidies as it will encourage the producers to produce more and the market inefficiency that arises due to underproduction can be dealt with.