Market Failure

The big picture

Figure 1. Water pollution.

Credit: Smithore Getty Images

Up to this point, we have worked on the assumption that the market will naturally reach
its optimum production levels and make the most efficient use of its resources as long as
we don't interfere with it; when the market is left to the forces of demand and supply, the
market will tell us What to produce?, How to produce? and For whom to produce? in the
most efficient way.

However, this is not always true in the real world as markets are not perfect systems.
There are a number of factors that prevent markets from allocating resources in the
optimal manner from society's point of view. When this happens we call it market
failure.
Figure 2. Deforestation.

Examples of market failure are: when a production process pollutes the air or the
water; when people consume goods that are harmful for them and the rest of society, such
as cigarettes and drugs; when the current generation exploits or depletes resources so that
they won't be available to future generations; when firms do not provide those goods and
services that everybody should have access to because their production does not generate
a profit for them; and so on.

When markets fail, governments are expected to intervene to try to correct that failure.

In this subtopic we will look into the reasons why markets might fail and the different
possible options that governments have to try to correct each situation.
Types of market failure
In the section Market Efficiency, we saw that when a market is in equilibrium, with no
external disturbances, it is said to be in a state of allocative efficiency. This means that
the resources are allocated in the most efficient way, from that society's point of view.

Figure 1. Consumer surplus and producer surplus.

 

When the price of a good adjusts to make the quantity demanded equal to the quantity
supplied, the equilibrium quantity reflects the optimal (best) allocation of resources to the
production of such good, maximising community surplus.

However, in reality, the free market fails to achieve this desirable situation for a variety
of reasons. For example, it might be that the private costs of production of a good do not
represent the social costs of production, or that the personal benefits gained from
consuming a good does not benefit the society as a whole. 

The market equilibrium shown in Figure 1, where  D = MSB = S = MSC, is not achieved
when the market fails because either D ≠ MSB or S ≠ MSC.
 

Definition
Market failure refers to the market failing to allocate resources efficiently because too much or too
little of a good or service is produced or consumed from the society's point of view. This happens
when an external effect or circumstance prevents the condition MPB = MSB = MPC = MSC from
being met.

Important

Remember that:

 The marginal private cost (MPC) refers to the cost for firms to produce one more unit

of a good. 
 The marginal social cost (MSC) refers to the cost for society when one more unit of a
good is produced. 
 The marginal private benefit (MPB) refers to the benefit to consumers of
consuming one more unit of a good. 
 The marginal social benefit (MSB) refers to the benefit to society when one more unit
of a good is consumed. 

Lack of public goods

Figure 2. Traffic lights.

Public goods are goods that would not be provided at all in a free market but which are
necessary and beneficial to society. Because the market would not provide these goods
without intervention, this is an example of market failure.

There is debate around what is considered a public good and what is not. Public
goods are not called 'public' because they are provided by the government, but because
they have certain intrinsic characteristics which results in a lack of them with no
government intervention in the market.

To understand what a public good is, it is useful to consider what private goods are. A

private good has two characteristics:

 It is rivalrous. This means its consumption by one person reduces its availability
to someone else. For example, beverages, pencils and clothes are rivalrous,
because when you buy one, another person cannot buy the same one. Most goods
are rivalrous.
 
 It is excludable. This means it is possible to exclude others from using the good
once it has been provided, because you have to pay for the good to use or consume
it. Again, most goods are excludable.

Definition

Public goods are goods and services that are simultaneously non-rivalrous and non-

excludable. They would not be provided by private firms in a free market as no private individual
would pay for them because of the free rider problem (see below).

A good is said to be non-excludable if it is impossible to stop other people from

consuming it once it has been provided even though you have paid for it. A flood barrier
is a good example to understand this concept. If someone privately constructs a flood
barrier to protect his house, other people might also be protected by it and gain the
benefit without having paid anything. This is known as the free rider problem. 

