Chapter 5, Problem 5.1LO

To determine

:

To justify the economic functions of the government in case of market failures arising out of the problem of externalities.

Concept Introduction:

Externality: It refers to either a harm caused to or a benefit conferred on society by individuals or firms through their actions.

Market failure: It refers to a situation in which the market is unable to allocate resources optimally due to the presence of externalities.

Explanation of Solution

Answer:

Externalities are of two types: Positive externalities and Negative externalities.

Positive externality arises when the actions of an individual or a firm affects others in the society in a positive way. It involves an external benefit that the market fails to recognize.

An excellent example of positive externality is education. An educated person benefit the entire society.

The market tends to undervalue such a commodity that bestows external benefits on the society. As a result, suppliers are unwilling to produce sufficient quantities of it.

Therefore, there is suboptimal production. Thus, quite clearly, the market fails to allocate resources optimally to the production of a commodity with positive externalities. In such a situation, the government intervention is warranted.

Government can offer subsidies to encourage consumption of such a commodity. The resultant greater demand will push the price of the commodity up that, in turn, motivates the producers to allocate more resources and produce more of it. Thus, market failure is solved through government intervention.

Negative externality arises when the actions of an individual or a firm affects others in the society in a negative way. It involves an external cost that the market ignores.

An apt example of negative externality is pollution. Smoke and fumes emitted by factories result in air pollution that entails huge costs for the entire society in the form of respiratory problems.

The market overvalues such a commodity that imposes external cost on the society. As a result, suppliers are willing to produce more of such a commodity than what is desirable for the society. Thus, the market fails to allocate resources optimally to the production of a commodity with negative externalities.

In such a situation, government intervention is justified. Government can levy taxes to discourage production of such a commodity which will increase the cost of production.. As a result, the price of the commodity rises and motivates consumers to demand less of it. Thus, once again, market failure is overcome through government intervention.

Thus, market failures rationalize economic actions of the government.