1

CHAPTER 2

MARKET FAILURE, PUBLIC

GOODS AND EXTERNALITIES
Dr. Anupam Das
Gupta

Chapter: Introduction
 Market Failure
Market failure occurs when there is a state of disequilibrium in the
market due to market distortion. It takes place when the quantity of
goods or services supplied is not equal to the quantity of goods or
services demanded.
The economy is Pareto efficient only under certain circumstances or
conditions. There are some important conditions under which
markets are not Pareto efficient. These are referred to as market
failures, and they provide a rationale for government activity.
Six Basic Market Failures:
1. Imperfect Competition 4. Incomplete Markets
2. Public Goods 5. Imperfect Information
Dr. Anupam Das

3. Externalities 6. Unemployment and other

Macroeconomic Disturbances
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Chapter: Introduction
 1. Imperfect Competition:
For markets to result in Pareto efficiency, there must be perfect
competition-that is, there must be a sufficiently large number of
firms that each believes it has no effect on prices. But in some
industries, there are relatively few firms, or one or two firms
have a large share of the market. When a single firm supplies the
market, economists refer to it as a monopoly; when a few firms
supply the market, economists refer to them as an oligopoly. And
even when there are many firms, each may produce a slightly
different good and may thus perceive itself facing a downward
sloping demand curve. Economists refer to such situations as
monopolistic competition.
In all of these situations, competition deviates from the ideal of
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perfect competition, where each firm is so small that it believes

there is nothing it can do to affect prices.
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Chapter: Introduction
 There are a variety of reasons why competition may be limited:-
a) Natural Monopoly: A Situation where it is cheaper for a single firm
to produce the entire output than for each of several firms to produce
part of it.
b) High Transportation costs: mean that goods sold by a firm at one
location are not perfect substitutes for goods sold at another location.
c) Imperfect information: mean if a firm raises its price it will not lose
all of its customers; it only faces a downward sloping demand curve.
d) Strategic Behavior to Discourages Competition: means threaten to
cut prices if potential rivals enter, and such threats may both be
credible and serve to discourage entry.
e) Imperfections of competition: arise out of government actions.
Dr. Anupam Das

Imperfect competition leads to market inefficiency i.e., Marginal

Revenue > marginal cost.
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Chapter: Introduction
 2. Public Goods
There are some goods that either will not be supplied by the market
or if supplied, will be supplied in insufficient quantity. An example
on a large scale in national defense; on a small scale, navigational
aids. These are called pure public goods.
Pure public goods have two critical properties
a) First, it costs nothing for an additional individuals to enjoy their
benefits; formally there is zero marginal cost for the additional
individual enjoying the good.
b) Secondly, it is in general difficult or impossible to exclude
individuals from the enjoyment of a pure public good.
The market either will not supply, or will not supply enough of, a
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pure public good.

Gupta

Chapter: Introduction
 3. Externalities
An externality stems from the production or consumption of a good or
service, resulting in a cost or benefit to an unrelated third party. On the
other way we can say, Externalities occur when the consumption of a good
or service benefits or harms a third party.
There are many cases where the actions of one individual or one firm
affect other individuals or firms; where one firm imposes a cost on
other firms but does not compensate them, or alternatively, where
one firm confers a benefit on other firms but does not reap a reward
for providing it. These are called externalities. Air and water
pollutions-are examples.
a) Negative Externalities: Instances where one individual’s
actions impose a cost on other are referred to as negative
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externalities
b) Positive Externalities: Instances where one individual’s actions
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confer a benefit upon others.