The free rider problem exists because no one is willing to pay for a good or service
when there is hope that somebody else will pay for it. This is why the good will not be
provided by the free market.

A good is said to be non-rivalrous if one person consuming it does not prevent someone
else from consuming it as well. As we said previously, most goods are rivalrous because
once one person has consumed the good, it cannot be consumed by someone else; for
example, once you have eaten an ice cream, no one else can eat that same one. 
Public goods are non-excludable and non-rivalrous because if one person consumes the
good, such as street lights, it does not prevent another person from using it as well – even
at the same time. You cannot keep the benefit of consuming the good all to yourself once
it has been provided. This means there is little incentive for a private individual to pay for
the good herself if other people can then consume it as well for free.
 

Be aware

A good must be both non-rivalrous and non-excludable for it to be a public good. If it has

only one of these characteristics then it is not a public good. It is difficult to find products that exhibit
these two characteristics perfectly. Even a traditional public good such as a lighthouse has the
potential to be excludable, for example, if the cost of providing the lighthouse is built into the docking
fees at the nearest port. Goods that partially exhibit the two characteristics are referred to
as quasi public goods. For example, a park or a highway.

Governments tend to intervene in such markets to reduce or eliminate the market failure.
The government will provide the goods and services that private firms won't provide, or it
will subsidise private firms to do so, covering all associated costs and then charging
consumers through taxes. 

Table 1 shows advantages and disadvantages to government provision of public goods.

Table 1. Advantages and disadvantages to government provision of public goods

Advantages of government provision Disadvantages of government provision

Improves social welfare as consumption is Has to be financed which generates an opportunity cost
increased

Eliminates the free rider problem Government provision may not be economically efficient
as the government is unable to determine the optimum
output

Could be more efficiently provided as the Some quasi-public goods, like highways, could be
government, as the sole provider, can achieve provided more efficiently by private firms
economies of scale
Lack of merit goods

Figure 3. Education, one of the most important merit goods.

Merit goods are goods that will be under-consumed by the market as consumers do not
appreciate the benefits to themselves and society of their consumption. As a result they
are under-provided by the market because firms are profit driven and will only produce
goods and services for consumers who can pay for them. 

As these goods will be under-consumed, they will be under-provided with respect to the

socially optimum amount, and so they are a market failure.

Merit goods are goods that are considered beneficial to both the individual and society as
a whole, as in the cases of education and healthcare. As governments think that these
goods should be consumed to a greater degree they will tend to provide them directly
or subsidise private firms to do so, increasing the supply and making them more
affordable.
 

Definition

Merit goods are goods that are beneficial to the individual and society as a whole, and are usually
under-provided in a free market.

Be aware

All public goods are merit goods, but not all merit goods are public goods.
Oversupply of demerit goods

Figure 4. Alcohol consumption, a demerit good.

Demerit goods are goods that will be over-consumed and therefore over-provided by

the market for the same reason that merit good will be under-provided: consumers do not
appreciate the costs to themselves and society of their consumption. Firms are profit
driven and the market will produce and consume based on the forces of demand and
supply.

As they will be over-consumed, they will be over-supplied with respect to the socially

optimum amount, so they are a market failure.

Demerit goods are considered to be harmful for both the individual and society as a
whole, as in the cases of cigarettes, illegal drugs and alcohol. As governments think that
they should be consumed to a lesser degree, or not consumed at all, they will tend
to reduce or attempt to eliminate supply and/or demand.
 

Definition

Demerit goods are considered harmful to the individual and society as a whole, and are usually
over-provided in a free market.

Existence of externalities
When a consumer buys and consumes a good, he benefits from it or is satisfied by it.
When a firm produces a good to be sold, it incurs costs. When these benefits or costs are
passed on to those who are not involved in producing or consuming that particular good,
it is called an externality.
 
Definition

An externality occurs when the production or consumption of a good or service has an effect on a

third party. If the effect is harmful we call it a negative externality. When the effect is beneficial we
call it a positive externality.

