10151034 costs and benefits and social costs and benefits.

Micro1 Essay

basic economic problem looks at the scarcity of resources within the market and
a belief is held that the price mechanism functions in such a way to resolve
such a problem. This involves the scarcity of goods and services creating
incentives for producers to increase the price levels in order to ration out
their products to those who can afford such. This sends out signals to the
consumers in the market surrounding the applicability of their position in it.
The functions of the price mechanism are associated with the successful
operating of a demand and supply curve. However, the price mechanism is not
always so successful, and this can be proven with the exploration of market
failure. Market failures arise when economic markets fail to allocate resources
in a pareto-efficient way. Throughout this essay the existence of the market
failure surrounding externalities is to be explored with reference to welfare
losses and forms of intervention.

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!

order now

can be understood to be actions which create unintended consequences onto a
third party and so exist when there is a distinct difference between private
costs and benefits and social costs and benefits. Although externalities can
take a positive form, one must explore the effect of negative externalities and
how such a market failure results in welfare losses within a functioning

externalities exist when the social costs are greater than private costs in
production, or when the private benefit exceeds the social benefit in
consumption. One way to define such is as ‘a cost suffered by a third party as
a result of an economic transaction’1.
An example of a negative externality in production is pollution. There is an
argument to say that whilst manufacturing such goods, a firm can add to the
levels of pollution within an economy due to the tools used. This is a distinct
social cost which is not taken into consideration by the private firm producing
such goods when setting a price level and so creates spill-over costs onto a
third party which are not compensated for.

one to understand such conditions in a diagrammatic form there must be a
distinction between the two forms of costs that make up the supply curves. The
two curves show the marginal private cost, which is the cost to the producer of
producing an additional unit of a good, and the marginal social cost which is
also the cost of producing an additional unit of such good whilst also
considering the outside costs incurred by those affected by the production of
the good. The diagram below helps one to understand such a condition as it
highlights how, at a set price, there exists marginal social costs which exceed
the marginal private cost. Whilst taking
such diagram into consideration, it is clear that the set price of P1 results
in market failure as the firm have misallocated resources as the price level
does not take into consideration all of the social costs of production and so
the pareto-efficient level of output would be at P2, where price equals the
marginal social cost.











examine the welfare losses which result from externalities one must consider
the idea of utility. Utility can be best defined as ‘the total satisfaction
received from consuming a good or service’2. Meaning
that, before such external effects are considered, the utility of Person A is
dependent upon the goods they consumed and so when externalities occur, Person
A’s utility is now also affected by the consumption of Person B. An example of
such would be the idea that Person A’s utility may be negatively affected by
Person B playing loud music in the early hours of the morning; this
demonstrates the idea of such external spill-over effects. When looking at
utility in the sense of consumption and production, one can make links to the
utility of wider society which can also be understood as social welfare.
Welfare economics focuses on ‘the optimal allocation of resources and goods and
how the allocation of these resources affects social welfare’3. When
we explore negative externalities, it becomes apparent that due to the external
costs or such actions society suffers a welfare loss. Also known as a
deadweight loss, a welfare loss can be described as a ‘a loss of total surplus
relative to a Pareto-efficient allocation’4.
For negative externalities, the deadweight loss occurs due to the market output
being supplied is higher than the optimum level where price equals marginal
social cost. The result of this excess production is the area highlighted below
showing the social welfare loss as the difference between the marginal social
and private cost.











is a compelling argument to say that due to the existence of negative
externalities, it becomes necessary for governments to intervene in order to
correct the market failure and avoid such welfare losses within an economic
society. There are numerous policies the government can be implemented to
correct such failures and will be successful in increasing total welfare under
the condition that ‘any costs incurred in intervention are less than the
benefits gained from intervention’. (Anderton
1991/2015: 129)

One form of government intervention would be an indirect
tax. If the government were to tax a product that was emitting negative
externalities it brings the price level higher and so reaching the socially
optimum output. The diagram below shows the result of an indirect tax on a good
which holds negative externalities in consumption and it highlights how the tax
is efficient in pushing the price level higher and by doing so eliminating the
deadweight loss which previously existed. Cigarette consumption is an action
which holds negative externalities in consumption as the marginal private
benefit is greater than the social benefit, yet it should be highlighted that
due to the price elasticities of demand, the effectiveness of an indirect tax
to combat this externality is questionable. There is an argument to say the consumption
of cigarettes is price elastic in demand, meaning the demand for a product is
unresponsive to a change in price due to the addictive qualities surrounding
such goods and so a higher price level, as a result of a tax, may not be as
effective in reducing output.













government intervention may be successful in some situations, there is a case
for governments failing in the same way markets do. Government failure is
present when intervention ‘leads to a net loss of economic welfare rather than
a gain’ (Anderton 1991/2015: 137) and
this can take various forms. For the case of negative externalities, an example
of government failure would be the excessive administrative costs as a result
of a subsidy. If one were to combat the negative externalities in consumption
of junk food through subsidising healthier alternatives, the government can
fail if the costs of implementing the subsidy were greater than the benefit of
imposing such. This form of government failure is likely to be more common once
considering the high levels of price elasticity surrounding unhealthy foods. Taking
into consideration the possibility of government failure one may believe that
government intervention to correct market failure is not always the most efficient

leads to the argument put forward by Ronald Coase surrounding Coasean
bargaining in attempt to address the market failure arising from negative
externalities. Bargaining, in this sense, follows the argument that private
bargaining is more successful than having to deal with the external effects of
government intervention due to the possibility of failure. Coase argues that
‘the two parties to the exchange often have more of the information necessary
to implement an efficient outcome than the government does’5. For
Coase, private bargaining ensures pareto efficiency if both parties involved
reach an agreement which results in the greatest potential mutual gains. Once
again, whilst taking into consideration this argument, the weaknesses must also
be addressed, including the idea that this model can not be applied to
situations where the transaction costs, the costs of bargaining, prevent pareto
efficiency as some parties’ costs may be too high to make an efficient bargain possible.

conclude, it is clear from this essay that when adopting a laissez-faire
attitude towards markets, the functions of the price mechanism are not always
carried out successfully and markets fail. The existence of negative
externalities is a clear form of market failure explored throughout this
writing referring to the welfare losses arising from such. Whilst it is clear
to combat market failures, intervention is necessary it has been highlighted
that government intervention, in all its forms, may be ineffective and result
in government failure leading one to look at other forms of intervention,
specifically Coasean bargaining.

count: 1475


1.     Anderton, A., 2015. Economics. 6th ed. Ormskirk: Anderton
Press Ltd.

2.     Bowles, S., Carlin, W. and Stevens, M. (2017). The economy:
Economics for a Changing World. 1st ed. ebook Oxford University Press.

3.     Economicsonline.co.uk. (2018). Negative externalities.
Available at: http://www.economicsonline.co.uk/Market_failures/Externalities.html

4.     Investopedia.com (2018). Utility. Available at: https://www.investopedia.com/terms/u/utility.asp

5.     Investopedia.com (2018). Welfare Economics. Available at:

1 http://www.economicsonline.co.uk/Market_failures/Externalities.html

2 https://www.investopedia.com/terms/u/utility.asp

3 https://www.investopedia.com/terms/w/welfare_economics.asp




I'm Dianna!

Would you like to get a custom essay? How about receiving a customized one?

Check it out