Chapter: Introduction
 Whenever there are such externalities, the resources allocation
provided by the market will not be efficient.
Since individuals do not bear the full cost of the negative externalities
they generate, they will engage in an excessive amount of such
activities;
conversely, since individuals do not enjoy the full benefits of
activities generating positive externalities, they will engage in too
little of these.
Dr. Anupam Das
Gupta

Chapter: Introduction
 4. Incomplete Markets
Whenever private markets fail to provide a good or service even
through the cost of providing it is less than what individuals are
willing to pay, there is a market failure that we refer to as
incomplete markets (because a complete market would provide all
goods and services for which the cost of production is less than what
individuals are will to pay). Some economists believe that private
markets have done a particularly poor job of providing insurance and
loans, and that this provides a rationale for government activities in
these areas.
Dr. Anupam Das
Gupta

Chapter: Introduction
 The private market does not provide insurance for many
important risks that individuals face, though insurance
markets are much better today than before. Like, deposit
insurance, crop insurance, flood insurance etc.
Why capital and insurance markets are imperfect?
a) Innovation
b) Transaction costs
c) Asymmetries of information and enforcement costs
Dr. Anupam Das
Gupta

Chapter: Introduction
 a) Innovation:
One focuses on innovation: we are used to new products,
constantly coming onto the market, but there are also
innovations in how the economy functions – innovations in
creating new markets, including inventing new securities and new
insurance policies. Indeed, those working in the insurance and
securities industries refer to these advances as new products.
b) Transaction cost:
Introduction of new products involved huge expenditures which is
related to the second explanation: transaction costs. It is costly to
run markets, to enforce contracts, and to introduce new
insurance policies. In insurance firm may be reluctant to go to the
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trouble of designing a new insurance policy if it is unsure whether

anyone will buy the policy. There is no effective “Patent
protection” and as a result there will be underinvestment in
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innovation.
Chapter: Introduction
 c) Asymmetric information and enforcement costs:
The insurance company may often less informed about the nature of
the some risks than the person purchasing insurance. When the
two parties to a transaction have different information of this
kind, we say that there is information asymmetry.
Dr. Anupam Das
Gupta

Chapter: Introduction
 5. Information Failures:
A number of government activities are motivated by imperfect
information on the part of consumers, and by the belief that the
market, by itself, will supply too little information. Information
is, in many respects, a public good.
Giving information to one more individual does not reduce the
amount others have. Efficiency requires that information be
freely disseminated or, more accurately, that the only charge be
for the actual cost of transmitting the information. The private
market will often provide an inadequate supply of information just
as it supplies an inadequate amount of other public goods.
Dr. Anupam Das
Gupta

Chapter: Introduction
 6. Unemployment and Other Macroeconomic Disturbances

The most widely recognized symptoms of market

failure are the periodic episodes of high unemployment
both of workers and machines. Most economists take the
high levels of unemployment as primary evidence that
something is not working well in the market. To some
economists, high unemployment is most dramatic and most
convening evidence of market failure.
Dr. Anupam Das
Gupta

Chapter: Introduction
 Redistribution and Merit Goods
Even if the economy is Pareto efficient, there are two further
arguments for government intervention:-
1. The first is income distribution. The fact that the economy is
Pareto efficient says nothing about the distribution of income;
competitive market may give rise to a very unequal
distribution, which may leave some individuals with insufficient
resources on which to live. One of the most important activities of
the government is to distribute income. Example: Food stamp
(Price support program); Medicare etc.
2. The second argument is that some believe that individuals, even
when well informed, do not make good judgments concerning
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the goods they consume (Smoking, fail to wearing seat belt), thus
providing a rationale for regulations restricting the
consumption of some goods, and for the public provisions of
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other goods, called merit goods.

Chapter: Introduction
 Merit Goods:
►Goods that the government compels individuals to consume
like seat belts and elementary education, are called merit
goods.
Paternalism and Libertarianism:
►The view that the governmental should intervene because it
knows what is in the best interest of individuals better than
they do themselves is referred to as paternalism.
►One might argue that smoking causes cancer, and that the
individuals who get cancer may be treated in the public hospitals
or financed by public funds, smokers impose a cost on
nonsmokers. This, however, can be dealt with by making smokers
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pay their full costs – for instance, by imposing a tax on cigarettes.