Externalities can result either from consumption of goods and services or from
production of goods and services, and they create a gap or difference between the MPC
and the MSC or between the MPB and the MSB. When there is an externality the free
market leads to an outcome where MPB is equal to MPC (MPB = MPC), but MSB
is not equal to MSC (MSB ≠ MSC), and therefore to allocative inefficiency.

Throughout the next sections we will analyse four types of externalities:

1. Negative externalities of production.

2. Positive externalities of production.
3. Negative externalities of consumption.
4. Positive externalities of consumption.

Important

 All negative externalities (of production and consumption) create external costs. When

there is an external cost MSC > MSB at the equilibrium point of the market.
 
 All positive externalities (of production and consumption) create external
benefits. When there are external benefits MSB > MSC at the equilibrium point of the
market.
 
 All production externalities (positive and negative) create a divergence between
private and social costs (MPC ≠ MSC).
 
 All consumption externalities (positive and negative) create a divergence between
private and social benefits (MPB ≠ MSB).
Negative externalities of
production

Figure 1. Air pollution caused by harmful emissions from factories.

When the production process of a good or service generates a negative effect on a third
party or on society as a whole, we say that there is a negative externality of production.

This usually happens when there is a negative impact on the environment caused by a
good being produced. For example, air or water pollution as a result of the production
process, loud noises generated while producing, or any other negative side-effects of
production activities.

Any negative effect on third parties caused by production that has not been part of the
decision-making process is considered a negative externality of production.
 

Definition

A negative externality of production is a situation where the production of a good or

service generates a negative effect on a third party or society, which has not been part of the
decision-making process of producing such good.
Figure 2. Production of steel while polluting the air.
              

When this happens, the marginal social cost of production (MSC) is greater than the
private cost of production (MPC), as firms do not take these extra costs into
consideration when deciding how much to supply at each price level.

This results in a greater amount produced of the good than the socially optimum amount,
and therefore an over-allocation of resources to the production of such good from the
society's point of view.

Look at the example in Figure 2. It shows the situation of a firm that pollutes the air
when producing steel.

Through the forces of demand and supply, only taking into consideration the firm's
private costs of production (MPC) and the private benefit of consumption (MPB), the
market will end up producing at the point where the quantity supplied is equal to the
quantity demanded of steel, 'Q1'.
 

Be aware
Because this type of externality involves only the production side of the market (the supply curve),
the demand curve represents both the marginal private benefit (MPB) and marginal social benefit of
consuming the good (MSB), i.e. MPB = MSB.

As seen in Figure 2, if the air pollution generated while producing steel is considered, the
total cost of production for society ('MSC') is greater than the private cost ('MPC'), for
every level of output. The vertical difference between 'MSC' and 'MPC' represents the
externality.

The optimum amount of steel produced, from the society's point of view, should be at the
point where the MSC curve crosses the demand curve (the MSB curve), at 'Q*'.

As the cost of producing steel is greater for society than for the private firm, the market
outcome results in a greater amount of steel produced than what should be produced if
the total social costs of production were taken into consideration, i.e. if the pollution
caused by the firm is not internalised (see Possible Solutions, below, for more on
internalisation). 
 

Important

When there is a negative externality of production, the amount produced is greater than what it

should be, from the society's point of view. Therefore, more resources are allocated to the
production of this good, than what is optimum for society. The market over-allocates resources to
the production of the good.

In the example of steel, society produces an amount Q1 > Q* and sells it a lower price,
P1 < P*. Therefore, there is an inefficient allocation of resources from the society's point
of view and a welfare loss – i.e. the amount of welfare society loses through allocative
inefficiency – is shown by the yellow shaded triangle in Figure 2. All of the units
produced from 'Q*' to 'Q1' have a higher cost for society than the benefit they bring to it
(MSC > MSB). This is why it is a market failure.
 

Exam Tip

Students usually confuse the position of the MSC curve with respect to the MPC curve.

