No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Thirteen: Market “Failure” and the Role of the Government 305 decreased utility since they can no longer swim in the river or eat the fish. If we look at the firm’s supply and demand curve in Figure 13.2 , we see that the producer will produce a quantity Q 1 at the market price (assume steel is a price taker market). This is because Stinky Steel does not internalize the externality (the external costs it imposes on others downstream). Stinky Steel management isn’t required to consider the costs that others suffer from its actions; therefore, they don’t. What would happen if somehow Stinky Steel did internalize the externality ; that is, what if they considered the external costs it imposed on others? Because these external costs are subjectively borne by others downstream, Stinky Steel can’t know how much costs should increase. But since those downstream face some positive costs, Stinky Steel’s supply curve would shift left (how far, we really don’t know), but conceptually it must move left, as in Figure 13.3 . This will result in a decrease in the quantity of steel that Stinky Steel brings to the market. Since it is in a price taker market, the price would not change. Recall from our discussion on price takers that they are a small player in a large market selling identical products, so the demand curve they face is horizontal: they have to take the price the market will pay. What do we conclude from this? In the presence of negative externalities, market outcomes will lead to higher quantities produced than is socially optimal. It is worth repeating: we cannot know how much more. We can’t have a central planner “know” the appropriate amount to produce to optimize a social welfare function, but we can recognize that it must be something less thanmarket quantities in the presence of negative externalities. In this limited sense, markets can be said to “fail” to produce the socially efficient amount. FLOWER POWER! Let’s consider the other side of the coin: when markets produce less than would be desired if everyone’s values (not just the market participants) were taken into account. In Figure 13.4 you see a picture of beautiful flowers that are planted in one of my neighbors’ yards. This neighbor does not have any idea how much I enjoy looking at them when I walk past his house, nor does he plant flowers to make me generally happy. Perhaps he has an abstract idea that he wants to make his house “look nice” to others, and planting flowers P ($) S 1 Q 1 P 1 Stinky Steel Market Q (#) D Figure 13.2, Steel Market without Regulation. When Stinky Steel considers only their own opportunity costs of production (the value of all the resource costs of production, including labor, materials, and the use of owner’s capital and time), they will produce according to the supply curve illustrated above. P ($) S 1 Q 1 Q 2 P 1 Stinky Steel Market Q (#) S 2 D Figure 13.3, Steel Market with Regulation. When Stinky Steel considers the external costs it imposes on others in calculating its costs (either by its own good behavior or government regulation), it will reduce its supply and the supply curve will shift left. Externality: a cost or benefit to a 3rd party who is not part of a market transaction.