Gupta

Chapter: Introduction
 Alternatively, smoking in the crowed room does indeed impose
a cost on nonsmokers in that room. But this is too, can be
dealt with directly by not allowing smoke in the room and
also in the public place. (Government policies toward drugs
like illegalization of marijuana and liquor etc.)
In contrast to the paternalistic view, many economist and
social philosophers believe that the government
should respect consumers’ preferences. Because they
worry that once the government assumes a paternalistic
role, special interest groups will attempt to use
government to further their own views about how
individuals should act or what they should consume. The
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view that government should not interfere with the

choices of individuals is referred to as libertarianism.
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Chapter: Introduction
 Two Important caveats to Economists’ General
presumption Against Government paternalism:-
1. The first concerns children. Someone must make
paternalistic decisions on behalf of children, either the
parents or the state. Some treat children as if they were the
property of their parents, arguing that parents alone should
have responsibility for taking care of their children. But most
argue that the state has certain basic responsibilities.
2. The second caveats concerns situations where the
government cannot, at least without difficulty, commit itself
to refrain from helping individuals who make poor
Dr. Anupam Das

decisions.
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Chapter: Introduction
 Two perspectives on the Role of Government:
1. Normative Analysis Which focuses on what the government
should do
2. Positive Analysis which focuses on describing and
explaining both what the government actually does and what
its consequences are.
Dr. Anupam Das
Gupta

Chapter: Introduction
 1. Normative Analysis:
The normative approach to the role of government asks, how
can government address market failures and other perceived
inadequacies in the market’s resource allocation should do.
2. Positive Analysis
The positive approach asks, what is it that the government
does, what are its effects, and how does the nature of the political
process (including the incentives it provides bureaucrats and
politicians) help explain what the government does and how it does
it. So it focuses on describing and explaining both what the
government actually does and what its consequences are.
Dr. Anupam Das
Gupta

Chapter: Introduction
20
Public Goods
Goods with benefits that cannot be withheld from those who do
not pay and are shared by large groups of consumers are public
goods.
In most cases, government provision of public goods implies that
the goods are freely available to all rather than being sold in
markets. The costs of making the good available are usually
financed by taxes.
Public Goods are goods for which exclusion is impossible.
One example is National Defense: A military that defends one
citizen from invasion does so for the entire public.
Dr. Anupam Das
Gupta

Chapter: Introduction
21 Characteristics of Public Goods
►Nonexclusion: The inability of a seller to prevent people from
consuming a good if they do not pay for it. For example, it is
infeasible to exclude those who refuse to pay for cleaner air from
enjoying the benefits of a given amount of air quality
improvement, once it has been supplied for the benefit of other
people. Air quality improvement has the property of nonexclusion.
►Nonrivalry: The characteristic that if one person “consumes” a
good, another person’s pleasure is not diminished, nor is
another person prevented from consuming it. For example,
television and radio transmissions are nonrival in consumption. A
given amount of programming per day can be enjoyed by a large
number of consumers. When an additional viewer switches on a
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television set, the quantity of programming enjoyed by other

viewers is not reduced. Similarly, the benefits of national defense
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services are nonrival.

Chapter: Introduction
22 Characteristics of Public Goods (Cont.)
►From a practical point of view, goods that are nonrival in
consumption need not necessarily be subject to nonexclusion.
Television broadcasting services, as was pointed out above, are
nonrival. However, it is feasible to exclude those who refuse to pay
from the benefits of transmissions through cable provision of the
broadcasts or use of signal coding for satellite transmission.
Similarly, the benefits of roads are often nonrival. However, it is
feasible to use tolls to exclude those who refuse to pay.
Dr. Anupam Das
Gupta

Chapter: Introduction
23 Pure Public Goods and Pure Private Goods
►A pure public good is nonrival in consumption for an entire
population of consumers, and its benefits have the characteristic
of nonexclusion. A given quantity of a pure public good is
consumed by all members of a community as soon as it is
produced for, or by, any one member.
►A pure private good is rival in consumption, and its benefits
are easily excluded from those who choose not to pay its market
price.
Dr. Anupam Das
Gupta