Remember that a 'higher social cost' means a 'lower socially optimum supply curve' and therefore
the MSC should be above the MPC, i.e. to the left of the MPC.

Possible solutions
Figure 3. Solutions to negative externalities of production.
 

In a free market these negative externalities of production would continue to exist

because firms are profit maximisers and will only take their private costs of production
into account. However, there are several possible ways in which the government can
intervene to solve or reduce the externality.

To 'solve the externality', in this example, means to eliminate the welfare loss by

reducing the quantity produced of the good until 'Q1' reaches 'Q*'.

The solutions below aim to make the contaminating firms internalise – meaning

they absorb – part of the cost they are generating for society, or to prevent firms from
using polluting methods of production. This can be done through different options:

1. Imposing a tax on polluting firms.

2. Laws and legislation.
3. Tradable emission permits.

Imposing a tax on polluting firms

The government could impose a tax on the firm per unit of output produced, or a tax per
unit of pollutants emitted, to increase the private costs of production.

As seen in Figure 3, the tax results in an upward shift of the supply curve from 'MPC' to
'MPC + tax', nearer to the point of social efficiency. If the tax is equal to the external cost
of production, then the externality would be internalised. If not, although the
deadweight burden for society would be reduced, it would not be eliminated completely.
There is still a welfare loss, but it will be less than with no government intervention at all.

Problems with this solution:

 It is often difficult to measure the pollution created and put a value on it to

establish the amount of the tax.
 It is also difficult to identify which firms are polluting and to what extent each
firm is responsible for the pollution.
 Taxes make firms pay for the pollution they create but do not actually stop the
pollution from taking place.

Laws and legislation

The government could pass laws relating to environmental standards that firms must
comply with in the production process, such as using specific types of machinery, air
filters, water processes and disposal methods. To meet these standards a firm's cost of
production would increase, shifting the supply curve upwards as shown in Figure 3. 

In this case, the effect on the market outcome would be similar to the one of taxes as the
MPC would increase nearer to the MSC reducing the externality and, therefore, the
welfare loss for society. 

An extreme intervention could also be to ban polluting firms altogether. 

Problems with this solution:

 The ban or restriction may lead to unemployment in the corresponding market,

as jobs would be lost if firms are closed or the market reduced.
 Banning a firm would create non-consumption of the good that was being
produced, which might be a good necessary or desirable to consumers.
 The cost of setting and then enforcing the policy standards may be very difficult
to implement, and/or have a greater cost than the pollution itself.

Tradable emission permits

This type of solution was agreed upon in The Kyoto Protocol, made under the United
Nations Framework Convention on Climate Change, which came into force in February
2005. The objective was to reduce the global emission of greenhouse gases. In this
particular example, the agreement was between countries, but a similar procedure could
be applied to individual market cases.
The government sets the level of 'admitted pollution' per year and splits the 'permission to
pollute' into a number of tradable emission permits. These are allocated to individual
firms, which now have a quota of emissions that they are allowed to produce. Firms that
pollute less can sell their remaining quota to other firms who need to pollute more. This
is why they are called 'tradable'.
 

Definition

Tradable emission permits are a market-based solution to negative externalities of production,

also known as cap and trade schemes. They are permits issued by the government that give firms
the licence to create pollution up to a certain level. Once they are issued, firms can buy, sell and
trade them in the market. 

Problems with this solution:

 To start with, it is difficult to set an acceptable level of pollution.

 It is also difficult to measure a firm's pollution production in order to establish the
amount of permits per firm.
 Firms pay for the pollution they create but it does not lead to a reduction in
pollution once the allowed limit has been set.

 
Positive externalities of
production

Figure 1. Team of workers and engineer at production training.

Contrary to what we saw in the previous section, when the production process of a good
or service generates a positive effect on a third party or on society as a whole, this is
called a positive externality of production.

