Sometimes the market fails to arrive at the “correct” price and quantity Something is interfering with the guiding function of prices. The most common form of market failure is externalities.

1. Market Failure
Prof. S.K Tannan,Faculty, School of Law,
Raffles University, Neemrana, Rajasthan,
India. E-mail:
sureshkumartannan@gmail.com,
sktannan@rediffmail.com
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2. Market failure
– Sometimes the market fails to arrive at the
“correct” price and quantity
– Something is interfering with the guiding function of
prices.
– The most common form of market failure is
externalities.
– Today we are going to explore how externalities
stop market achieving an allocatively efficient
equilibrium
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3. Externalities
– An externality is a cost or benefit that arises from
production and falls on someone other than the
producer, or a cost or benefit that arises from
consumption and falls on someone other than the
consumer.
– A negative externality imposes an external cost
and a positive externality creates an external
benefit.
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4. Externalities
• The four possible types of externality
are:
– Negative production externalities
– Positive production externalities
– Negative consumption externalities
– Positive consumption externalities
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5. Externalities
• Negative Production Externalities
– Negative production externalities are common.
– Examples are noise from aircraft, logging and
clearing of forests, and pollution
– There is an incentive for firms to produce negative
externalities, correcting externalities adds to costs
and reduces profits.
– Pollution lowers costs and increases profits.
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6. Externalities
• Positive Production Externalities
– Positive production externalities are less common
than negative externalities.
– Example: a beekeeper locates beehives in an
orange-growing area, the bees primary purpose is
to collect nectar to make honey, but they also
assist in pollination so increase the productivity of
orchards and vineyards.
– This increase production and profits for the
farmers.
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7. Externalities
• Negative Consumption Externalities
– Negative consumption externalities are a common
part of everyday life.
– Smoking in a confined space poses a health risk to
others; noisy parties or loud car stereos disturb
others.
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8. Externalities
• Positive Consumption Externalities
– Positive consumption externalities are also common.
– When you get a flu vaccination, everyone you come
into contact with benefits.
– When the owner of an historic building restores it
the value of nearby houses increase, so house prices
and rents rise.
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9. Correcting Negative
Externalities:
• Two major approaches
• Command and control policies
• Market intervention
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10. Correcting Negative
Externalities
• Command and control policies
• These usually take the form of regulations
that
– forbid certain behaviours
– require certain behaviours.
• Examples:
– Regulations on pollution emission levels
• Internalise the externality, force the polluter
to either not pollute or not discharge
pollution. 10

11. Correcting Positive
Externalities: Knowledge
• Government Action in the Face of
External Benefits
– There are three main methods that the government
uses to cope with external benefits:
 Public provision
 Private subsidies
 Vouchers
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12. Positive Externalities:
Knowledge
• Private Subsidies
– A subsidy is a payment by the government to
private producers. The government can induce
private decision makers to consider external
benefits by making the subsidy depend on the
level of output
– If the government pays the producer an amount
equal to the marginal external benefit for each unit
produced, the quantity produced increases to that
at which marginal cost equals marginal social
benefit—an efficient outcome. 12