Market failure

Externality = the spillover effect of an economic activity on a third party not directly involved in the transaction.

Key concepts:

• MPC = Marginal Private Cost — cost to the producer.
• MSC = Marginal Social Cost — cost to society.
• MPB = Marginal Private Benefit — benefit to the consumer.
• MSB = Marginal Social Benefit — benefit to society.

In a perfectly free market: equilibrium occurs where MPB = MPC. Social optimum requires MSB = MSC. When these diverge, the market FAILS.

Negative externality of PRODUCTION (e.g. factory pollution):

• MSC > MPC (extra social costs from pollution).
• Market produces too MUCH at too LOW a price.
• Welfare loss = triangle where MSC > MSB beyond social optimum.

Negative externality of CONSUMPTION (e.g. cigarette smoking affecting bystanders):

• MSB < MPB (society's benefit is less than the smoker perceives).
• Market consumes too MUCH.

Positive externality of PRODUCTION (e.g. R&D spillovers):

• MSC < MPC if we count broader benefits.
• Market produces too LITTLE.

Positive externality of CONSUMPTION (e.g. education, vaccinations):

• MSB > MPB (others benefit when you're educated/vaccinated).
• Market consumes too LITTLE.

Merit goods — goods with positive externalities AND information failure (people underestimate the private benefit). Examples: education, healthcare, vaccinations.

• Market UNDER-consumes them.
• Justifies subsidies, mandatory schooling, public health programmes.

Demerit goods — goods with negative externalities AND information failure (people underestimate harm). Examples: tobacco, alcohol, sugary drinks.

• Market OVER-consumes them.
• Justifies taxes, age restrictions, warning labels, education campaigns.

Common access resources (also called "commons" or "common pool resources").

• Non-excludable: hard to stop people from using them.
• Rival: one person's use reduces availability for others.

Examples: fish stocks, forests, groundwater, atmosphere.

Tragedy of the commons. Each user has an incentive to take more (private benefit), but the cost is shared across all users → over-use, depletion, ecosystem collapse.

Historic example: overfishing of cod in the North Atlantic (1990s collapse, never fully recovered).

Modern example: atmosphere as a carbon sink — countries individually benefit from emissions but the climate-damage cost is global.

Solutions:

• Government regulation — quotas, licences, protected areas.
• Property rights — give ownership (e.g. tradeable fishing quotas).
• International agreements — Paris Agreement, Antarctic Treaty.
• Community management (Elinor Ostrom, Nobel 2009) — local communities self-govern shared resources, often successfully.

Public goods — covered separately. Different from common access: public goods are non-excludable AND non-rival.