ALLOCATIVE EFFICIENCY

Under the assumptions of perfect competition and no externalities, the economic well-being of a society is measured as:

The sum of consumer and producer surplus.

The invisible hand is powerful but not omnipotent, which leads to market failure.

MARKET FAILURE

If a market system affects individuals other than buyers and sellers of that market, side-effects are created called Externalities.

» Externalities cause markets to be inefficient, and thus fail.

MARKET FAILURE

• Due to externalities, market equilibrium is not the socially desirable equilibrium.

• Market price and quantity is not the same as socially desirable price and quantity.

• The market (invisible hand) does not allocate resources efficiently (allocatively)

EXTERNALITIES

From Production and Consumption

EXTERNALITIES

• Unintended side effects or spillovers, both positive and negative, which affect a third party, caused by production or consumption.

• Externality =• Side-Effect• Spillover• External cost/benefit

EXTERNALITIES

• Caused by production• Positive or negative

• Caused by consumption

• Positive or negative

SOCIAL COST

• Social cost = total cost to society from production including any spillover effects.

• Private cost = cost to individual firm (MC)

• Social cost = MC + spillover cost or

• Social cost = MC – spillover benefit

SOCIAL BENEFIT

• Social benefit = total benefit to society from consumption including any spillover effects.

• Private benefit = benefit to individual consumer (MB)

• Social benefit = MB + spillover benefit or

• Social benefit= MB – spillover benefit

Negative externalities of production

External costs experienced by a third party caused by production. For example;

Air pollution – causes lung disorders, breathing discomfort and increased cleaning costs.

Noise pollution – causes hearing problems and the discomfort of loud noise.

Water pollution - causes unsafe drinking water, loss of fishing and recreational enjoyment.

Negative externalities of production

Q

Cost

Benefit

Price

$

MC

MSC The good is overproduced and underpriced in the market. Resources are mis-allocated. The market fails.

SpilloverCost per

unit

MB

Pm

Ps

QmQs

Positive externalities of production

• Firms planting trees or gardens create cleaner air and a more appealing look to the environment.

• A food shop might locate near a big firm and gain from the external benefits of more customers.

Positive externalities of production

Q

Cost

Benefit

Price

$

MSC

MC The good is underproduced and overpriced in the market. Resources are mis-allocated. The market fails.

Spilloverbenefit per unit

MB

Pm

Ps

Qm Qs

Negative externalities of consumption

• Cigarette smoke exhaled affects the health of others.

• Driving cars in the city pollutes the air as well as adding to traffic congestion.

• Planting trees, or building a house might interfere with others’ views.

Negative externalities of consumption

Q

Cost

Benefit

Price

$

MCThe good is overproduced and underpriced in the market. Resources are mis-allocated. The market fails.

MSB

MB

Spillovercost

per unit

QmQs

Pm

Ps

Positive externalities of consumption

• Going to an educational program such as defensive driving or first aid gives others a potential benefit in terms of fewer road accidents and urgent first aid when required.

• Using public transport means less air pollution for others and less traffic congestion.

Positive externalities of consumption

Q

Cost

Benefit

Price

$

MC

The good is underproduced and overpriced in the market. Resources are mis-allocated. The market fails.

MB

MSB

Spilloverbenefitper unit

Qm Qs

Pm

Ps