Market Failure: Externalities

Study Notes

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

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

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 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

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

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

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

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 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

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