Solving The Positive Externality Problem Economics Essay

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Market can be defined as a public gathering held for buying and selling merchandise or a place where goods are offered for sale. (Free dictionary (N.D) [Online]). Market can also be defined as a place where forces of demand and supply operate. Market plays an important role in most economies in the modern day. An economy can be defined as a system which attempts to solve their economic problem "Ande et all (2008)". Economic system can be defined as a set of tools that is used for allocating resources and also used to make decisions to satisfy human wants (Economies in transition (ND) [Online]"). "Market system is any systematic process enabling many market players to bid and ask. They help bidders and sellers interact and make deals. Because a market system relies on the assumption that players are unequally enabled, a market system is distinguished specifically from a voting system where candidates seek the support of voters on a less regular basis" (Norca.c (2009) [Online]).

Resource allocation can be defined as the assignment of different resources to specific tasks to solve or answer the fundamental economic questions, which are; what to produce, how to produce; and for whom to produce for. What to produce, in a market system forces of demand and supply determine what to produce. Here, it is mainly about the goods the producer can make maximum profit of. How to produce, "the problem is what combination or mix of productive resources or inputs should be used in order to produce a desired product. It is concerned with the method of production. In some cases, labour may play a major role. It is called labour intensive technology. In others, capital may play a major role. It is called capital intensive. A labour intensive method creates more jobs favouring more employment" (Jeevan.T (2012) [Online]). "For whom to produce, Production for masses or productions for profit are two major choices that every economy has to decide. Basic needs of common people cannot be ignored. Of course, the priority goes to wage goods production. In the quality is determined by the level of living standard, which is the outcome of the development level of the economy" (Jeevan.T (2012) [Online]). These are the three basic or main questions to be solved.

An economic system refers to the laws and institution in a state, which helps utilize and manage economic resources in producing and providing goods and services. It also shows how people buy and sell those resources. (The USA online (N.D) [Online]). As Lucks observes, "An economic system consists of the totality of a people's or a nation's, ways of handling the job of using its resources for the satisfaction of human wants." The US operates under a mixed economic system, where there is little or no interference in private trade by the government. The United States is an example of a free market economy; their economic system is called capitalism. Here, the basic questions which are: what; who, and how are by the market. But in reality there is no such thing as economic system because there would still be a form of intervention by the government in its activities. It is generally understood that every market economy began as either a command or traditional economy. In the modern world today, most societies are seen as mixed economies because they have all the features of all the three. Finally, market economy is governed by the laws of demand and supply, which means the market, will determine the price of goods and services produced.

There are six main characteristics of the market economy, which would be explained extensively below.

Private Ownership/Property- "Most of the private individuals own most of the private property (Land and capital). The factors of production are efficiently owned and managed by the private individuals. This allows the owners to make lawfully binding contracts to buy, sell, lease or rent their property. In other words, their property gives them the right to profit from ownership. However, there are exclusions to what is considered private property. For example, since 1865 the United States does not allow you to buy and sell other people, or even yourself. This includes your own body or body parts". (Source: University of Auburn, Market economy). Private property rights encourage; investments, innovations, exchange of assets, maintenance of properties, and economic growth.

Freedom of choice - Here, there is freedom of enterprise, producers and consumers have freedom to acquire and use resources efficiently, to produce and consume products of their choice. "Owners, businesses, consumers and workers are free to produce, sell and purchase goods and services in a free market. Their only constraint is the price they are willing to buy or sell for, and the amount of capital they have." (Kimberly. A (2012) [Online]). Every individual has freedom to start his own business and also to determine what to produce. Also consumers are free to choose.

Self-interest- This regarded as one of the most important characteristics, because producers want to maximise profit and also minimise losses. The entrepreneur initiates production with a good view of making profit. The market is motivated by sellers struggling to sell their goods to dealers or customers at an acceptable and profitable price. While consumers on the other hand want to pay the least or minimum price for the goods and services they need. Although the motive is selfish, it works to the benefit of the economy over the long run. For example, an increase in the price of petrol when there is fuel scarcity, consumers will complain about the price but, they will eventually pay because there is no alternative or substitute. When the scarcity is over producers will allocate their resources somewhere else.

