Economics Essay Example, Market Failure: Positive Externality

Capitalist, who are inherently seeking for opportunities to maximize profit, advocated for laissez-faire or "free alone" markets. They anticipated a free economy in which businesses decide prices and quantities of goods without government involvement or any regulation. However, the capitalists failed to anticipate a situation where markets become inefficient by failing to account for entire benefits or costs as the result of utility or production processes. Market failure results in externalities. An externality results where the actions of one economic agent in the market impact on the utility or production possibilities of another agent yet the effect is not reflected in the marketplace (Just, Hueth and Schmitz, 2004). An externality results with improperly defined property rights so that there is a good created with no market (lack of maximized efficiency). There are two types of externalities; positive and negative. A negative externality occurs when the production cost does not account for the indirect costs born by those who suffer from the byproduct whereas positive externality results from goods enjoyed without incurring a cost. This paper examines positive externalities in detail in light of the role of social costs and benefits, private costs and benefits, the role government can play in correcting the externality, free-rider problem and how it can be corrected. Although markets do fail, they can result in positive externalities which are beneficial to the members of the society and the government should be involved to promote them.

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Understanding Positive Externality as a Result of Market Failure

The concept of positive externality was best explained by Meade (1952) who used the example of honey and apple producers. The author argued that the bees from the honey producers consumed nectar from the farm of the apple producers. However, the beekeepers did not compensate for the nectar consumed. Nectar was a private depletable good which was "unpriced" (Meade, 1952). The market, in this case, is considered inefficient because when calculating the private marginal cost of apple producer, the "unpriced" and unpaid fees for nectar consumed by the honey producer's bees. Nonetheless, this externality is considered positive because it improves or rather is crucial for pollination and production of apples.

Positive externalities can be divided into two; production and consumption. Positive production externality occurs when a producer enhances the well-being of others whereas the firm is not compensated. On the other hand, positive consumption externality results when a personal consumption enhances the well-being of others, but he or she is not compensated (Saez, n.d).

Social and Private Costs and Benefits

Activities undertaken by firms lead to costs and benefits for both the owners and the external stakeholders. A private cost is that is a charge for establishing the firm including the cost of machinery, wages, and others while a private benefit is the monetary benefits accruing to the owner from investment (Nas, 2016).

On the other hand, a social cost is the problems encountered by the external stakeholders as a result of the firm's activities such as air or water pollution whereas social benefit is the gain accruing to the external stakeholders as a result of the firm activities such as training leading to an individual establishing his or her own successful business and earning profit (Nas, 2016).

Therefore, positive externalities can lead to marginal private benefits (MPB), marginal social benefit (MSB) or marginal social cost (MSC). MPB is the direct benefits to the consumers as a result of consuming an additional unit of a product while MSB is the MPB to consumers including costs associated with consumption of a product that is imposed on others (Saez, n.d).

Positive Production Externality

A positive production externality arises where the external stakeholders gain but are not charged so that an incentive to supply such a product is driven by the incentive to serve those who are charged. Positive production externalities occur in many cases, for example, when setting up a new airport. A town may develop as a result of proximity to the airport and the landowners benefit from high rent as well as booming businesses.

Figure 1: Positive production externality

Quantity and price are such that MPB=PMC in free markets. Social optimum is given by MSB=MSC. In a positive consumption externality, the MSB curve lies below MBP. This occurs because, for example, the expenditures on the establishment of an airport leads to positive impacts on the business community around the area leading to MSC that is below the MPC as well as an optimum quantity (Q1) which is larger than the competitive market equilibrium quantity (Q). Underproduction (Q1-Q) denoted as welfare loss due to under provision of the service or product. Therefore, positive externalities lead to underproduction because of lack of an incentive to produce such as an increase in demand. Likewise, positive consumption externalities result in underconsumption (Saez, n.d).

Role of the Government in Correcting Positive Externalities

Positive externalities accrue occur across a wide range of crucial services for people such as in healthcare, education, roads, bridges, airports and social housing. Because these externalities benefit the citizens, the government has to find a way for compensating the firms that produce such services, and this can be done through free taxation, government grants and subsidies (Vorotnikova & Schmitz, 2013). For example, government subsidies or grants for an airport establishing firm encourages the owner by reducing production costs thus promoting the establishment of such a crucial service. Free taxation for education institutions reduces the cost paid for learning and encourages consumers to consume more. The government deems it necessary to subsidize education because it has positive impacts such as high productivity in the society which can stimulate economic growth.

Figure 2: Role of government in correcting positive externalities

In the graphical representation above, it is seen that the private sector would only be willing to produce an education quantity of Qa at a price of Pa as a point where profit is maximized. However, if the government subsidizes education and waives taxation for educational institutions, they will supply quantity Qb at a lower price of Pb, and it becomes affordable to many citizens (Shadhganga n.d).

Free Rider Problem and How to Fix

As the government intervenes to safeguard the positive externalities for its citizens, there is a further risk of those citizens taking advantage of free resources and even failing to pay their fair share of taxes, for example, free taxation for educational institutions.

The problem of free rider can be resolved through internalizing the externality (Saez, n.d). In this manner, the third party is made to pay for the benefits. For example, in the case of education, the students may be given a loan which they will repay after graduating. Even though such a loan may be long-term and attract less or no interest at all, it will increase literacy rates in the society and enhance productivity.

Trade-Offs as a Result Of Correcting for Positive Externality

As the government embarks on correcting for positive externalities, some tradeoffs have to be made. For example, in opting to subsidize education, the taxes that would have been collected from that sector are reduced. Also, the taxpayers' money will be used to subsidize education or in the form of grants instead of developmental or social benefits for the citizens.

Conclusion

Market failure is not always bad as it can result in positive externalities which benefit the members of the society. Positive externalities occur when the third party (members of the society) gain from production activities of a firm. However, positive externalities should be compensated by the government as a way of encouraging and motivating the firms to continue in their production activities for the benefit of the society. Government involvement in the economy leads to trade-offs for the public, but such tradeoffs are worthy the externalities accruing to society.

References

Just, R. J., Hueth, D. L., & Schmitz, A. (2004). The economics of public policy: a practical guide to policy and project evaluation. Elgar, Cheltenham.

Meade, J.E. (1952) External Economies and Diseconomies in a Competitive Situation. Economic Journal. 62: 54-67.

Nas, T. F. (2016). Cost-benefit analysis: Theory and application. Lexington Books.

Saez, E. (n.d). Externalities: Problems and solutions. 131 Undergraduate Public Economics. UC Berkeley. Retrieved March 03, 2018, from https://eml.berkeley.edu/~saez/course131/externalities1_ch05.pdf

Shadhganga n.d. Chapter 4 social cost and externalities. Retrieved on March 03, 2018, from https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=3&cad=rja&uact=8&ved=0ahUKEwj8yLb206DaAhUHKcAKHWILDGsQFgg0MAI&url=http%3A%2F%2Fshodhganga.inflibnet.ac.in%2Fbitstream%2F10603%2F26194%2F11%2F11_chapter%25204.pdf&usg=AOvVaw3246tnf1Kw7ajhoSW1uQx9

Vorotnikova, E., & Schmitz, A. (2013). On Positive Externality. In 2013 Annual Meeting, August 4-6, 2013, Washington, DC (No. 150462). Agricultural and Applied Economics Association.