Essay for the Course: Public Economics. Essay: How Does the Presence of Externalities Explain Government Intervention in Health Care Production and Financing?. It is showed 12 out of 27 pages. Más Información en: https://www.linkedin.com/profile/preview?vpa=pub&locale=es_ES http://www.blogmisproyetosuniversitarios-carlos.blogspot.com.es/

2. The following pages of this essay have the objective of understanding how the presence
of externalities can explain government intervention in health care production and
financing.
According with the First Fundamental Theorem of Welfare Economics “…an unfettered
competitive market system in which both consumers and producers are intent on
maximizing their individual net benefits will lead to the maximization of society´s net
benefit”.
It is this claim that provides the major theoretical basis for the preference for the market
over other methods of economic organisation. However, this prediction rests on certain
standard assumptions about the way the market operates. If this is not the case, market
failure will arise. This means that the market systems will not produce the equitable
level of output, for instance, if externalities appear, these produce market failure, in
such case, government intervention, through public policy, may be employed to
reallocate or redistribute resources in an effort to achieve the equitable level of output.
That government intervention happens for example, in the health care.

3. 1 Introduction
2 Positives Externalities in
Health Care
2.1 Explanation and Analysis Positives
Externalities in Health Care
2.2 Government Intervention
3 Negatives Externalities in
Health Care
3.1 Explanation and Analysis Negatives
Externalities in Health Care
3.2 Government Intervention
4 Bibliography

4. The healthcare sector may be characterised by the presence of externalities which
is one of the most readily identifiable indicators of market failure in this sector.
Due to these externalities the public sector remains the main agent responsible for
the finance and delivery of health services in the most development countries.
The externalities are defined as the uncompensated impact of one person’s action
on the well-being of a bystander, in other words, an externality occurs whenever
the actions of one party make another party worse or better off and the first party
neither bears the costs nor receives the benefits from doing so. The externalities
can be positive (or external benefits) or negative (or external costs) and can be in
the production and/or in the consumption. This definition of an externality
implicitly distinguishes between two broad categories: A production externality
occurs when the effect of the externality is on a profit relationship and a
consumption externality whenever a utility level is affected. Clearly, an
externality can be both a consumption and a production externality
simultaneously.
A good that produces a positive externality is similar to a public good, in that
some of its benefits are non-excludable and accrue to others than just the direct
consumer. However, such goods may be rivalrous and may be partially
excludable, so that some private provision occurs even if the level of production is
inadequate.
The externalities appear when private costs or benefits are out of line with social
costs or benefits. For a positive/negative externality, private benefits/costs are less
than social benefits/costs, meaning that output is below/above the socially optimal
level. The standard solution to an externality is to levy a Pigouvian tax in the case
of goods or services that produce negative externalities.
Free childhood vaccinations against infectious diseases and excise taxes on
cigarettes are the most obvious examples of government intervention in the health
sector due to the presence of externalities. A vaccinated population confers a
positive externality on society because people vaccinated against an infectious
disease for example, are not able to spread the infectious disease through the rest
of the country so that they prevent that other persons can be infected whereby in
general the healthcare of the country would better off (benefit to all in society,
including those who do not consume it) while second-hand cigarette smoke
confers a negative externality on society because smoking cigarettes harm not
only the health of the people who consume the cigarettes but the general
environment since the smoke spreads into the atmosphere and specially the people
who is close to the origin of the externality (cost to all in society, including those

5. who do not consume it ) ; in the absence of government intervention, vaccination
levels would be less than the socially optimal level due to higher social benefits
than private benefits, while cigarettes smoking levels would be greater than the
socially optimal level due to higher social cost than private costs. So that,
activities generating positive externalities are under-produced (too little
consumption or production) and those generating negative externalities are over-
produced (too much consumption or production). Of course, the efficacy of taxes
in changing behaviour to reflect the socially optimal level depends on the price
elasticity of demand for the good/service, the availability of substitutes, its budget
share, etc.
In the following pages we are going to use the following notation: we have
Marginal Social Benefit (MSB) is equal to the Marginal Private Benefit (MPB)
plus the Marginal External Benefit (MEB) where MEB>0 (positive externality in
consumption) and thereby MPB will not equal to MSB. Without Market Failure
the optimum would be: MPB=MSB thereby MEB=0. For negative externalities in
consumption MSB=MPB-MEB.
The decisions that consumers and producers make in the private market are based
on private marginal benefits and do not take into account the true MSB thereby
Pareto efficiency is unlikely to be achieved in the market.
On the other hand we have Marginal Social Cost (MSC) is equal to the Marginal
Private Cost (MPC) plus the Marginal External Cost (MEC) (negative externality
in production), where MEC>0 and thereby MPC will not equal to MSC. Without
Market Failure the optimum would be: MPC=MSC thereby MEC=0. For positive
externality in production MSC=MPC-MEC.
The decisions that consumers and producers make in the private market are based
on marginal private costs and do not take into account the true MSC thereby
Pareto efficiency is unlikely to be achieved in the market.

