Market Failure: Externalities

Market Failure

Externalities

• Definition: Externalities occur when a transaction between two parties affects a third party who is not directly involved in the transaction.
• Types:
  • Positive externality: A beneficial effect on a third party, e.g., a beekeeper's bees pollinate nearby crops.
  • Negative externality: A harmful effect on a third party, e.g., pollution from a factory affecting neighboring residents.
• Examples:
  • Environmental pollution (air, water, noise)
  • Second-hand smoke
  • Noise pollution from airports
• Consequences:
  • Overproduction or underproduction of goods and services
  • Inefficient allocation of resources
  • Social welfare loss

Public Goods

• Definition: Goods and services that are non-rivalrous (can be consumed by multiple people without reducing their quantity) and non-excludable (difficult or impossible to exclude people from consuming).
• Characteristics:
  • Non-rivalry: Multiple people can consume without reducing the quantity.
  • Non-excludability: Difficult or impossible to exclude people from consuming.
• Examples:
  • National defense
  • Public parks
  • Street lighting
• Consequences:
  • Underproduction or lack of provision due to free-rider problem
  • Inefficient allocation of resources
  • Social welfare loss

Consequences of Market Failure

• Inefficient allocation of resources
• Social welfare loss
• Overproduction or underproduction of goods and services
• Inequitable distribution of goods and services
• Reduced economic efficiency
• Potential for government intervention to correct the market failure

Market Failure

Externalities

• Externalities occur when a transaction affects a third party who is not directly involved in the transaction.
• There are two types of externalities:
  • Positive externality: a beneficial effect on a third party, e.g., a beekeeper's bees pollinate nearby crops.
  • Negative externality: a harmful effect on a third party, e.g., pollution from a factory affecting neighboring residents.
• Examples of externalities include:
  • Environmental pollution (air, water, noise)
  • Second-hand smoke
  • Noise pollution from airports
• Consequences of externalities include:
  • Overproduction or underproduction of goods and services
  • Inefficient allocation of resources
  • Social welfare loss

Public Goods

• Public goods are non-rivalrous and non-excludable.
• Non-rivalry means multiple people can consume without reducing the quantity.
• Non-excludability means it's difficult or impossible to exclude people from consuming.
• Examples of public goods include:
  • National defense
  • Public parks
  • Street lighting
• Consequences of public goods include:
  • Underproduction or lack of provision due to the free-rider problem
  • Inefficient allocation of resources
  • Social welfare loss

Consequences of Market Failure

• Market failure leads to:
  • Inefficient allocation of resources
  • Social welfare loss
  • Overproduction or underproduction of goods and services
  • Inequitable distribution of goods and services
  • Reduced economic efficiency
• Government intervention may be necessary to correct market failure.

Inflation

Causes of Inflation

• Excessive aggregate demand leads to higher prices due to demand-pull inflation
• Increase in production costs, such as higher wages or raw materials, leads to cost-push inflation
• Excessive growth in money supply leads to inflation through monetary policy
• Supply shocks, like natural disasters or global pandemics, disrupt supply chains and lead to higher prices

Effects of Inflation

• Inflation redistributes wealth from fixed-income earners to borrowers
• Inflation creates uncertainty, making it difficult for businesses to make long-term plans
• Inflation exacerbates income inequality, benefiting those who own assets that increase in value

Monetary Policy and Inflation

• Central banks use monetary policy tools to control inflation
• Inflation targeting involves setting an inflation target and adjusting monetary policy to achieve it

Hyperinflation

• Extreme inflation rates exceed 50% per month, rendering the currency nearly worthless
• Causes of hyperinflation include excessive money printing, fiscal policy mistakes, and supply shocks
• Hyperinflation leads to currency devaluation, economic collapse, and loss of savings

Deflation

• Deflation is a sustained decrease in the general price level of goods and services over time
• Causes of deflation include decreased aggregate demand, improvement in productivity, and increased productivity
• Effects of deflation include increased debt burden, reduced spending and investment, and potential for deflationary spiral

Fiscal Policy and Inflation

• Increased government spending can stimulate economic growth but may lead to inflation if excessive
• Taxation can reduce aggregate demand, helping to combat inflation
• Fiscal discipline helps maintain low and stable inflation through a sustainable fiscal stance