Market Failure: Worksheet on Pollution

Step 1 - The market gets a 'U' - it's failed! Why?

Free markets are the means used in a market economy to allocate resources. Prices go up or down depending on whether resources are plentiful or scarce. Firms supply goods according to how much it costs them to produce the good or service. The higher the cost, the less they will supply.

Show on the diagram below the effect of an increase in the firm's costs. Mark in the equilibrium price and quantity before and after the cost increase.

There are two different types of costs. Most of the costs are private costs. These are costs that the firm has to pay to produce. However, sometimes production also leads to external costs. These are costs that are paid by society, not by the firm. They are often known as negative externalities.

In the table below try to identify each of the costs as private or external costs.

cost	private or external? or Both?
Paying wages	Private
A worker has an accident with a faulty piece of machinery and has to be treated in hospital	Both
The cost of security to prevent equipment being stolen	Private
An accidental leak leads to fish being killed in a local river	External
Paying interest on a loan	Private
A lorry delivering the product has an accident with a car leaving the lorry needing repair	Private
Heavy lorries delivering to the factory cause damage to the road	External

When a firm is producing, will they take account of the external costs? No

Who pays for the external costs? Society (before the government begins to internalize the externalities)

The true or full cost of production should therefore take account of all costs - both private and external. The effect of this is to shift the supply curve as in the diagram above. Draw a new diagram on the axes below to show:-

• the demand curve
• the supply curve including just private costs
• the supply curve including private and external costs
• the equilibrium price and quantity the firm will produce
• the equilibrium price and quantity that the firm should produce if they account for the external costs

Should the equilibrium price be higher or lower taking account of the external costs? Higher

Should the equilibrium quantity be higher or lower taking account of the external costs? Lower

Why do we therefore consider external costs, where they exist, to be a market failure?
We consider external costs as a market failure as it leads to an overallocation of resources to a particular product; the external costs indicate that more products (which are yielding the external costs) are being produced than is socially optimal.

Step 2 - Polluting the atmosphere

Pollution is an external cost. What problems can be caused by pollution?
1) Worsening health conditions of citizens,
2) Global warming
3) Animal extinction (as the environment is destroyed)
4) Decreases aesthetic value of the environment (as nature is destroyed)

Will firms take account of this pollution as a cost? No.

Justify your answer.
The firms will not take account of this pollution as a cost because firms neglect external effects of their actions when they decide how much to supply. If they considered the external costs, their supply would shift inwards (from marginal private cost curve to marginal social cost curve), decreasing their quantity supplied while increasing their costs. As profit-maximizers, this is obviously not the firms’ most favorable scenario; thus, the firms will ignore the external costs.

Who therefore has to deal with the effects of pollution? The government

Step 3 - Help - what can we do?

What policy options are open to the government to deal with pollution?|
1) The Coase Theorem
2) Command-and-control policies: regulation
3) Corrective taxes
4) Tradable pollution permits

One way they might choose to try to deal with the problem might be taxation. Show the effect of a tax on the diagram below:-

To ensure the optimum outcome for society, how much must the tax be?
The tax should be enough to cover the external costs; in other words, the tax should be enough to shift the supply curve to where the marginal social curve should be.