Chapter: Introduction
24 Pure Public Goods and Pure Private Goods
►A pure public good is not divisible into units that can be
apportioned among consumers. A given quantity of a pure
public good can only be shared rather than enjoyed
individually. Its benefits are collectively consumed by the
entire population. A unit of a pure private good, on the
other hand, can be enjoyed only by a single consumer. The
more units of a given amount available to be consumed by
one person, the less is available to rival consumers.
Dr. Anupam Das
Gupta

Chapter: Introduction
25 Marginal Costs for Provision of Public Goods
►The marginal cost of distributing a pure public good to an
additional consumer is zero for a given amount of the public
good. This follows from the nonrival characteristic of pure
public goods. Figure A in the next slide shows that the marginal
cost of allowing additional people to consume certain amounts
of a pure public good falls to zero after the good has been made
available for any one person.
►The marginal cost of allowing another person to benefit
from a pure public good is zero, while the marginal cost of
providing a greater level of public good is positive.
Dr. Anupam Das
Gupta

Chapter: Introduction
26 FIGURE : MARGINAL COSTS OF CONSUMING AND
PRODUCING A PURE PUBLIC GOOD-FIGURE A

200
Cost (Dollars)

Marginal Cost of Allowing an

Additional Person to Consume a
Given Quantity of Pure Public Good
Dr. Anupam Das
Gupta

0 1 Number of Consumers
Chapter: Introduction
27 Marginal Costs for Provision of Public Goods (Cont.)
►The marginal cost of producing additional units of the public
good will be positive, as is the case for all economic goods,
because increasing the quantity of a pure public good requires
additional resources. This is illustrated in Figure B in the next
slide, where we assume that the average cost of a pure public good
is constant. Two units of the public good cost twice as much as one
unit. In this case, if the average cost of the public good is $200 per
unit, the marginal cost will also be $200.
Dr. Anupam Das
Gupta

Chapter: Introduction
28 FIGURE B: MARGINAL COSTS OF CONSUMING AND PRODUCING
A PURE PUBLIC GOOD--FIGURE B

Marginal Cost of Producing

a Pure Public Good

200 MC = AC
Cost (Dollars)
Dr. Anupam Das
Gupta

0 Units of a Pure Public Good per Year

Chapter: Introduction
29 Example: Bread versus Heat
A simple example will help to clarify the distinction between pure
public goods and pure private goods. Suppose, each day, residents
of the room receive a fixed quantity of bread and a certain amount
of fuel to heat the room.
►Bread – Clearly a pure private good because there is the ability
to exclude and there is rivalry to consume.
►Heat – Clearly a pure public good because there is no ability to
exclude and there is no rivalry to consume.
Dr. Anupam Das
Gupta

Chapter: Introduction
30 Provision of Private Good and Public Goods:
Markets and Government
The supply of goods and services and the mechanisms of
distributing them among individuals reflect collectively agreed-upon
institutional arrangements that have emerged in a community.
It is difficult to make generalizations about the most
appropriate means for making goods and services available.
Private goods that are individually consumed are sometimes
supplied through markets by government, as is the case for
certain transportation services, electricity, and other public
utility services.
Dr. Anupam Das
Gupta

Chapter: Introduction
31
On the other hand, many goods that are nonrival in consumption
and which have characteristics of public goods, are privately
produced and supplied through markets. For example, certain
recreational services sold through private clubs, television and
other communication services, and private police protection.

