Correcting Market Failures: Externalities and Social Optimum

Addressing Externalities to Achieve Social Optimum

Negative Production Externality: Adjusting Equilibrium

The social cost of production exceeds the private cost reflected in the supply curve. The socially optimal quantity is where the value to consumers (demand curve) equals the social cost curve. A tax imposed on producers, reflecting the social cost, shifts the supply curve to coincide with the social-cost curve, thus achieving the social optimum.

Positive Production Externality: Adjusting Equilibrium

The social cost of production is less than the private cost reflected in the supply curve. The ideal outcome is to produce more than the private market dictates. Governments can internalize this by issuing subsidies, which shift the supply curve downward by the subsidy amount, increasing the equilibrium quantity. To match the social optimum, the subsidy must equal the value of the externality.

Negative Consumption Externality

Example: Driving under the influence of alcohol. In this case, the social value is less than the private value, meaning the socially optimal quantity is smaller than the quantity determined by the private market.

Positive Consumption Externality

Example: Education, where knowledge spillovers create added value. Here, the social value is greater than the private value, and the socially optimal quantity is greater than the quantity determined by the private market.

Three Core Problems of Externalities

• Number of Parties Involved: The larger the number of interested parties in an agreement, the more costly reaching consensus becomes.
• Asymmetric Information/Assumption of Rational Behaviour: Occurs when one party in a transaction possesses more or superior information than the other, or when individuals make choices maximizing individual benefit rather than overall social benefit.
• Existence of Free Riders: A party benefits from a collective effort without contributing significantly or at all to that effort.

Pigovian Taxes and Tradeable Pollution Permits

Pigovian Taxes are enacted specifically to correct the effects of negative externalities.

Tradable Permits are instruments aimed at reducing pollution. The government sets a maximum permissible emission rate, and permits allowing for that maximum emission are issued to industry players.

Both Pigovian taxes and pollution permits share the common goal of internalizing the externality of pollution by imposing a cost on firms for polluting.