6. Social benefit: benefit to all in society, including those who do not be affected in
his production. Equals private benefit of production plus benefit to others.
Causes market failure (too little production).
The positive externality in production leads to a social marginal cost that is below
the private marginal cost and a social optimum quantity (Q2) that it is greater than
the competitive market equilibrium quantity (Q1).
There is under-production with an associated deadweight loss of area ABC
because the private market produces less than the socially accepted or social
optimum. Under-production in Q2-Q1. I.e. MSC<MSB. So that, in the private
market, when the production is Q1 units and the price is P1, the private market
doesn’t reach a Pareto efficient level of output, in this case we are in a Pareto
inefficient level of output. The private market does not take into account the true
MSC. The private market is producing less than optimum social.
One example of one externality positive in production which affects another
producer analytically is the next:
x
f
f
RMT y
x
x
y
y
yx
∂
∂
−
∂
∂
∂
∂
=
Φ
Φ
Φ
=+
=
=
0yx
yy
xx
fff
)x,f(y
)f(x
Φ
Φ

7. Where x= quantity produced by the company X and y= quantity produced by the
company Y. Note that the quantity produced by the company Y depends on the
quantity produced by the company X. You can see that in the production function
of the company Y.
But the private market operates as if
Therefore for the Private market:
As the externality in production is positive:
So, to reach additional units of the good or service produced by the company X:
“x”, the individuals are willing to give up more units of the quantity produced by
the company Y: “y” than are imposed on conditions production.
Efficiency is achieved by producing more of the good or service that generates the
positive externality, so in our case producing more units of x.
Private markets make the production of the good or service that causes the
externality positive is too little.
One example of a positive externality in production which affects at one consumer
is the next:
Where U is the utility of the consumer which depends on the quantity produced by
the company X: “x”.
The private market operates as if:
0
x
y
=
∂
∂Φ
I1,2,...,iRMS
f
f
RMT i
yx
x
x
y
y
.comp
yx ==
∂
∂
∂
∂
=
Φ
Φ
>
∂
∂
0
x
yΦ
x
f
f
RMT y
x
x
y
y
real
yx
∂
∂
−
∂
∂
∂
∂
=
Φ
Φ
Φ
.comp
yxRMT< I1,2,...,iRMSi
yx ==
>=
=
0')x(z
)z,y,x(UU
ϕϕ yy
xreal
yx
UMg
'
z
U
UMg
UMg
RMS
ϕ
∂
∂
+=
0
z
U
=
∂
∂
yx
.
RMT==
y
xcomp
yx
UMg
UMg
RMS

8. As the externality in production is positive:
So, to reach additional units of the good or service produced by the company X:
“x”, the individuals are willing to give up more units of the quantity produced by
the company Y: “y” than are imposed on conditions production.
Efficiency is achieved by producing more of the good or service that generates the
positive externality, so in our case producing more units of x.
Private markets make the production of the good or service that causes the
externality positive is too little.
2.) Analysis Positive Externality in Consumption.
Positive externality: where social benefit of consumption of good or service
exceeds private benefit.
Private benefit: Benefit to consumers who buy and consume the good or service.
Social benefit: benefit to all in society, including those who do not consume it.
Equals private benefit of consumption plus benefit to others.
Causes market failure (too little consumption).
P
Q
D = MPB
S = MPC = MSC
>
∂
∂
0
z
U
yy
xreal
yx
UMg
'
z
U
UMg
UMg
RMS
ϕ
∂
∂
+= .comp
yxRMS> yxRMT=

