Market Failure

Read this section for a more detailed look at the topic of market failure. Attempt the "Try It” problem before checking your answer.

External Costs and Benefits

External Costs and Efficiency

The case of the polluting firms is illustrated in Figure 6.11 "External Costs". The industry supply curve S1 reflects private marginal costs, MCp. The market price is Pp for a quantity Qp. This is the solution that would occur if firms generating external costs were not forced to pay those costs. If the external costs generated by the pollution were added, the new supply curve S2 would reflect higher marginal costs, MCe. Faced with those costs, the market would generate a lower equilibrium quantity, Qe. That quantity would command a higher price, Pe. The failure to confront producers with the cost of their pollution means that consumers do not pay the full cost of the good they are purchasing. The level of output and the level of pollution are therefore higher than would be economically efficient. If a way could be found to confront producers with the full cost of their choices, then consumers would be faced with a higher cost as well. Figure 6.11 "External Costs" shows that consumption would be reduced to the efficient level, Qe, at which demand and the full marginal cost curve (MCe) intersect. The deadweight loss generated by allowing the external cost to be generated with an output of Qp is given as the shaded region in the graph.

Figure 6.11 External Costs

Figure 6.11

When firms in an industry generate external costs, the supply curve S1 reflects only their private marginal costs, MCP. Forcing firms to pay the external costs they impose shifts the supply curve to S2, which reflects the full marginal cost of the firms' production, MCe. Output is reduced and price goes up. The deadweight loss that occurs when firms are not faced with the full costs of their decisions is shown by the shaded area in the graph.