This usually happens when there is an external benefit to third parties when producing a
good. Examples are: when a firm engages in research and development and succeeds in
developing a new technology that then spreads throughout the economy; when firms train
their employees who later switch jobs and transfer their skills elsewhere; any other
positive side effect of production activities.

Any positive effect on third parties caused by production, which has not been accounted
for in the decision-making process, is considered a positive externality of production.
 

Definition

A positive externality of production is when the production of a good or service generates a

positive effect on a third party or society, which has not been considered in the decision-making
process of producing such good.
When this happens, the marginal social cost of production (MSC) is smaller than the
private cost of production (MPC), as firms are the ones who pay for the costs of
training, research and development, or any other costs while producing the good or
service, and not the society as a whole. 

Figure 2. Positive externality of production: employee training in the insurance industry.

 

This results in a smaller amount produced of the good than the socially optimum amount,
and therefore an under-allocation of resources to the production of such good, from the
society's point of view.

Figure 2 shows the example of a firm that invests in training its employees while
offering insurance services.

By the forces of demand and supply, taking into consideration the firm's private costs of
production ('MPC') and the private benefit of consumption ('MPB'), the market will end
up producing at the point where the quantity supplied is equal to the quantity demanded
of insurance policies, 'Q1'.
 

Be aware

As with the previous section, the externality discussed here involves the production side of the
market (the supply curve), and therefore the demand curve represents both the marginal private
benefits (MPB) and marginal social benefits of consuming the good (MSB), i.e. MPB = MSB.
As seen in Figure 2, as the cost of training is paid for by the private firm, the total cost of
production for society ('MSC') is smaller than the private costs ('MPC'), for every level of
output. The vertical difference between 'MSC' and 'MPC' represents the externality.

The optimum amount of insurance policies produced, from the society's point of view,
should be at the point where the MSC curve crosses the demand curve (the MSB curve),
at 'Q*'.

As the cost of production is greater for the private firm than for society, the market
outcome results in a smaller amount produced than what should be produced if the net
social costs of production were taken into consideration (private costs minus the external
social benefit this production generates). 
 

Important

When there is a positive externality of production, the amount produced is smaller than what it

should, from the society's point of view. Therefore fewer resources are allocated to the production of
this good than what is optimum for society. The market under-allocates resources to the
production of the good.

In the example of insurance, society is producing an amount, Q1 < Q*, and selling it a

higher price, P1 > P*. Therefore, there is an inefficient allocation of resources from the
society's point of view and the potential welfare gain – i.e. the maximum amount of
welfare society could gain if resources were allocated efficiently – is shown by the
yellow shaded triangle. All of the units not being produced from 'Q1' to 'Q*' have a lower
cost for society than the benefit they bring to it (MSC < MSB). This is why it is a market
failure.

Possible solutions
Figure 3. Solutions to positive externalities of production.

In this case, 'to solve the externality' means to gain the extra potential welfare for society
by increasing the quantity produced of the good until 'Q1' reaches 'Q*'.

The solutions now point to government motivating firms to invest more in those

production process side-effects that benefit society, or for government to invest in them
itself. This can be done in two different ways:

1. Subsidise firms.
2. Direct government provision.

Subsidise firms

The government could grant subsidies to the firms that invest in training or research and
development, thereby increasing the supply curve.

As seen in Figure 3, the subsidy results in a downward shift of the supply curve from
'MPC' to 'MPC – -subsidy' nearer to the point of social efficiency 'a'. As firms' costs of
production are reduced, they are willing and able to produce more at every price level,
and the society gains from the positive external benefits this production generates. In
turn, this reduces the potential welfare gain, i.e. the social welfare gained from this
production process has increased.

Problems with this solution:

 It is very difficult for the government to estimate the level of subsidy deserved by
every firm.
  Each subsidy uses government funds and therefore they have an opportunity
cost; the government would have to cut back on other expenditures that might
be important, such as healthcare.

Direct government provision

Governments often fund research and development into many areas, including new
technologies, medicine and pharmaceuticals. The government can also directly provide
training for workers by setting up training centres for workers in certain industries.

