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Topic 3.8
Limitations of Markets
In this topic, the different types of externalities, and the methods that can be used to correct them. You will also evaluate how effective each method is.
Externalities
An externality is a benefit or cost of an economic activity on a third party.
A positive externality (or external benefit) is a benefit of an economic activity to a third party
A negative externality (or external cost) is a cost of an economic activity to a third party
A private benefit is a benefit of an economic activity to those involved in the activity/transaction
A private cost is a cost of an economic activity to those involved in activity/transaction.
Most goods with positive externalities (known as merit goods) and underproduced and underconsumed (e.g. education, fruit)
Most goods with negative externalities (known as demerit goods) are overproduced and overconsumed (e.g. alcohol, fast food)
These patterns occur because both consumers and producers only consider their private benefit/cost when producing or consuming a good/service, without worrying about the effect on society as a whole.
Correcting Externalities
Taxation
For both negative and positive externalities
Negative externalities: higher firm taxes and VAT reduce retained profit and cut incentives to produce by raise production costs, which shifts supply left and contracts demand, so price rises and quantity sold falls, reducing overconsumption and overproduction.
Positive externalities: lower firm taxes and VAT increase retained profit and raise incentives to produce by lowering production costs. This shifts supply right and expands demand, so price falls and quantity sold rises, reducing underconsumption and underproduction.
Subsidies
For positive externalities ONlY
A subsidy is a payment made by the government to firms to encourage the production of merit goods. This lowers the private cost of production, shifting supply to the right and increasing consumption. Production is incentivised and prices decreased, which reduces underproduction and underconsumption
State Provision
For positive externalities ONlY
Governments may decide to directly provide and supply merit goods for free at the point of use (e.g. NHS or public schools). This ensures that consumption is based on need rather than ability to pay, maximizing external benefits. This prevents underconsumption and underproduction
Information Provision
For both negative and positive externalities
Externalities often exist because of information failure. Governments can run advertising campaigns to educate consumers about the true costs (e.g. smoking) or benefits (e.g. 5-a-day) of consumption. It corrects market failure by helping people make better choices, which lowers underconsumption of merit goods and overconsumption of demerit goods.
Regulation and Legislation
For both negative and positive externalities
Direct regulations and laws can be used to limit external costs (e.g. banning public smoking) or mandate external benefits (e.g. compulsory school age). This forces consumers to align with the social optimum. Regulation and legislation refers to rules, directives or government order to control the ways that people and organisations behave. The legislation sets the what, regulations set the how. It can be used to encourage production/consumption for goods with positive externalities, and can even put a stop entirely to production of goods with negative externalities.
Evaluating the use of taxation to correct externalities
Points
Evaluations
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Can simply explain how it works and that it reduces the externality as one benefit
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For negative externality - more tax so more tax revenue - can invest into improving areas or reducing budget deficit
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Depends on PED - if demand is inelastic then quantity will not change by much so there will be a very limited effect
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Increases black market usage and smuggling so there is no tax revenue at all while crime increases. This requires increased spending on security services e.g. police
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Effect on distribution of income - affects low-income groups more
Evaluating the use of subsidies to correct externalities
Points
Evaluations
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You can explain how the subsidy works to correct the externality for the first benefit
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Increased positive externalities so the society benefits more: positive spillover effects - increased producitivity (workforce might be more healthy) so they might end up making more money and producers might output more and make more money
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Cheaper than state provision
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Severe opportunity cost - the money could be used on state provision/investing into infrastructure
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State provision guarantees increased production, subsidies does not and govt then cannot control how much more is produced as it is dependent on market forces of demand and supply - producers might not increase production as there might not be a private benefit over a good with negative externalities (i.e. there might be more revenue potential or even lower costs of production)
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Producers might see the decreased cost of production and then see that as a reason to decrease efficiency or innovation or quality - no incentives to increase efficiency
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Depends on PED
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Producer might not spend the subsidy on production - they might spend it on dividends for stakeholders instead
Evaluating the use of state provision to correct externalities
Points
Evaluations
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Explain how it works
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Works better than subsidies (explained why above)
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Solves the missing market problem for public goods - a producer has no private benefit from a public good e.g. a streetlight as it is non-excludable and non-rivalrous so they will make no money - the government provides this so that people get these goods - the free market good would not provide them this otherwise
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Positive spillovers as the positive externality improves society ... (explained above)
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Costs a lot of money (more than subsidies) and uses tax revenue - budget deficit
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Opportunity cost as it could've been spent on improving infrastructure
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Depends on PED
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Demand almost always exceeds supply which leads to rationing or long waiting lists which reduces the quality of the good/service
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Inefficiency due to lack of profit motive
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Subsidies might be better as they are cheaper and also give the producer a profit motive
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Key Tip: The answer for both state provision and subsidies will be similar as they both correct positive externalities. Your first point can be explaining how they work and also their positive spillover effects, but then the evaluation can be the opportunity cost. Your second point can be why they are better than the other strategy, and the evaluation can be why the other strategy is better
Evaluating the use of information provision to correct externalities
Points
Evaluations
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If consumers know more about the good they will demand more/demand less (depends on whether good is merit/demerit) - then explain the chain of reasoning for how this leads to less/more consumption
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Cheaper so less budget deficit than state provision/subsidies
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Less effective as it is hard to spread the information far and wide to have an effect
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People rarely listen
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Other methods are more effective at correcting externalities e.g. legislation & regulation
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Depends on PED
Evaluating the use of legislation & regulation to correct externalities
Points
Evaluations
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Stops production/consumption and causes immediate behaviour change
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More effective than other methods
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Increased black market provision and crime so less tax revenue
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Needs investment into policing to make sure the legislation is carried out
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Key Tip: If you are ever stuck on a point or evaluation for any of these 5 strategies, you can explain why the strategy is better than others, or why other strategies might be more useful. Make sure you memorise these 6-markers, as externalities tends to come up every two years, and can sometimes come up in exams two years in a row!