Competition- Competition among buyers and sellers is a controlling factor. "The forces of competitive pressure keep prices moderate, and ensure that goods and services are provided most efficiently. That's because, as soon as demand increases for a particular item, prices rise thanks to the law of demand. As competitors see there is additional profit to be made, they start production, adding to supply. This lowers prices to a level where only the best competitors remain. This force of competitive pressure also applies to workers, who are competing with each other for the highest-paying jobs, and consumers, who are competing for the best product at the lowest price" (Kimberly. A (2012) [Online]). This also means that there are a large number of buyers and sellers in market systems who are motivated by self-interest.

Limited government- The government has a little role to play in the functioning of the economy. Here, decisions are made by individuals not the government so the powers of the government are limited. The "role of government is simply to ensure that the markets are open and working. For example, it is in charge of national defence so no other country can destroy the markets. It also makes sure that everyone does have equal access to the markets. For example, government exerts penalties on monopolies, which unfairly restrict competition. The government watches to make sure no one is unfairly manipulating those markets, and that all information is distributed equally." (Source: National Council on Economic Education).

System of market and prices- Here, the price is determined by the forces of demand and supply. A market economy depends on an efficient market to sell goods and services. In an efficient market, there is equal access by buyers and sellers and decisions are based upon equal information.

The market economy advantages, there is free interplay of demand and supply in a market economy, desired goods are produced. This is because consumers will want to pay higher prices for such goods because they are of need or value, these goods are inevitable. Good and services are produced in the most efficient way possible. The most efficient producers will receive more profit than less efficient ones.

Innovation is rewarded. Innovative producers come up with new things and also new methods. They would be more profitable because they would keep on introducing new products which will lead to the satisfaction of the needs of consumers. "The businesses and individuals who are most efficient and innovative will accumulate more capital. They can invest this in other efficient and innovative companies, giving them a leg up and leading to an overall higher quality of production." (Source: Harper College, Pure Capitalism and the Market System).

Market economy disadvantages, the market economy functions through competition. However, "there are many people in a society who are at a natural competitive disadvantage, such as the elderly, children, and mentally or physically challenged people. In addition, the caretakers of those people are also at a disadvantage, because their energies and skills are taken up with caretaking, not competing. Thus, a society based on a pure market economy must decide whether it's in its larger self-interest to set aside resources to make sure they get their needs met, or whether to let them just fall by the wayside. A market economy rewards those who are good at being competitive. Therefore, the society reflects the values of those people and organizations. This explains why a market economy may produce private jets for some while others starve and are homeless." (Source: Brown University, Louis Putter man, Markets vs. Controls).

"Market failure is a situation where resources cannot be efficiently allocated, due to the breakdown of price mechanism caused by factors such as establishment of monopolies" (Business dictionary (N.D) [Online]). "Market failures have negative effects on the economy because an optimal allocation of resources is not attained. In other words, the social costs of producing the good or service (all of the opportunity costs of the input resources used in its creation) are not minimized, and this results in a waste of some resources. Take, for example, the common argument against minimum wage laws. Minimum wage laws set wages above the going market-clearing wage in an attempt to raise market wages. Critics argue that this higher wage cost will cause employers to hire fewer minimum-wage employees than before the law was implemented. As a result, more minimum wage workers are left unemployed, creating a social cost and resulting in market failure." (Investopedia (N.D) [Online]). Government controls or stops market failure. Basically, market failure occurs when market does not bring about market efficiency, it arises when there is miss-allocation of resources.

The roles of government in a market economy

The government plays an important role in the market economy, the would be discussed extensively below;

1. "Providing the economy with a legal structure: This is one of the major roles of government in a market economy. This makes the government to provide property right and also provide enforcement of contracts. "In order to perform this function, the government should furnish the economy with regulations, legislations, and means that ensure product quality, define ownership rights and enforce contracts. Our legal system, the FDA, The FED and SEC are examples of how the government fulfils this task" (Hassan Y. (2008) [Online]).