The effect on the market outcome would be similar to the effect of subsidies; the MPC
would shift outwards towards the MSC reducing the externality as the government would
pay for such investment, reducing firms' costs of production.

Problems with this solution:

 The cost for the government might be high and create an opportunity cost, as in
the case of subsidies.
 The government might lack the expertise found in firms, which are specialised in
their area of knowledge. 
 Private firms might be dissuaded from investing in these areas themselves
because of this government policy.

Negative externalities of
consumption
Figure 1. Car congestion in Istanbul.

In the previous sections we looked at externalities caused by the production side of the
market. Now, we will be looking into cases where the external effect on third parties is
caused by the consumption of a good or service. These are called negative
externalities of consumption.

This type of externality occurs when an individual's consumption of a good generates a

negative effect on third parties who were not factored into the decision to consume that
good. For example, when people consume goods like cigarettes around other people, the
non-smokers will be affected by the second-hand smoke; people also drive cars that
pollute the air for everyone, and when someone listens to very loud music it can cause
discomfort to others around them.
 

Definition

A negative externality of consumption is a situation in which the consumption of a good or

service generates a negative effect on a third party or society, which has not been considered when
deciding to consume that good.

Figure 2. Negative externality of consumption: market of petrol-run cars.

 
When this happens, the marginal social benefit (MSB) is smaller than the marginal
private benefit (MPB), as the benefit of the private use is diminished by the negative
impact suffered by the third party.

This results in a greater amount consumed of the good than the socially optimum amount,
and therefore an over-allocation of resources to the production of such good, from the
society's point of view.

Look at the example of the use of cars that produce carbon emissions, shown in Figure 2.

By the forces of demand and supply, only taking into consideration the individual's
private benefit of using cars ('MPB') and the cost of producing cars ('MPC'), the market
will end up producing at the point where the quantity supplied of cars is equal to the
quantity demanded, 'Q1'.
 

Be aware

When the externality is on the demand side of the market, and not generated by the production
process, the social and private costs of production are equal, i.e. MPC = MSC.

As seen in Figure 2, if the air pollution generated while consuming cars is considered,
the total benefit for society ('MSB') is lower than the private benefit ('MPB') for every
level of output. The vertical difference between 'MSB' and 'MPB' represents the
externality.

The optimum amount of cars consumed and produced from the society's point of
view should be at the point where the MSC curve crosses the MSB curve, at 'Q*'.

As the benefit to society is smaller than the benefit to the individual, the market outcome
results in a greater amount of polluting cars produced than what should be produced if the
total social costs of consumption were taken into consideration.
 

Important

When there is a negative externality of consumption, the amount of the good consumed is
greater than what it should be, from the society's point of view. Therefore, more resources are
allocated to the production (and thus consumption) of this good than what is optimum for
society. The market over-allocates resources to the production of the good.

In the example of cars, society is producing an amount Q1 > Q* and sells it at a higher
price, P1 > P*. Therefore, there is an inefficient allocation of resources from the society's
point of view and the welfare loss is shown by the yellow shaded triangle. All of the
units produced from 'Q*' to 'Q1' have a higher cost for society than the benefit they bring
to it (MSC > MSB). This is why it is a market failure.

Possible solutions

Figure 3. Possible solutions to negative externalities of consumption.

There are several possible ways in which the government can intervene to solve or reduce
this type of externality.

To 'solve the externality' in this case, like in the case of a negative externality of
production, means to eliminate the welfare loss by reducing the quantity consumed of the
good until 'Q1' reaches 'Q*'.

The solutions aim to make people aware of the risks associated with their consumption,
or to demotivate people from consuming the good by increasing the cost of the good
itself. This can be done through different methods:

1. Ban or regulate the good

2. Impose an indirect tax on the good
3. Negative advertisement

Ban or regulate the good

The government could directly stop the consumption of negative goods by making them
illegal. This would make the externality disappear completely as the good would no
longer exist on the market. Alternatively, the government could regulate the consumption
of the product by introducing legislation. For example, in the case of cigarettes, many
governments have restricted where people can smoke, have introduced uniform
packaging or have tightened up on who can buy cigarettes in an attempt to reduce
demand and shift the MPB closer to the MSB. 

