ECON 356 - Outline Fifteen



Ostrom on YouTube. (beautiful)

There are so called “Market Failures” from the standard welfare economics view (from Mitchell and Simmons Reading - handout in class).

But - really - what is market failure? “ . . . the failure of real world markets to achieve the standards of the imaginary market.” (from William Mithchell and Randy Simmons, Beyond Politics:  Markets, Welfare, and the Failure of Bureaucracy, 1994)

Is it misunderstood? 

Can (or should) we really put the market up next to an imaginary construct of perfection?

 Probably the two most famous so called "market failures" are externalities and public goods.  Since they are seen as market failures, they are also used to attempt to justify the existence of government.  Let's look at these two phenomenon as they relate to markets (and beyond).

Start with Externalities (spillovers):  One or more person’s actions create costs for a second person without the second person’s permission, and sometimes without his/her knowledge.



Argument:  People get a free ride at others expense.  Either the person causing the externality is free riding (negative) or the person gaining a positive externality is free riding off the person who created it.

Obvious response:  internalize the costs/benefits  (more on this later)

What is an externality as it relates to markets?  An externality is an economic cost or benefit that is the by-product of economic activity but that is allocated outside of the market system. 

Example:  A candy maker's factory is located right next to a doctor's office.  The candy maker uses a machine that creates noise and vibration that penetrates the doctor's office - as a by-product of the production of candy.  Because no market existed to allocate the cost, the allocation is external to the market system, so the candy maker is producing an externality.  (

All other costs of making the candy (buying the sugar, paying wages to labor, etc.) are allocated through markets and therefore these costs are born by the candy maker himself.

So, for example, if the doctor sold the right to the candy factory to create noise and vibration in the doctor's office - the cost would be allocated through a market.

More common and broader definition:  Externalities are costs or benefits that are felt by third parties as a by-product of productive (and consumption) activities.   

There are many categories of externalities:

            Production Externality


            Consumption Externality: 


            Network Externalities (basically the same as network economies): 

If you decided to get a telephone, this provides a positive externality for those who want to call you from their telephone.


Externalities and the Efficiencies of Markets - The Mainstream Theory

Private Costs + External Costs = Social Costs

Private Benefits + External Benefits = Social Benefits

Efficient Output of a Good:  When Social Costs = Social Benefits

If a good does not produce any externalities, then the private costs and benefits = the social costs and benefits.

So the theory states --


Cost (or Negative) Externality:  the market quantity of a good is greater than the "efficient" quantity.




Benefit (or Positive) Externality:  the market quantity of a good is less than the "efficient" quantity.

Graph:  Cost or Negative Externality in Production



 Graph:  Benefit or Positive Externality in Production




Graph:  Cost or Negative Externality in Consumption





Graph:  Benefit or Positive Externality in Consumption





We will discuss the "solutions" later.



Marginal and Inframarginal Externalities:

            Inframarginal externality – basically is irrelevant at the margin -- only private costs and benefits are relevant at the point where the good is supplied.

            Changes in market quantity do not effect efficiency (mainstream efficiency of MB = MC – so no inefficiency is caused by inframarginal externalities

Positive Inframarginal Externality:

Example:  Education – supposed to create positive or benefit externalities because literate people are better to be around (communication, etc.). 

This is one argument for state-subsidized education.  But if education creates inframarginal externalities, subsidizing it only benefits the individuals getting the education, not society at large.

Suppose that after 10 years of education everyone is sufficiently literate that getting more education would not increase anyone’s ability to communicate, etc. and therefore would not cause any more positive externalities.  However, there are private benefits to two more years of education.  So the market provides the quantity where the MWTP = MSC of education.  The market goes beyond what would be produced due to externality anyway.

Assume MC of education is constant.


Graph of a Positive Inframarginal Externality




The quantity of education chosen by the individual is efficient.  We have gained all of the external benefits that we will get – more production will not bring forth any more.

Question:  could it be argued that some education creates negative externalities? ? ? ?


Another potential example - Healthcare.

In a relatively wealthy (in terms of monetary income) society, do you think that health care also is a case of inframarginal positive externality? 

What is the argument that healthcare (some forms only) create positive externalities?



Pecuniary Externalities

Pecuniary externalities only exist if we use the more broader definition of an externality because they take place within the market system (and therefore are seen as irrelevant to economists).


pecuniary externality: occurs when an individual’s decision affects others through a change in market prices.

You buy a tube of toothpaste and this shifts the market demand slightly to the right, increasing the price.  Everyone pays more for toothpaste.

Sounds like an externality.  But there is an offsetting externality in this case.  So although the individual’s consumption of the toothpaste increases the price slightly, this does not cause a net loss to the economy (assuming of course that the two externalities cross each other out, so to speak).