2. Maintaining competition: Competition is one of the main reasons why producers respond to price signals. The government should make sure that there is competition, so as to reduce monopoly. "Thus, anti-monopoly laws (Sherman Act of 1890; Clayton Act of 1913) are designed to regulate business behaviour and promote competition. It is important to mention here that Microsoft was found guilty of violating these laws in 2000." (Hassan .Y (2008) [Online])

3. Redistribution of income: The government should attempt to provide assistance or liberations to the poor, less privileged and those who are dependent. Good and affordable health care can be provided for the sick and security and employment opportunities can be provided for the poor. These programs are constructed on relocating income from the high income earners to the low or limited income earners; this can be done by a type of taxation (Progressive). (Hassan. Y (2008) [Online])

4. Provision of public and quasi-public goods: This occurs when the producers cannot provide certain goods, which are known as public goods, the government fills in the void. The examples of public goods are police protection and defence. While the examples of quasi-public goods are education and health care, because producers cannot provide enough. In most cases the government provide the public goods then support in the provision of the quasi-public goods. (Hassan. Y (2008) [Online]).

5. Promoting growth and stability: "The government (assisted by the Fed) should promote macroeconomic growth and stability (increasing the GDP, fighting inflation and unemployment) through changes in its fiscal and monetary policies. The fiscal policies means the use of taxes and spending and it is managed by the executive branch represented mainly by the Treasury Department. The monetary policies signifies the use of interest rates, money supply, reserve requirements, etc. and it is managed by the Federal Reserve System." (Hassan. Y (N.D) [Online]).

Market failure could occur in a number of was because, some products maybe under produced that means resources are not efficiently allocated to their production. While some maybe over produced, that means that resources are over allocated to their production. There are different causes to market failure which would be examined the paragraphs below.

Externalities­- An externality is an economic side effect. It is an effect on a third party, which is non-participating individual who is receiving a benefit or cost involuntarily. Externalities occurs when private costs and private benefit is different from social costs or social benefits.

There are two main types of externalities which are;

Positive Externality

Negative Externality

Positive Externalities- These are positive useful or advantageous effects enjoyed by the third party. For example, provision of health care and education. Here, the social benefit is more than the private benefits. With positive externality less is produced.

"When a positive externality exists in an unregulated market, consumers pay a lower price and consume less quantity than the socially efficient outcome. This can be seen on the graph above. Consumers pay price P' and consume quantity Q', but at that quantity society would have them pay more. At P' Q' the marginal benefit to society is much higher than marginal cost, resulting in a deadweight welfare loss. The socially efficient outcome is to pay price P* and consume quantity Q*. At this price and quantity the marginal benefit to society is equal to the marginal cost. There are many Common examples of a positive externality. Immunization prevents an individual from getting a disease, but has the positive effect of the individual not being able to spread the disease to others. Keeping your yard well maintained helps your house's value and also helps the value of your neighbours' homes. Beekeepers can collect honey from their hives, but the bees will also pollinate surrounding fields and thus aid farmers" (B. Taylor (2006) [Online]).

Solving the Positive Externality Problem

"In order to get consumers to consume more of a good that has a positive externality, a subsidy can be given to them. The subsidy will increase the marginal benefit they receive when they consume the good. The subsidy can be paid for by all those who receive the external benefits" (B. Taylor (2006) [Online])

Negative externality- These are the bad effects suffered by the third party, for example pollution. Here, social cost is more than social benefits.

"This graph shows the effect of a negative externality. The red line represents society's supply curve/marginal cost curve while the black line represents the marginal cost curve that the firm or industry with the negative externality faces. The optimal production quantity is Q', but the negative externality results in production of Q*. The deadweight welfare loss is shown in grey." (Fundamental finance (N.D) [Online]).