Problems with this solution:

 This would have a large effect on the corresponding industry in terms of

shareholders and employment.
 It might have a big effect on the government's revenue as it would receive fewer
or no taxes from this market any more.
 Banning the good might cause a negative reaction from consumers if they
consider banning the good restricts their liberties and rights. This could have a
negative effect on the government's future election as consumers are also voters,
which makes it unlikely that governments will choose this option.
 Regulations will need to be enforced and this may impose an additional cost on
the government.

Impose an indirect tax on the good

The government could impose an indirect tax on the good itself to increase the private
costs of production and therefore the price of the good for consumers.

As seen in Figure 3, the tax results in an upward shift of the supply curve from 'MSC' to
'MSC + tax', which reduces the quantity demanded nearer to 'Q*', as the price in the
market increases from 'P1' to 'P2'. Because consuming the good has become more
expensive, people will tend to consume less of it due to the law of demand. 

Depending on the amount of the tax, the externality could be completely eliminated. If it
isn't there will still be a welfare loss, but it will be less than with no government
intervention.

On the other hand, the government will gain a revenue from the tax, which can be used to
correct or mitigate some of the negative effects caused by the consumption of the good.

Problems with this solution:

 When the good is addictive, such as cigarettes, its demand tends to be price
inelastic and an increase in price will not reduce the quantity consumed very
much. 
 If taxes are raised too much, consumers might look for other illegal sources of
supply causing black markets to appear.
  Taxes make people pay for the external cost they create but do not stop the
negative effect from taking place as there will still be people using or consuming
the good.

Negative advertisement

The government could provide education about the risks and dangers that consuming
these harmful goods has on others or to the consumer itself. Alternatively, the
government could fund negative advertising in order to reduce demand, as shown
in Figure 3. 

In this case, the demand curve would shift inwards closer to the MSB curve, thereby
reducing the externality and the welfare loss for society because less of the good would
be consumed.

Problems with this solution:

 The costs of these solutions might be high and generate an opportunity cost for
the government. However, if these goods were taxed as well then the revenue
generated could be used to fund these measures.
 There is always a level of doubt about how effective advertising is on reducing
demand, especially in cases such as cigarette consumption within certain age
groups. Many studies show that advertising does not have a great effect on
teenagers in reducing cigarette consumption.

Positive externalities of
consumption
Figure 1. Vaccines are an example of positive externalities of consumption.
 

When the consumption of a good or service generates a positive effect on a third party or

on society as a whole, we say that there is a positive externality of consumption.

This is the case of merit goods and any other good or service that has a positive side
effect on third parties when being consumed.

Education and health care are the most common examples that come to mind. When an
individual takes a vaccine, for example, he or she is not the only one who benefits from
its consumption. Vaccines prevent the individual consumer from getting sick, but this has
the secondary effect of preventing others from getting sick because vaccinations reduce
the spread of illness. 
 

Definition

A positive externality of consumption is when the consumption of a good or service generates a

positive effect on a third party or society, which was not considered during the decision-making
process.
Figure 2. Positive externality of consumption: health care services.
 

When this happens, the marginal social benefit of consumption (MSB) is greater than
the marginal private benefit (MPB), as the demand for the good or service does not
take into consideration the positive external effects it has on the society as a whole, but
only the benefits to the private individual that consumes it. 

This results in a smaller amount consumed of the good than the socially optimum
amount, and therefore an under-allocation of resources to the production of such good,
from the society's point of view.

Figure 2 shows the example of the market of health care services.

