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

Chapter Thirteen: Market “Failure” and the Role of the Government 306 is a part of that. But in any case, he doesn’t attempt to find out whether more flowers would make me even happier. And even if he does, I have other neighbors who don’t plant any flowers—and I wish they would! Let’s call my neighbor Mr. Anderson. His demand for flowers to purchase for planting in his yard might look something like Figure 13.5 . In this case, Mr. Anderson faces a horizontal supply curve (in the range of quantities he is reasonably likely to purchase). He will have to pay the going market price, since his individual demand is highly unlikely to affect the overall market price for flowers. His demand curve will reflect the marginal utility of each additional basket of flowers, which declines as shown since each additional flower gives smaller and smaller increases in utility. But what would change if Mr. Anderson somehow took into consideration the benefits I receive when I walk by his house? What if he added my increase in utility to his own? In this case, his demand curve would shift (since he would add my benefit to his own benefit) and the flower output would look something like Figure 13.6 . As you can see, Mr. Anderson’s demand would increase when he internalized the externality , and the socially optimal quantity would increase from Q1 to Q2. So once again, we see that in the presence of externalities (in this case a positive externality ), the market result would not be socially optimal, and thus could be considered a market “failure.” Nevertheless we must once more repeat several caveats. To begin with, Mr. Anderson would have to overcome the transaction costs of determining what his neighbors want. Does he pay a firm to survey his neighbors to find out how much they like his flowers? Obviously not. Next, even if he gathered some information on his neighbors’ desires, he has no way of telling how much the demand curve should shift to the right; Mr. Anderson is not omniscient. Should he buy five more flowers, or fifty? Even if he knew all of his neighbors wanted him to purchase additional flowers, he would have no basis to compare their subjective increase in utility to his own. He could only know that they would prefer more flowers and that buying more would increase social welfare—but he wouldn’t know how much. This gets to the heart of the matter. Yes, markets can “fail” in the sense that we could imagine some superior result, with higher quantities of goods produced when a good yields a positive externality, and lower amounts of goods when there is a negative Figure 13.4, Flower as a Positive Externality. Homeowners don’t accrue all the benefits to the flowers they plant; neighbors walking by get to enjoy them, too. Photo by Megan Haymond. P ($) Q (#) Q 1 P 1 S 1 D 1 Figure 13.5, Mr. Anderson’s Flower Decision. When Mr. Anderson considers only his own enjoyment of flowers in his yard, he will purchase the quantity of flowers as above and pay the market price. Internalize the externality: when parties to any exchange include the costs and benefits that their actions impose (or provide) to others in their supply and demand schedules. Positive externality: A benefit to a 3rd party from a market transaction.