NTPC SCHOOL OF BUSINESS

PROGRAMME NAME: PGDM (Executive)

COURSE TITLE: ENERGY ECONOMICS
Faculty Name: Dr. Abhinav Jindal, PhD (Economics) IIM Indore
Email: [email protected]

Lecture Notes

Sessions 4: Market Failure, public goods and externalities.

• Markets do many things well (invisible hand, efficient allocation), but they do not
do everything well.
• Market outcomes are not always efficient, and governments can sometimes
remedy market failure.

4.1 Externalities

• Market failure
• An externality arises when a person engages in an activity that influences the well-
being of a bystander but neither pays nor receives compensation for that effect.
• Adverse effect (spillover costs): Negative externality
Beneficial effect (spillover benefits): Positive externality.
• In the presence of externalities, society’s interest in a market outcome extends
beyond the well-being of Bs/Ss who participate in the market to include the well-
being of bystanders who are affected indirectly.
• Market equilibrium fails to maximize the total benefit to society as a whole.
• Examples:
Sl. Externality Positive/Negative Policy action for
No. internalizing externality
1. Vehicular pollution Negative Tax, emission norms
2. Industrial effluents Negative Tax, effluent norms
3. Restoration of historic Positive Preventing the
buildings destruction of historic
buildings and by
providing tax breaks to
owners who restore them
4. Barking dogs Negative Illegal activity
5. Research in new Positive Patent system
technologies (technology
spillovers)
6. Vaccination Positive Vaccine passports,
Subsidy
7. Education Positive Subsidy, scholarship
• Internalizing an externality involves altering incentives so that people take account
of the external effects of their actions.
4.1.1 Negative externalities

• In the presence of a negative externality, the social cost of the good exceeds the
private cost.
• They lead market to produce a larger quantity (QMarket) than is socially desirable
(Qptimum), i.e., QMarket > Qptimum.
• They cause the socially optimum quantity (Qptimum) in the market to be less than
the equilibrium quantity (QMarket), i.e., QOptimum < QMarket.
• Demand side market failure.
• Graphical illustration of equilibrium for steel production without and with negative
externalities (pollution)

Fig. 1(a) Market equilibrium for steel (w/o E) & Fig. 1(b) Social optimum for steel market (w NE)

Market equilibrium for steel without Externalities (see Fig 1(a))

Demand curve for steel reflects value of steel to consumers, measured by prices they
are WTP. At any given quantity, height of the demand curve shows the WTP of the
marginal buyer (i.e., it shows the value to the consumer of the last unit of steel bought).
Supply curve reflects costs of producing steel. At any given quantity, the height of the
supply curve shows the cost to the marginal seller (i.e., the cost to the producer of the
last unit of steel sold).
The equilibrium quantity, QMarket, maximizes the total value to buyers minus the total
costs of sellers. In the absence of externalities, the market equilibrium is efficient.
Social optimum for steel with negative externalities (see Fig 1(b))

Now we consider a case when steel industries emit pollution (negative externality).
Because of this externality, the cost of producing steel to society as a whole exceeds the
 cost incurred by the steel producers. The social-cost curve is above the supply curve
because it takes into account the external costs imposed on society by steel production.

Social cost= Cost of producing steel (private cost) + cost to bystanders (external cost)
The planner would now choose the level of steel production at which the demand curve
crosses the social-cost curve, which determines the optimal amount of steel from the
standpoint of society as a whole.
Thus, reducing steel production and consumption below the market equilibrium level
raises total economic well-being.

• Internalizing the externality: By taxing the producers.

To achieve the optimal outcome, steel producers can be taxed (the amount equal to
external cost) so that the new supply curve coincides with the social cost curve and the
steel producers would produce socially optimal quantity of steel.

4.1.2 Positive externalities

• Example: Education
• In the presence of a positive externality, the social value of the good exceeds the
private value of the good.
• They lead markets to produce a smaller quantity (QMarket) than is socially
desirable (Qptimum), i.e., QMarket < Qptimum.
• They cause the socially optimum quantity in the market (Qptimum) to be greater
than the equilibrium quantity (QMarket), i.e., QOptimum > QMarket.
• Supply side market failure.
• Graphical illustration of equilibrium with positive externalities (education)

Fig. 2: Social optimum for education with positive externality

 The demand curve does not reflect the value to society of the good. Because the
social value is greater than the private value, the social-value curve lies above
the demand curve. The optimal quantity is found where the social value curve
and the supply curve intersect. Hence, the socially optimal quantity exceeds the
quantity that the private market would reach on its own.