As with the other types of externalities, the market will produce and consume where the
demand is equal to the supply, only taking the private costs and benefits into
consideration. This will result in a quantity 'Q1' smaller than the socially optimum 'Q*'.
The MSB is greater than the MPB at every output level and therefore a potential welfare
gain is created, as shown by the yellow shaded triangle.

Once again we see that the market allocating resources in a way that does not agree with
the most efficient allocation of resources from the society's point of view is the reason
why this, too, is a market failure. The society would be better off if more of these goods
were consumed and therefore produced.
 

Important

When there is a positive externality of consumption, the amount consumed is smaller than what

it should be, from the society's point of view. Therefore, fewer resources are allocated to the
production of this good than what is optimum for society. The market under-allocates resources to
the production of the good.

Possible solutions

Figure 3. Possible solutions to positive externalities of consumption.

 

In this case, 'to solve the externality' means to gain the extra potential welfare for society
by increasing the quantity consumed of the good until 'Q1' reaches 'Q*'.

The solutions now point at the government motivating people to consume these goods.
This can be done using different methods:

1. Subsidise firms.
2. Direct government provision.
3. Positive advertisement
4. Legislate to make consumption compulsory.
Subsidise firms

The government could grant subsidies to firms that provide, for example, health care, and
in this way increase the supply curve.

As seen in Figure 3, the subsidy results in a downward shift of the supply curve from
'MSC' to 'MSC + subsidy', nearer to the point of social efficiency 'a'. As firms' costs of
production would be reduced, they would be willing and able to produce the good or
service at a lower price so that more people can afford it. The society would benefit from
the positive external benefits consumption of the good generates, therefore reducing the
potential welfare gain, i.e. gaining extra social welfare.

Problems with this solution:

 The main problem with this solution is the cost for the government. Each subsidy
uses government funds and therefore has an opportunity cost because the
government would have to cut back on alternative expenditures that might be
important.
 Another problem is that subsidies can generate production inefficiencies in
private firms because part of their revenue is guaranteed by the government.

Direct government provision

Governments often provide goods and services that have positive externalities of
consumption. These goods are usually free of charge to all consumers, as is the case with
state schools and public hospitals in most countries in the world. 

As we have seen, education and health care have such large and important benefits for
society as a whole that they cannot be left to the private sector alone. However, in most
countries where there is direct state provision of these services, there is also provision
by the private sector for those who are willing and able to pay privately for school or
healthcare. Although this can alleviate some pressure from public services (something
that features in the news media in most countries), private provision of such services can
also raise several questions about fairness, equal opportunities, social mobility and
quality of provision. 

The effect this has on the market is similar to the effect from subsidies; the supply curve
'MSC' (MPC = MSC) will increase, shifting downwards, therefore decreasing the price
and increasing the quantity consumed nearer to the socially optimum point 'Q*'.

Problems with this solution:

 The cost to the government might be very high and create an opportunity cost, as
in the case of subsidies.
  The government might be less efficient than private firms at providing these
services, and the quality of the good or service might not be as good. 
 Private firms might be dissuaded from investing in these areas because the
government will provide these goods or services anyway.

Positive advertisement
The government could educate people about the benefits to the consumer and others of
consuming such goods, or it could fund positive advertising in order to increase demand
towards the MSB curve, as shown in Figure 3. 

Problems with this solution:

 The costs might be high and generate an opportunity cost for the government, as
with any other government expenditure.

Legislation
The government could pass laws to make the consumption of these goods compulsory.
This is the case for education up to a certain age in many countries, and certain
vaccinations in some countries.

This solution increases the demand for the good or service (e.g. vaccines), shifting the
demand curve outwards towards the MSB curve, as in the case of positive advertising.
Ideally, it will shift until it reaches the MSB curve where 'Q*' is produced and consumed,
eliminating the externality as society gains the maximum potential welfare.

Problems with this solution:

 This solution will only be successful if the government provides the goods and
services free of charge.
 Some people might resent laws of this type if they see them as an
infringement of their civil liberties. 
 There is the additional cost of enforcing the law.