Exam questions

1. Explain using examples why externalities lead to market failure. Discuss

the different ways in which the problems associated with externalities
can be resolved.
ANSWER
An externality is a link between economic agents that lies
outside the price system of the economy. Everyday examples include
the pollution from a factory which harms a local fishery and the envy
that is felt when a neighbor proudly displays a new car. Such
externalities are not controlled directly by price - the fishery cannot
choose to buy less pollution nor can you choose to buy your neighbor
a worse car. This prevents the efficiency theorems from applying.
Indeed, the demonstration of market efficiency was based on the
following two presumptions:
(a) the welfare of each consumer depended solely on her own
consumption decision;
(b) the production of each firm depended only on its own
input/output choice.
In reality a consumer or a firm may be directly affected by the
actions of other agents in the economy; that is, there may be external
effects from the actions of other consumers or firms. In the presence
of such externalities the outcome of a competitive market is unlikely
to be Pareto efficient because agents will not take account the external
effects of their (consumption/production) decisions.
The control of externalities is an issue of increasing practical
importance. Global warming and the destruction of the ozone layer are
two of the most significant examples but there are numerous others,
from local to global environmental issues. Some of these may not
appear immediately to be economic problems but economic analysis
can expose why they occur and investigate the effectiveness of
alternative policies.
i. Definition of externality
An externality is present whenever some economic agents welfare
(utility or profit) is directly affected by the action of another agent
(consumer or producer) in the economy.
By directly we exclude any effects that are mediated by prices.
That is, an externality is present if a fisherys productivity is
affected by the river pollution of an upstream oil refinery, but not if
the fisherys profitability is affected by the price of oil (which may
depend on the oil refinerys output of oil). The latter type of effect
(also called a pecuniary externality) is present in any competitive
market but creates no inefficiency (since price mediation through
competitive markets leads to a Pareto efficient outcome). We shall
present later an illustration of a pecuniary externality. The
definition of externality implicitly distinguishes between two broad
categories of externality. A production externality occurs when the
effect of the externality is upon a profit relationship and a
consumption externality whenever a utility level is affected. Clearly,
an externality can be both a consumption and a production
externality simultaneously. For example, pollution from a factory
may affect the profit of a commercial fishery and the utility of
leisure anglers.
ii. Examples of Externalities
iii. Definition of market failure
iv. Why is there Market Inefficiency?
It has been accepted throughout the discussion above that the presence of externalities
will result in the competitive equilibrium failing to be Pareto efficient. The immediate
implication of this fact is that incorrect quantities of goods, and hence externalities, will be
produced. It is also clear that a non-Pareto efficient outcome will never maximize welfare.
This provides scope for economic policy to raise welfare.