2. Public goods- Public goods are goods that provide benefit to people; because of its nature it is non- excludable and also non- diminishable. The public cannot be prevented of consuming these products. They are unavoidable and they also do not have any form of rivalry. Producers or individuals do not pay for these goods or services because they can get them for free. These services are provided by the government, for example; street lights. Here, government would have to provide goods and services directly, because producers are not willing to provide them.

3. Merit goods- These are goods that are considered as beneficial for the people, but in most cases these goods are under produced. The consumers may under- value these products due to imperfect information or knowledge. "

As the diagram illustrates, the MSB lies above the MPB and the difference between the two consists of positive externality. The socially optimal level is where MSB=MSC that is Q*, however, due to under-allocation of resources the output/consumption is at q1." (Denshbakshi (N.D) [Online]). In this situation the government would subsidies such goods in order to encourage producers to supply or produce more of these products. This will enable consumers to consume or buy more of these products at an affordable price.

4. Demerit goods- These are goods that are considered as socially undesirable, they are harmful goods. For example; drugs cigarettes. These products are overvalued by the consumers, therefore they are over produced.

"In negative consumption externality, the MPB is not reflecting social benefit and thus MSB lies below MPB. The vertical difference between MPB and MSB is the negative externality. The optimal level of consumption is where MSB=MSC i.e. Q*. However the negative externality is being ignored and thus there is an over consumption of the goods at Q1." (Denshbakshi (N.D) [Online]). Here, the government should ban such goods and also tax them accordingly.

5. Asymmetric information- This occurs when one party has more accurate information than the other. Here, the seller may have more knowledge about the product or vice- versa. For example; a used car, the seller obviously has more information than the buyer. To solve this problem there would need to be regulation of quality and also provision of information.

6. Market power- Excess market power causes the producer to under produce and also charge higher prices. This is known as monopoly when one producer dominates or is the main supplier in the market. Here, there is no competition. This abuse of power would lead to misallocation of resources.

The traditional view of monopoly, stresses the costs to the society associated with higher prices, because of the lack of competition. Here, the producer or the monopolist charges a higher price because there is no substitute good. This is shown in the graph above at P1 than in a competitive market at P

"The area of economic welfare under perfect competition is E, F, and B. The loss of consumer surplus if the market is taken over by a monopoly is P P1 A B. The new area of producer surplus, at the higher price P1, is E, P1, A, C. Thus, the overall (net) loss of economic welfare is area A B C.

The area of deadweight loss for a monopolist can also be shown in a more simple form, comparing perfect competition with monopoly." (Economics online (N.D) [Online]).

7. Inequality of income - There is inequality of income in a free market economy; income is not evenly distributed, whereby they are a wide gap between the rich and the poor. To solve this problem the Government would have to redistribute income. This can be done through taxation (Progressive tax).

In conclusion, the government has an active role in the market, particularly in the area of setting prices. To solve the free rider problem the government could raise revenue through taxation to provide public goods; this also means that everyone has to cooperate in paying the taxes in order to benefit from the public goods. The market system cannot allocate resources efficiently without the intervention of the government.

Referencing and Bibliography

Business dictionary (N.D) [Online] Market failure, Available at;

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B. Taylor (2006) [Online] Positive externality, Available at;

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Dineshbakshi (N.D) [Online] Demerit and Merit goods, Available at; [accessed 24/10/2012]

Economics Online (N.D) [Online] Monopoly, Available at; [Accessed 24/10/2012]

Fundamental finance (N.D) [Online] Negative externalities, Available at; [Accessed 24/10/2012]

Hassan. Y (2008) [Online] Role of Government in a market economy, Available at; [Accessed 22/10/2012]

The USA online (N.D) [Online] U.S economic system, Available at;

Investopedia (N.D) [Online] Market failure, Available at; [Accessed 24/10/2012]

Jeevan .T (N.D) [Online] Allocation of resources, Available at; [Accessed 20/10/2012]

Kimberly. A (2012) [Online] Market Economy, Available at; [Accessed 21/10/2012]