Consumers pay more, but toothpaste producers receive a higher price and earn a higher profit (higher producer’s surplus).  In other words, the decision to consume more toothpaste just transfers consumer’s surplus into producer’s surplus.  This affects the distribution of income in the economy but does not make it more or less efficient (using the standard definition).

Of course -- this is what people are complaining about right now -- that higher oil prices are increasing profits of oil firms, harming consumers.....


Question:  why are the benefits to the producers discounted, while the costs to consumers considered large and "unfair" by some?

Graph - Pecuniary Externality





Externalities and Property Rights

Property right:  legal rule of entitlement that grants the owner of a property the right to enjoy the benefits it provides, to command payment if the property is used for the benefit of others, to prevent trespass, and to sue for compensation in the even that he or she loses the benefits from the property (or the property is damaged by someone else).

Property rights allow the owner to appropriate the benefits of finding the more highly valued use.  When property rights are missing or ambiguous, the market is not likely to perform this function.

The absence of property rights is a main reason externalities exist.  If property rights can be established, costs and benefits can be internalized and no externalities exist.  This then becomes a legal or technical problem. 

Legal - the government doesn't allow the property right.

Technical - it is difficult or even impossible to establish a property right (in a "piece" of air that is blowing around, for example).

For Example:  The Tragedy of the Commons:

            A common property resource is rival but not excludable.  So each individual has an incentive to use as much of the resource as possible (otherwise someone else will use it).  And they can’t establish a property right in its use until they use it.  Basically it’s the prisoner’s dilemma again – all would benefit from conservation, but nobody has the incentive to conserve.

Examples:  fishing, hunting, grazing cattle.  Property rights in game animals, for example, are not established until the animal is dead - except on private game preserves.

The outcome:  the destruction of the resource. 

Basically this is a cost or negative externality.  Since the good is rival, me using it increases your cost of using it, or even excludes you from using it if I consume it to the end.  The more I fish, the higher the cost is for you to catch a fish.


The solution:  Property rights.  I can't use it unless it is my property or I pay the property owner.  Then the costs and benefits are all born by the users of the property.

The Reciprocal Nature of Externalities

Example:  Smoker vs. Nonsmoker:

How should the air in a room be used?  The smoker wants to smoke and the nonsmoker doesn’t want any smoke in the room. 


We typically see this only as a negative externality caused by the smoker, but what about the externality caused by the nonsmoker on the smoker if the smoker is not allowed to smoke? 

So who should win?

Let's do an exercise - Assumptions

There are two people in a room, one is a smoker and one is a nonsmoker.

The smoker wants to smoke and has a willingness to pay of $5 to light up.

The nonsmoker wants the room smoke free and has a willingness to pay of $10 to keep it that way.

We assume that both people are fully informed about the dangers of tobacco smoke to their health and take these costs into account in their willingness to pay. 

No one else is in the room.

1.      Is it efficient for the scarce resource – the air in the room – to be used for smoking or kept smoke free?

The room should be kept smoke free. Because the nonsmoker’s willingness to pay for clean air is more than the smoker’s willingness to pay to light up.  Keeping the air smoke-free is the highest valued use for the air.

2.      Would this change if one person is assigned property rights to the air?

Coase Theorem:  If transactions costs are low enough, the assignment of transferable property rights to a resource will create an efficient outcome.

Doesn’t matter who gets the property rights.

Remember, the smoker is willing to pay $5.00

The nonsmoker $10.

Obviously if the nonsmoker is given the property rights, the room will remain smoke free.

But what if the smoker is given the property rights – the nonsmoker will pay the smoker $6.00 not to smoke and it will remain smoke free.

But does the Coase Theorem always work?

3.      What about transactions costs?  If the smokers in a no-smoking restaurant have a higher willingness to pay to smoke than the non-smokers have for clean air, why don’t they offer a payment?

a.      To the extent that the no-smoking policy gives property rights to the nonsmokers, they are probably not transferable - i.e., there's a No Smoking law.

b.     Tradition and custom dictate that there are certain things we don’t bargain over.

c.      High bargaining and transactions costs.  Especially if there are a lot of people in the restaurant.  How do the smoker’s decide how much to pay and how to divide the payment up?  Even they do get together one of the nonsmokers might veto and demand a larger share of the payment.


Private Solutions for Controlling Externalities 

Let's face it, basically externalities boil down to conflicts of values between individuals (at least with respect to negative externalities).  I want the lake to swim in and you want the lake to pollute in.  I want a smoke free room and you want to smoke.  In many cases (I would say most), especially when property rights are clearly defined, the least cost way of dealing with externalities is to let the individuals work it out on their own.

