Externalities in Economics - Ties between Market Failure, Price Mechanism Strategies, and Social Costs - Essay Example

Name Tutor Course Date Introduction Externalities are dominant in virtually every aspect of economic activity. They are considered as third parties or the spill-over effects that arise from the consumption and production of goods and services without incurring the appropriate compensation costs. In addition, externalities can result into market failure if price mechanism strategies do not take into consideration the full social costs as well as social benefits associated with production and consumption. Studies on externalities by economists have extensively been carried out in the recent years due to the increased concerns about the relationship between the economy and environment. Externalities create a difference between private and social costs incurred in production. For instance, social cost involves production cost spent to output a specific good and service (Block, p.314). Externalities and market failures When the negative production externalities occur, the marginal social cost increases the private marginal cost. The diagram below illustrates how the marginal social cost surpasses the private costs incurred only by the producer or supplier of a given product. For example, in the illustration below the supplier of fertilizers to an agricultural industry generates some external costs to its environment arising from the production process undertaken (Block, p.319). Rationale for the occurrence of market failures due to externalities Based on the assumption that a producer’s interest is maximizing profits then more attention will be given on the private costs as well as private benefits that arise from the supply activities of the product. It is clearly reflected on the diagram below that the level of profit maximization of the output is observed at Q1. On the other hand, the socially efficient production level has taken into consideration the external costs. As a result, the level of social optimum output is considered to be lower at Q2. From the above illustration, it can identified that private optimum output is much greater compared to the social optimum rate of production. This implies that the producer responsible for the creation of externalities has failed to involve the effects of such externalities into their calculations. Therefore, private optimum output is achieved when private marginal benefits are on the same level with private marginal cost, and hence resulting into output Q1. However, in the case of a society at large, though social optimum is perceived to be where the social marginal benefit is at the equal level with the social marginal cost, leading into output Q2. Due to the failure to take into consideration the effects of negative externality turns out to be the example of a market failure. Externalities take place when either the producers or consumers undertakes full costs as well as benefits resulting from their activities. This implies that they occur at the time when an action of certain agent imposes a given cost or benefit to another agent though he or she may not be charged or given compensation (Block, p.324). When the positive externality occurs within an unregulated market, most of the consumers pay lower price as they consume in less quantities compared to a socially efficient product. This is illustrated in the graph below, where consumers are expected to pay price (P) and make a consumption of quantity (Q) though at that quantity the society requires them to incur more costs. Therefore, at P and Q, the marginal benefits accrued to the society are far much higher compared to the marginal cost, causing a burdensome welfare loss. With the existence of both positive and negative externalities, the market outcomes require some kind of regulations so as to become more efficient. Since market failure is more detrimental to the society at large the government ought to intervene within the markets, making changes in their structures with the objective of accurately representing the costs incurred on the environment associated with individual and firm activities. Governments can at times improve the market outcomes, but with the existence of competition in the absence of externalities, majority of the markets allocate the resources in order to maximize the surplus offered (Block, p.328). Various economic policies exists that address the market failures related to the positive and negative externalities. However, if such conditions are not well met, markets end up not achieving their optimal outcome, and hence leading to market failure. When the economic agents are not directly involved, then negative externalities exists. For instance, free markets have the tendencies of over-producing goods which results into a negative externality, while under-producing those with the positive externality. In addition, negative externalities leads into a lower free-market output. For the market to produce the optimal amount, a tax has to be imposed a strategy that is referred to as internalizing the externality. Not all the externalities are negative since others create some benefits to such individuals who are not directly involved, for example, in the technology spillover in which the new inventions are capable of benefiting beyond the inventors. Other economic policies such as of government to subsidize research and development, becomes necessary since it creates positive externalities to all the people. Offering patents with the opportunity to give the monopoly rights to the new inventions for a certain period of time as well as encouraging such activity, is another important method to the careful implementation of the economic policy in the attempt to address market failures (Beckmann & Wesseler, p. 56). Since externalities causes inefficiencies in the quantity of both production and consumption, the best remedies may be implemented either