Market Failures External Costs and Benefits

In its broadest definitional sense, collective action is the enactment and enforcement of law. The justification for all collective action, for government, lies in its ability to make men better off.  This is where any discussion of the bases for collective action must begin.

James Buchanan

Howmuch should government involve itself in the marketplace? How much does business want government involvement.” These questions touch on one of the most important economic issues of our time: the division of responsibility between the public and private sectors. In general, economic principles would suggest that government undertake only functions that it can perform more efficiently than the market.  As we will see, businesses are not always opposed to government involvement in the economy. Indeed, many businesses have incentives to try to make sure that government is more involved in the economy than is “efficient.”

Economics provides a method for evaluating the relative efficiency of government and the marketplace. It enables the United States to identify which goods and services the market will fail to produce altogether, and which it will produce inefficiently. We saw in an earlier chapter that such market failures have three sources: monopoly power, external costs, and external benefits. Now, using the principles and graphic analyses developed in earlier chapters, we will take a closer look at external costs and benefits and at government attempts to capture them and correct market failures.  

In a competitive market, producers must minimize their production costs in order to lower their prices, increase their production levels, and improve the quality of their products. Consumers must demonstrate how much they will pay for a product, and in what amount they will buy it. In a competitive market, production will move toward the intersection of the market supply and demand These results cannot be achieved unless competition is intense, buyers receive all the product’s benefits, and producers pay all the costs of production.  If such optimum conditions are not achieved, the market fails. Part of the excess benefits shown by the shaded area in the figure will not be realized by either buyers or sellers. When exchanges between buyers and sellers affect people who are not directly involved in the trades, they are said to have external effects, or to generate externalities. Externalities are the positive or negative effects that exchanges may have on people who are not in the market. They are third-party effects.  When such effects are pleasurable they are called external benefits. When they are unpleasant, or impose a cost on people other than the buyers or sellers, they are called external costs. The effects of external costs and benefits on production and market efficiency can be seen with the aid of supply and demand curves. Producers may not bear all the costs associated with production, however.  A by-product of the production process may be solid or gaseous waste dumped into rivers or emitted into the atmosphere. The stench of production may pervde the surrounding community. Towns located downstream may have to clean up the water. People may have to paint their houses more frequently or seek medical attention for eye irritation. Homeowners may have to accept lower prices than usual for their property. All these costs are imposed on people not directly involved in the production, consumption, or exchange of the paper product. Nonetheless, these external costs are part of the total cost of production to society. In a perfectly competitive market, in which all participants act independently, survival may require that a producer impose external costs on others. An individual producer who voluntarily installs equipment to clean up pollution will incur costs higher than those of its competitors. It will not be able to match price cuts, and so in the long run may be out of business -- and some producers may not care whether they cause harm to others by polluting the environment. Even socially concerned producers cannot afford to care too much about the environment. Government dictates in educational institutions have sometimes imposed onerous costs on students. For instance, until the late 1960s, the University of Virginia had a dress code that required male students to wear coats and ties. Colleges routinely set the hours by which students should return to their dormitories and expelled those who rebelled. At the University of California, students were once forbidden to engage in on-campus political activity. Costs are imposed on those who must obey such rules. The more centralized the government that is setting the standards, the less opportunity people will have to escape the rules by moving elsewhere. In certain markets, government action may not be necessary. Over the long run, some of the external costs and benefits that cause market distortions may be internalized. That is, they may become private costs and benefits.  Suppose the development of a park would generate external benefits for all businesses in a shopping district. More customers would be attracted to the district, and more sales would be made. An alert entrepreneur could internalize those benefits by building a shopping mall with a park. Persuasion External costs arise partly because we do not consider the welfare of others in our decisions. Indeed, if we fully recognized the adverse effects of our actions on others, external cost would not exist. Our production decisions would be based as much as possible on the total costs of production to society. Thus government can alleviate market distortions by persuading citizens to consider how their behavior affects others.  Forest Service advertisements urge people not to litter or to risk forest fires when camping. Other government campaigns encourage people not to drive if they drink, to cultivate their land so as to minimize erosion, and to conserve water and gas. Although such efforts are limited in their effect, they may be more acceptable than other approaches, given political constraints. Persuasion can take the form of publicity. The government can publish studies demonstrating that particular products or activities have external costs or benefits.  The resultant publicity may in turn encourage those activities with external benefits and discourage those activities with external costs. The government has, for example, used this method in the case of cigarettes, publishing studies showing the external costs of smoking. Government production can be a mixed blessing. When other producers remain in the market, government participation may increase competition. Sometimes it means the elimination of competition. Consider the U.S. Postal Service, which has exclusive rights to the delivery of first-class mail.  As a government agency, the Post Office is not permitted to make a profit that can be turnover to shareholders. Because of its market position with little competition for home delivery of mail, however, it may tolerate higher costs and lower work standards than competitive firms. Some government production, such as the provision of public goods like national defense, is unavoidable. In most cases, however, direct ownership and production may not be necessary. Instead of producing goods with which externalities are associated, government could simply contract with private firms for the business. That is precisely how most states handle road construction, how several states handle the penal system, and how a few city governments provide ambulance, police, and firefighting services.