1.      Coase Theorem:  if property rights are clearly defined, then the problem takes care of itself.


2.      Persuasion


3.      Integration or merge:  Bee Keeper and the apple orchard example, train and field example.


4.      Voluntary agreements or contracts:  Bee Keeper and apple grower make a contract, train and field example.


5.      Charities (for positive externalities):  voluntary subsidies to places that provide positive externalities for example.


Government Policies for Controlling Externalities

Policies to control externalities can be grouped into two types:

            Correction:  adjusts activities with externalities by creating a corrective penalty or reward.

For a cost externality the corrective policy might subject them to a penalty unless they reduce it.  Could be a fine or punishment for exceeding limits, or a tax on the activity.

For a benefit externality the corrective policy might be a subsidy – or a penalty for not producing enough.

            Internalization:  adjusts activities with externalities by changing the institutional arrangements that led to the externalities in the first place.

This is more the government getting out of the way instead of getting in the way.  Two examples:

1.  Allow Mergers:  Let’s say you have a group of firms that hire similar employees.  If one firm trains its employees, they could work for any firm.  So firms try to free ride off the training of other firms (firms that train the employees create a positive externality for other firms). 

The answer:  merge.  But firms don’t need the government to tell them about the efficiencies of mergers.  And if the firms don't merge, this would tell us the free riding isn't that big of deal.

So what the government can do is remove obstacles for mergers.  Does this say that antitrust laws possibly cause externalities to persist?


2.  Enforce Property Rights:  Another internalization policy is for the government to enforce property rights – make a common good a private good (sell off some of its common property).


Command and Control Policies

Most government policies toward externalities are command and control policies; consisting of regulations that command polluters to do certain things, such as purchase pollution-control equipment, and to control their polluting activities. 

For example:  the amounts and types of waste products (effluents) that a firm can discharge into the environment are controlled and must be less than specified limits.  Some things, such as hazardous waste cannot be dumped at all.

1.  Quantity Standards are often set.

Problem:  What is the "right" quantity?


2.  Technology Standards specify the equipment and processes that firms and individuals must use. 

The Clean Air Act sets quantity standards on different types of air pollutants the firms can emit and also on emissions standards for individuals.


    How does the government know which equipment and processes are best?  Forcing one will stifle innovation of better equipment and process.  Also,

    setting standards is one thing; enforcing them is another!  Very costly.


3.  Variable and Tradable Permits


With command and control policies, the limit is fixed regardless of the cost the firm must incur to comply with the standard.  So the standards are in conflict with the interest of the firm.  All firms, regardless of their costs of abatement, face the same limits.

This makes the cost of the pollution abatement higher than it needs to be.

The Clean Air Act of 1990 introduced what is now called emissions trading –which created a market in transferable discharge permits for sulfur dioxide.

The government issues transferable discharge permits equal to the total level of emissions that it wishes to allow and then lets firms buy the permits they need in order to emit.  The firms with higher cost of abating pollution will bed the most for the permits, whereas the firms with lower abatement costs will choose to sell their permits and reduce their emissions instead.

Why efficiency enhancing:  If one firm has higher abatement costs than another, they will purchase the permits and the firms with lower abatement costs will do more abatement.

But same old problem:  how does the government determine the initial allocation of permits?

According to the Coase Theorem, it doesn’t matter.  Trading will lead to the efficient allocation.

But is that true?

Another advantage:  the policy rewards plants who invest in abatement equipment or find other ways of reducing their emissions below the existing standard.

Problem:  How many permits should be issued?

4.      Effluent Charges and Corrective Taxes: an effluent charge or fee is a dollar price charged to plants per unit of effluent (smoke or dirty water) they discharge into the air or watershed. 

GRAPH:  The Effect of an Effluent Fee




AT the efficient quantity of effluent, the marginal external cost (MEC) is equal to MWTP to dump by the firms.  Firms would dump Qm.  With the charge, firms dump Qc, and the most efficient would be Q*.

Closely related to effluent charges or fees are corrective taxes or subsidies – these are imposed on a good or service subject to a production or consumption cost externality, and a corrective subsidy is imposed on a good subject to a production or consumption benefit externality.

Example of a cost externality in consumption:  gasoline, which causes air pollution when used by automobiles, or alcohol and driving.

GRAPH:  A Corrective Excise Tax on Gasoline




Problem:  how much should the taxes or subsidies be?

5. Assigning Property Rights:  To get rid of the tragedy of the commons.  So to prevent over-fishing, assign property rights to so many fish, and that’s it, for example.


Problem:  How should the individual rights be assigned?  Given to the fishermen in the industry now?  Sold to the highest bidder?

Does it matter?  According to the Coase theorem, it doesn’t matter for an efficient outcome.