In many cases, goods and services are supplied both through markets
under private production and by governments. For example, both
private and public schools are available. Recreational services and
facilities, such as parks, tennis courts, and golf courses, are supplied
by both the government and the private sector.
Dr. Anupam Das
Gupta

Chapter: Introduction
32 Provision of Private Good and Public Goods: Markets and
Government
►Pure private goods being supplied through government and
financed through taxation. For example, citizens could agree
collectively to supply clothing through government and allow
every person one identical suit of clothes per year at no direct
charge, financing the production and distribution of the clothing
through taxation. Similarly, it is possible to envision goods that
have the characteristics of public goods being produced privately
and sold through markets when the costs of exclusion are not very
high. Example of such good is Cable Television services.
►In practice, it is not possible to draw a neat line between pure
private goods and pure public goods.
Dr. Anupam Das
Gupta

Chapter: Introduction
 PROVISION OF PRIVATE GOOD
33

AND PUBLIC GOODS: MARKETS

AND GOVERNMENT
Price Excludable Public Goods
vs
Congestible Public Goods
Dr. Anupam Das
Gupta

Chapter: Introduction
34
Price Excludable Public Goods
Excludability, but no rivalry
►Another type of good is a price-excludable public good: no
rivalry but exclusion is easy.
►Price-excludable public goods are those with benefits that
can be priced.

Examples: Country Clubs, Cable TV, Swimming Pool.

Dr. Anupam Das
Gupta

Chapter: Introduction
35 Congestible Public Goods
Rivalry but no excludability
►There are public goods where, after a point, the enjoyment
received by the consumer is diminished by crowding or congestion.
These are called Congestible Public Goods.
►Examples: roads and parks
►The marginal cost of accommodating an additional consumer is
not zero after the point of congestion is reached. For example, an
additional user of a congested road decreases the benefits to
existing users by slowing down traffic and increasing the risk of an
accident. This is illustrated in the Figure in the next slide. After
N* users of a road have been accommodated per hour, the marginal
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cost of allowing another user on that road becomes positive.

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Chapter: Introduction
36 FIGURE : A CONGESTIBLE PUBLIC GOOD
Marginal Cost

Marginal Cost per User

Dr. Anupam Das
Gupta

0 1
Number of Consumers per Hour
Chapter: Introduction
37 Classifying Goods According to the Degree of Rivalry
and Excludability of Benefits from Their Use
Goods and services have been divided into four categories:
1. Pure private goods
2. Price-excludable public goods
3. Congestible public goods
4. Pure public goods
Followings Tables summarizes alternative means for producing,
distributing, and financing goods and services.
Dr. Anupam Das
Gupta

Chapter: Introduction
38 Pure Private Goods
CHARACTE MEANS OF METHODS METHODS EXAMPLES
RISTICS PRODUCTI OF OF
ON DISTRIBUT FINANCE
ION PRIVATE PUBLIC

No 1. Private Markets; Revenue Food; Government

externality; firms; direct from clothing; liquor
low-cost Government unit charge Sales cars stores;
exclusion
2. No direct Government
Government; unit Taxes distribution
private firms charge; of
under eligibility medical
contract with to consume services
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government various and food to

amounts low-income
determined Citizens.
politically
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Chapter: Introduction
 Price-excludable public goods
CHARACT MEANS OF METHODS METHODS EXAMPLES
ERISTICS PRODUCTI OF OF
ON DISTRIBU FINANCE
TION PRIVATE PUBLIC

External 1. Private Markets; Revenue Schools; Transit

benefits firms; direct unit from hospitals; facilities;
when Government charge (may sales; taxes transportation public
produced be hospitals
or consumed; subsidized).
low-cost 2. No direct
exclusion Government; unit charge; Taxes Public
private firms consumption schools;
under available or public
contract with required only sanitation;
Dr. Anupam Das

government at Inoculations
collectively
chosen
quantity
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and quality

Chapter: Introduction
39
40 Congestible public goods
CHARACT MEANS OF METHODS METHODS EXAMPLES
ERISTICS PRODUCTI OF OF
ON DISTRIBU FINANCE
TION
PRIVATE PUBLIC

