External Costs And Benefits Of Production Economics Essay

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In the recent year's governments all over the world lean towards putting more reliance upon the markets, however they still tend to fail quite often. (John Sloman 2007) Some of the issues occur due to the problems within the markets and some are caused by the government intervention (Non-Market Failure). The purpose of this research paper is to analyze the key issues that cause market failure.

Market Failure

In order to start analysing the issue, it is essential to examine what is market failure. The key responsibility of the market is to allocate the recourses in the way that satisfies greatest possible level of consumer needs. The market failure theory implies that this is not the case and free markets might fail to deliver the best allocation of recourses. (Stephen Munday 2000) There are numerous theories about different factors that might influence the market failure; however in order not to make this research too long and over-complicated it is better to focus only on the major factors. Stephen Munday suggests four major issues that cause market to fail:

Externalities in the market

Public goods

The breakdown of free market

Asymmetric information


The first issue is going to be discussed is so called externalities. This theory implies that the market will not reach the social efficiency as long as the actions of producers and consumers affect people other than themselves. (John Sloman 2007) There are different theories concerning externalities. We can divide them into:

External Costs and Benefits of Production

External Costs and Benefits of Consumption

2.1.1 External Costs and benefits of Production

In order to analyze different types of externalities it is best to use examples. Gregory Mankiw suggests the example of aluminium factory (figure a) opposed to the company that plants new woodlands (figure b). Suppose that for each unit of aluminium produced, a certain amount of smoke enters the atmosphere. These fumes cause the health hazard to everybody who is breathing this air, therefore the external cost arises. As the result the cost to society of aluminium production becomes larger than private costs of the factory. (Gregory Mankiw) This implies that the factory would have to produce the optimum to the society level of aluminium (the point where Demand curve crosses Social Cost curve). It is obvious that Qmarket (Equilibrium) is larger than Qoptimum, this causes inefficiency. At the point Qmarket demand curve lies below the social-cost curve, therefore reducing the price would increase the total economic well-being. The best way to deal with this issue, is for the government to impose the tax on the factory, that would shift the equilibrium to the optimum point. (Gregory Mankiw)

In the case with the woodlands, the company is producing something that is beneficial to both: company and the world (John Sloman 2007), this causes the situation where social-cost curve is below private cost curve. When this situation arises, the equilibrium quantity (Q1) is smaller that optimum quantity (Q2), therefore the market failure occurs and government intervention is needed. This type of externality is best dealt with by imposing the subsidies to the firm and therefore increasing the production until the optimum point. (Gregory Mankiw)


Price of Aluminium

Social Cost (Privat Cost + External Cost)

Supply (private cost)




Qoptimum Qmarket Quantity of Aluminium

Source: John Sloman « Essentials of Economics" 2007


P Supply

Social Cost




Q1 Q2 Q

Source: John Sloman « Essentials of Economics" 2007

2.1.2 External Costs and Benefits of Consumption

After analysing the externalities for production, it is important to mention that same external costs arise for the consumers as well. These are pretty much the same. John Sloman in his book "Essentials of Economics" suggests the example of a consumer using a car (graph c) and one using train service (graph d). As we can see similarly to the externalities in production sector, the benefit of other people shifts the optimum consumption away from the equilibrium, therefore forcing the market failure. (John Sloman 2007)






Q2 (social optimum) Q1 Q

Source: John Sloman « Essentials of Economics" 2007






Q1 Q2 (social optimum) Q

Source: John Sloman « Essentials of Economics" 2007

Public Goods

After analysing one of the most important issues that cause market failure, it is essential to look at the other factors. One of them is the existence of public goods in the market. These are the goods that are characterized by non-rivalry in consumption; they can also be executable (can be denied if not paid) and non-executable (cannot be denied if not paid). (Roger Arnold 2008) The problem arises with the use of non-rivalry, non-executable goods. This issue is called free rider theory. It implies that in order to finance an efficient level of output for a public good, all the consumers must donate the amount that is equal to their willingness to pay. However because the good is non-executable, this means nobody can stop people from using it, even if they have not paid. The free rider problem makes it very difficult if not impossible for the government to provide public goods efficiently and therefore this issue causes market to fail. (David Besanko 2008)