through public policies or in form of private arrangements such as moral codes as well as social sanctions, internalization, voluntary organizations including charitable and lobby groups. In order to overcome the problem of negative externality, taxing the producers the amount of negative externality is a necessary step. This is simply because increases the producers marginal cost, and hence forcing them to minimize the output. On the other hand, the problem of positive externality can be solved through giving the consumers subsidies so as to increase their marginal benefits received after consuming a certain good or product. The availability of a negative externality within a competitive market normally allocates the economic resources inefficiently. Direct regulation is also another method of addressing market failure. It concerns with the limitation by the government on the amount goods that individuals are allowed to have a direct use of them. This is an ideal method since it eliminates the occurrence of monopoly behaviors within the market. However, incentive policies are considered to be more efficient in comparison to the direct regulatory policies, for instance, a tax incentive program which makes use of the tax in order to create some incentives for people to structure their own activities in a manner that is consistent with required or desired ends is essential in addressing the market failures. In addition, a tax normally yields the desired goal or end in a more efficient way than the straight regulation. Since the British tourists only value their own enjoyment (benefits) if on vacation, this implies that they consume alcohol to the level that fails to take into consideration the social costs associated with their behaviors. In the economic terms, it can analyzed that the marginal private benefit obtained from the consumption of alcohol more than the marginal social benefit, indicating that an over allocation of resources to alcohol is made within tourist towns. In addition, government action by the British consulates is directed to reducing the demand or marginal private benefit among the tourists, shifting the MPB curve to the backward side of the MSB curve, this is with a view that alcohol consumption will fall down to a socially optimal level, where the marginal social benefit is on the same level with the marginal social cost (Beckmann & Wesseler, p. 64). . In the above diagram, there is an impression that a fine distinction between too much alcohol taking and which is not sufficient within the tourist spots of European community exists. As far as the effects that the British drunkenness has on the business is concerned, some people within the tourist trade consider the prospect of wild parties as well as cheap booze as what maintains the local economies afloat. Therefore, cracking down largely on the wild Britons and the business could subside as customers are attracted to the lawlessness stop arriving. In case one condition fails within a single market, then the policy direction becomes straightforward. For instance, remedy a given isolated failure, and the outcome will turn out to be a "first-best" solution. However, if multiple failures exist within a single market, or the multiple failures within the multiple markets, then the analysis becomes exceedingly complicated. As illustrated by Lipsey and Lancaster within their analysis about the "general theory of the second best," the efficiency of competitive equilibria becomes an all-or-nothing proposition. In such cases, unless the entire conditions can be well satisfied in all the markets, then there could be no guarantee for remedying the separate market failures for improved efficiency. There is also an implication of the counterintuitive suggestion that the remedying will isolate the market failures could truly make the outcomes become worse (Beckmann & Wesseler, p. 69). Conclusion Externalities can result into market failure if price mechanism strategies do not take into consideration the full social costs as well as social benefits associated with production and consumption. They create a difference between private and social costs incurred in production. Failure of the economists to take into consideration the effects of negative externality results into market failures. When the economic agents are not directly involved, then negative externalities exists. Free markets have the tendencies of over-producing goods which results into a negative externality, while under-producing those with the positive externality. Additionally, negative externalities lead into a lower free-market output. In order for the market to produce the optimal amount, a tax has to be imposed a strategy that is referred to as internalizing the externality. Given that externalities causes inefficiencies in the quantity of production and consumption, the best remedies should be implemented either through public policies or in form of private arrangements that involve moral codes as well as social sanctions, internalization, voluntary organizations including charitable and lobby groups. The availability of a negative externality within a competitive market normally allocates the economic resources inefficiently. Works Cited Beckmann, V., & Wesseler, J. (2007). Spatial Dimension of Externalities and the Coase Theorem: Implications for Co-Existence of Transgenic Crops. In: Regional Externalities, ed. by W. Heijman, Dordrecht: Springer. Karl, E. C., Fair R. C. Principles of economics. Edition7, New Jersey: Prentice Hall, 2004. Block, Walter. (2003) “National Defense and the Theory of Externalities, Public Goods, and Clubs,” in The Myth of National Defense: Essays on the Theory and History of Security Production, ed. by Hans-Hermann Hoppe, Auburn, AL: The Ludwig von Mises Institute, pp. 301-334. Cordato, R. E. Welfare economics and externalities in an open ended universe: a modern Austrian perspective. Kluwer Academic Publishers, 1992. Read More