Collectively 1. Private Fees for the Revenue Clubs; Public golf

consumed firms; right from theaters; courses;
benefits Government to use the sales amusement roads
subject facility Parks,
to crowding; sold in sporting
possibility markets events
of exclusion
Dr. Anupam Das
Gupta

Chapter: Introduction
41 Pure public goods
CHARACT MEANS OF METHODS METHOD EXAMPLES
ERISTICS PRODUCTI OF S OF
ON DISTRIBUTI FINANCE
ON PRIVATE PUBLIC

Collectively 1. Private No direct unit Fees; Private Public television

consumed firms; charge; quantity contributio charity and radio
benefits not Government dependent on ns
subject to Amount
crowding; collected.
high cost No direct unit National
exclusion 2. charge; defense;
Government; quantity and environmental
private firms quality of Taxes protection
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under service
contract with collectively
government chosen
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Chapter: Introduction
42 Classifying Goods According to the Degree of Rivalry and
Excludability of Benefits from Their Use
►Figure in the next slide shows how goods could be categorized
according to the degree of rivalry in consumption and the
degree of excludability. The horizontal axis of the graph plots the
extent to which the benefits of the good are rival on a scale of zero
to one. The vertical axis measures the excludability of the good on
a scale of zero to one.
Dr. Anupam Das
Gupta

Chapter: Introduction
43 FIGURE : CLASSIFYING GOODS ACCORDING TO THE DEGREE OF
RIVALRY AND EXCLUDABILITY OF BENEFITS FROM THEIR USE

A (Pure private
1 good)
C (Excludable
Public goods)

H (Congestible public good)

Excludability
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B (Pure public good)

0 1
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Rivalry

Chapter: Introduction
44 Classifying Goods According to the Degree of Rivalry and
Excludability of Benefits from Their Use
►A pure public good corresponds to point B, where there is no
rivalry for benefits and excludability from benefits is
impossible. A pure private good corresponds to point A on the
graph. A nonrival good, such as TV transmissions, for which
exclusion is possible, corresponds to a point like C. A
congestible public good for which it is possible to charge for
use, such as a limited access highway, corresponds to a point
like H.
Dr. Anupam Das
Gupta

Chapter: Introduction
45 Education as a Public Good
►Education is a service that has some characteristics of a
public good and some characteristics of a private good.
►External benefits
►It helps us live in a civil society.
►It has a “socializing ” function.
►It teaches the importance of following rules, obeying orders,
and working together.
►It provides students with basic skills like punctuality and the
ability to follow directions that increase their productivity as
workers.
►It helps students identify their abilities and choose appropriate
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occupations, thereby increasing productivity levels for a nation.

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Chapter: Introduction
46 Education as a Private Good
►Education has characteristics of a private good.
►Wide disparities exist in the quantity and quality of education
provided among school districts.
►The level of support that parents can give students at home
increases with income and home support is an important factor
in learning for children.
►There is no way to prevent parents who want more than a
standardized quantity and quality of education for their children
from buying it in the marketplace.
Dr. Anupam Das
Gupta

Chapter: Introduction
47 Free-riding
►A free rider is a person who seeks to enjoy the benefits of a
public good without contributing anything to the cost of financing
the amount made available. The free-rider problem stems from the
incentive people have to enjoy the external benefits financed by
others, with no cost to themselves. Free riding can be a reasonable
strategy for any one individual, provided that no penalty exists and
that only a few individuals choose the strategy.
►Private firms have no incentive to produce such goods since they
can't make everyone pay for them. Wikipedia is another example
of the Free Rider problem – few people contribute (financially or
otherwise), but everyone gets to use it.
►Free-riding occurs when people are not honest in stating their
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Marginal Benefit, because if they understate it, they can get a

slightly reduced level of the public good while paying nothing
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for it.
Chapter: Introduction
48
Free-riding is easier with
►Anonymity: If everyone knows who contributes, there can be
powerful social stigmas applied to shirkers.