9. Social cost: cost to all in society, including those who do not be affected in his
production. Equals private cost of production plus cost to others.
Causes market failure (too much production).
A negative production externality leads to a marginal social cost that is above the
marginal private cost.
0
1
2
3
4
5
0 10 20 30 Q
P
€
Demand curve shows
private value or MSB or
MPB, the value to buyers
(the prices they are willing
to pay).
Market Supply curve
shows MPC, the costs
directly incurred by
producers.
The Private market
eq’m maximizes
consumer
+ producer surplus.
€2.50
25 P= Price good or service
Q= Quantity produced
good or service
0
1
2
3
4
5
0 10 20 30 Q
P
€
Supply (private cost)
MPC
= value of the
negative impact
on bystanders
= €1 per quantity unit
(value of harm
from negative
impact)
MSC
= MPC + MEC
external
cost

10. There is over-production, because the private market produces more (25) than the
socially accepted or social optimum (20). Over-production in 25-20=5. I.e.
MSC>MSB. So that, in the private market, when the production is 25 units and
the price is €2.5, the private market doesn’t reach a Pareto efficient level of
output, in this case we are in a Pareto inefficient level of output. The private
market does not take into account the true MSC. The private market is producing
more than optimum social.
One example of one negative externality in production which affects another
producer analytically is the next:
0
1
2
3
4
5
0 10 20 30 Q
P
€
DM
SM
MSC
Private Market
eq’m
(Q = 25)
is greater than
social optimum
(Q = 20).
25
This yellow
triangle is the
deadweight or
welfare loss.
=+
=
=
0yx
yy
xx
fff
)x,f(y
)f(x
Φ
Φ
x
f
f
RMT y
x
x
y
y
yx
∂
∂
−
∂
∂
∂
∂
=
Φ
Φ
Φ

11. Where x= quantity produced by the company X and y= quantity produced by the
company Y. Note that the quantity produced by the company Y depends on the
quantity produced by the company X. You can see that in the production function
of the company Y.
But the private market operates as if
Therefore for the Private market:
As the externality in production is negative:
So, to reach additional units of the good or service produced by the company X:
“x”, the individuals are willing to give up less units of the quantity produced by
the company Y: “y” than are imposed on conditions production.
Efficiency is achieved by producing less of the good or service that generates the
negative externality, so in our case producing less units of x.
Private markets make the production of the good or service that causes the
negative externality is too much.
One example of a negative externality in production which affects at one
consumer is the next:
Where U is the utility of the consumer which depends on the quantity produced by
the company X: “x”.
The private market operates as if:
As the externality in production is negative:
0
x
y
=
∂
∂Φ
I1,2,...,iRMS
f
f
RMT i
yx
x
x
y
y
.comp
yx ==
∂
∂
∂
∂
=
Φ
Φ
<
∂
∂
0
x
yΦ
x
f
f
RMT y
x
x
y
y
real
yx
∂
∂
−
∂
∂
∂
∂
=
Φ
Φ
Φ
.comp
yxRMT> I1,2,...,iRMSi
yx ==
>=
=
0')x(z
)z,y,x(UU
ϕϕ yy
xreal
yx
UMg
'
z
U
UMg
UMg
RMS
ϕ
∂
∂
+=
0
z
U
=
∂
∂
yx
.
RMT==
y
xcomp
yx
UMg
UMg
RMS
<
∂
∂
0
z
U

12. A tax of t* per unit (equal to the marginal damage in the health care) increases the
firm´s marginal private cost curve from OM to O*M, which coincides with the
MSC curve in the efficient level. The quantity produced falls from QM to Q*, the
socially optimal level of production. Just as the Coasian payment, this tax
internalizes the negative externality and removes the inefficiency of the negative
externality.
Some problems could happen when we are trying to value the function of the
external cost (could vary according with the context). We can as well find
troubles at the moment knowing the consumption or production each agent (used
to calculate his tax payment). There are incentives to hide the information (to
avoid payment tax). Levy tax could affect to the efficiency. The distributive
effects, who holds finally the tax, influence on achieved equilibrium.
2.) Subsidy.
Subsidy means that the government pays to an individual or firm that lowers the
cost of consumption or production, respectively. The public sector pays per each
unit in which consumption or production of the good or service causing the
negative externality is reduced once exceeds its efficient level a subsidy whose
amount corresponds to the value of the marginal external cost in efficiency.
This means that resources are redistribute from society to those causing the
negative externality.
A subsidy of s* per unit (equal to the marginal damage in the health care)
increases the firm´s marginal private cost curve from OM to O*M, which coincides
with the MSC curve in the efficient level. The quantity produced falls from QM to
Q*, the socially optimal level of production.