Chapter 5, Problem 5.1LO

To determine

How market failures resulting from externalities rationalize the economic functions performed by the government?

Explanation of Solution

Externalities can be of two types: positive externality and negative externality.

Positive externality involves an external benefit that the market fails to recognize. An excellent example of positive externality is education. Not only does the person getting educated benefit, but also the entire society as a result of one more educated person amidst them. 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 overcome through government intervention.

Negative externality 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. Taxes, by increasing the cost of production, and thereby this decreases supply. 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.

Economics Concept Introduction

Introduction:

Externality: This 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.