►Large numbers of people: It’s easier to determine the shirkers

in a small group and the punishment is more profound when
people close to you shun you for not paying your share.
Dr. Anupam Das
Gupta

Chapter: Introduction
49 Externalities
►Externalities are costs or benefits of market transactions not
reflected in prices. When an externality prevails, a third party
(other than the buyers or sellers of an item) is affected by its
production or consumption. The benefits or costs of the third party
(either a household or a business) are not considered by either
buyers or sellers of an item whose production or use results in an
externality.
►The third parties are people like you who bear the costs of polluted
air and water. These third parties often organize politically through
groups to lobby legislators and public officials to protect their
rights to a clean environment. In the United States and other
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industrial nations, environmentalists have emerged as an effective,

potent political force to induce governments to pass laws that limit
the rights of producers and consumers to emit wastes that pollute
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the air, water, and land.

Chapter: Introduction
50 Types of Externalities
►Negative externalities are costs to third parties other than the
buyers or the sellers of an item not reflected in the market price. An
example of a negative externality is the damage done by industrial
pollution to people and their property.
►Positive externalities are benefits to third parties other than the
buyers or the sellers of a good or service not reflected in prices. For
example, a positive externality is likely to exist for fire prevention,
because the purchase of smoke alarms and fireproofing materials
benefits those other than the buyers and sellers by reducing the risk
of the spread of fire.
Dr. Anupam Das
Gupta

Chapter: Introduction
51 Types of Externalities
►Effects of market exchanges on third parties are not externalities
when those effects are included in prices. For example, if a
person’s hobby is photography, increases in the demand for
photographic equipment by others could make that person worse
off by increasing the price of the equipment. Some economists
refer to these as pecuniary externalities; that is, the effects of
increases (or decreases) in the price of a good on existing
consumers as a result of changes in the demand or supply of a
good. Pecuniary externalities merely result in changes in real
income of buyers or sellers. Real externalities are unpriced costs or
benefits. They are the effects of market exchanges external to
prices.
Dr. Anupam Das
Gupta

Chapter: Introduction
52 Externalities and Efficiency
►When an externality exists, the marginal costs or marginal benefits
that market participants base their decisions on diverge from the
actual marginal social costs or benefits. For example, with a
negative externality, business firms producing a product for sale in
the marketplace neither pay for nor consider the damage the
production or consumption of that product can do to the
environment. Similarly, with a positive externality, buyers and
sellers of a product in the marketplace do not consider the fact that
their production or consumption of the item benefits third parties.
Dr. Anupam Das
Gupta

Chapter: Introduction
 Externalities and Efficiency (Cont….)
53

►The marginal external cost is the dollar

value of the cost to third parties from the
production or consumption of an
additional unit of a good. These occur
when market transactions for a good
produce negative externalities.
Dr. Anupam Das
Gupta

Chapter: Introduction
54 Negative Externalities
►A negative externality might be associated with paper
production because of damages done by pollutants
emitted into streams and rivers. Pollutants decrease the
benefit obtained by other users of streams, rivers, or lakes
such as commercial fishers, recreational users like
swimmers, boat racers etc.
►Assume that the paper industry operates under perfect
competition.
Dr. Anupam Das
Gupta

Chapter: Introduction
55 Positive externalities & Efficiency
►When a positive externality is present, prices do not fully
equal the marginal social benefit of a good or service. For
example, suppose inoculation against a disease results in a
positive externality. Those who are vaccinated benefit
themselves as well as reduces the probability of outbreaks of
the disease for the entire population, including those who are
not vaccinated.
Dr. Anupam Das
Gupta

Chapter: Introduction
 Positive externalities & Efficiency
56

►The marginal external benefit is the dollar value of the

benefit to third parties from an additional unit of production
or consumption of a good. These occur when the market for
a good creates positive externalities.
Dr. Anupam Das
Gupta

Chapter: Introduction
 Thank You
Dr. Anupam Das
Gupta

Chapter: Introduction