Monopoly (The Break of Free Market)

Another issue arises when there is a dominating firm in the market (monopoly). Under the imperfect competition the market fails to produce an output where MSB=MSC, even with an absence of externalities. (Roger Arnold 2008) The reason behind it is that monopolists face downward-sloping demand curve and therefore marginal revenue is below average revenue. (John Sloman 2007) If you take a look at the figure 2.1, it becomes obvious that due to the fact that profits are maximised at the point where MC=MR, the profit-maximising output Q1 is smaller than social optimum Q2 (MSB=MSC). Therefore monopolistic companies would tend to produce less that social efficient level of output. (John Sloman 2007) This is not the only issue with monopolistic competition, however due to the limitation in length it is impossible to analyse the deadweight loss problem in detail. The only thing that has to be said is that deadweight loss occurs due to consumer or production surplus. These two terms are used to describe the difference between the profits that the firm would have earned under free-market economy and the ones under monopoly. (Walter Wessels 2006)










0 Q1 (Monopoly output) Q2 (Social optimum) Quantity

Source: John Sloman « Essentials of Economics" 2007

Asymmetric Information

The last problem to be discussed in this research is the asymmetric information. This issue implies that in most of competitive markets, goods are standardized and consumers, as well as producers, know exactly what they are getting and for how much. However in other markets two parties might be confused and the situation when one person knows more than the other might arise. (Walter Wessels 2006) For example person A is willing to pay £2000 for a good-quality used car, while person B is willing to sell his used high-quality car for £1000. Therefore the joint benefit of this trade is £1000. However the problem arises because the trade might not take place due to the fact that person A does not know that the car is high-quality. The outcome of this situation would be that person A walks away from a trade and leave both parties worse off. This kind of failure to make mutually advantageous trades is causing market failure. (Walter Wessels 2006) Walter Wessels singles out four elements of market failure caused by asymmetric information:

One person benefits from not revealing relevant information

The other party cannot find this information on his own

It results in two parties not making a trade and causing market to fail

Often third party appear that is trying to make the profit by getting two parties, which would not have traded due to difference in information, together.

Non-Market Failure

Finally, after analysing the issues associated with the market itself, it is essential to look on the other side of the problem. Sometimes markets fail due to intervention of the government. (Anderton 2000) There are various theories on why does government fail, for the purpose of the research only the main ones are going to be considered:

Inadequate information- this implies that government rarely gets accurate information on which they have to make a decision. This might cause government adopting wrong policy to solve the problem. (Anderton 2000)

Shortages and Surpluses- this arises when the government decides to put a fixed price on some kind of goods. If they choose the price different to the equilibrium this would cause shortages (below equilibrium) or surpluses (above equilibrium). (John Sloman 2007)

Market distortions- this issue implies that sometimes government intervention to correct market failure, causes far more serious market failures. For example if government of one country starts to support farmers and is giving them subsidies, this would cause supply to raise, however this does not mean that demand is going to do the same. As the result, government will try to sell the products to the other countries at cheap prices; this would result in lower farm income in the other countries. (Anderton 2000)

Bureaucracy- the main argument of this issue is that whenever government intervenes it always involves administrative costs. The bigger the intervention the more people and recourses is used. And this usage of the resources might be wasteful. (John Sloman 2007)

Problem with taxes and subsidies- it was already mentioned that government might use taxes or subsidies to solve the market failure caused by externalities. However it is impossible for it to choose the right amount of tax or subsidy, because different firms produce different level of externalities and therefore what would be perfect amount for one company might be lethal for another. (John Sloman 2007)

These are the main issues with government intervention; all of these factors might cause non-market failure. Therefore it is widely argued that government should not intervene and let the market to work on laissez-faire base. (John Sloman 2007) The main topic of an argument is that the problem the intervention causes is much bigger than the issues it overcomes.


Finally, after analysing market failure, we can state that the main reasons for market to fail might be associated with the market itself (market failure) or with the intervention of the government (non-market failure). The main issues within the market are: externalities, public goods, monopolistic competition and asymmetric information. The main arguments against the intervention of the government: inadequate information, shortages and surpluses, market distortions, bureaucracy and taxes and subsidies problem.