• Internalizing the externality: By subsidy and scholarships.

To move the market equilibrium closer to the social optimum, a positive
externality requires a subsidy. Education is subsidized through public schools
and government scholarships.

4.2 Different kinds of goods

• Most goods in our economy are allocated through markets, in which Bs pay for what
they receive and Ss are paid for what they provide. For these goods, prices are the
signals that guide the decisions of Bs/Ss, and these decisions lead to an efficient
allocation of resources. When goods are available free of charge, however, the
market forces that normally allocate the economy’s resources are absent.
• When a good does not have a price attached to it, private markets cannot ensure
that the good is produced and consumed in the proper amounts. In such cases,
government policy can potentially remedy the market failure and increase economic
well-being.
• Excludability: If people can be prevented from using a good, the good is excludable.
Rivalry in consumption: If one person’s use of a unit of a good reduces another
person’s ability to use it, the good is rival in consumption. If one person’s use does
not diminish another person’s use, the good is not rival in consumption.

• Private goods: Excludable & rivalrous

Public goods: Non-excludable & non-rivalrous
Common (property) resources: Non-excludable & rivalrous
Club goods: Excludable & non-rivalrous

Excludable Non-Excludable
Rival Private Goods Common resources
• Ice cream • Fish in the ocean
• Clothing • The Environment
• Congested toll roads • Congested non-toll roads

Non-Rival Club Goods (Natural monopoly) Public Goods

• Fire protection • National defense
• Cable TV • General knowledge
• Uncongested toll roads • Uncongested non-toll roads

Fig. 3: Four types of Goods

• Markets work best for private goods. Markets do not work as well for other types of
goods.
 • Both for public goods and common resources, externalities arise.
Public good → positive externality (National defense)
Common resources → negative externality (Fish in the ocean)

4.2.1 Public Goods (gives rise to free rider problem)

• Free rider: A person who receives the benefit of a good but avoids paying for it.
• Because people would have an incentive to be free riders rather than ticket buyers,
the market would fail to provide the efficient outcome. Therefore, govts usually
provides for public goods.
• Because public goods are not excludable, the free-rider problem prevents the
private market from supplying them. The government can remedy the problem. If
the government decides that the total benefits of a public good exceed its costs, it
can provide the public good, pay for it with tax revenue, and potentially make
everyone better off.
• E.g. Firecrackers in a residential colony
500 residents, INR 10/resident value on experience of viewing firecrackers.
Cost of firecrackers= INR 1000
Even though the fireworks display is socially desirable (as benefits exceed costs), it is
not profitable (as external benefits are not considered as it is not being paid by
others who watch it), and therefore person will make a privately rational but socially
inefficient decision not to put on the display.
By raising taxes by INR 2 and sponsoring the fireworks, the benefit of each resident
will be INR 8/resident.
• Governments can improve the allocation of resources by providing public goods and
deciding the quantity of each good using cost–benefit analysis (CBA).
• The efficient provision of public goods is intrinsically more difficult (through complex
CBA) than the efficient provision of private goods (through price signals of market).

4.2.2 Common resources (gives rise to tragedy of the commons problem)

• When one person uses a common resource, she diminishes other people’s
enjoyment of it.
• Because of this negative externality, common resources tend to be used excessively.
• Common grazing land, environmental degradation.
• The government can limit the use of common resources by devising regulations
(regulate the no. of sheep) or taxes (taxing sheep). Alternatively, the government
can sometimes turn the common resource into a private good (dividing land &
fencing).

Example: Roads

Non toll roads: Public goods/Common resources

Uncongested non toll roads: Public goods
Congested non toll roads: Common resources
 Non toll roads: Public goods/Common resources
Uncongested toll roads: Club goods
Congested toll roads: Private resources

Takeaways:

• Negative externalities lead markets to produce a larger quantity than is socially

desirable. Positive externalities lead markets to produce a smaller quantity than
is socially desirable.
• To remedy the problem, the government can internalize the externality by
taxing goods with negative externalities and subsidizing goods with positive
externalities.

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Objective: Are there situations where markets fail due to externalities? To understand and
analyse the problems in provision of public goods.

Learning Outcomes?