The aspect of failure takes place when the marketplace is not able to offer the optimal output. In this aspect, the market provides a sub-optimal mix of services and goods. In essence, the understanding of the market failure concept is of great importance as there are instances when the government intervention is justified on economic considerations. It is worth noting that there are common courses that bring market failure, including inequality, monopoly power, public goods, and externalities.
An externality occurs if any activity by an organization or an individual, including production and consumption, affects another party that is not directly involved. In this case, the effect may be negative or positive for the third parties (Gottheil 272). Indeed, economists refer externalities to the unintended spillovers that are the result of economic activities.
Positive Externalities. Notably, positive externalities arise when business operations by an individual or organization benefit the uninvolved people. In fact, since those who produces the benefits are not paid for the positive externality they create for others, they produce very few of such activities. In this case, a good example would be when individuals increase their property; thus, they may end up encouraging their neighbors on creating a pleasing neighborhood which would boost the surrounding property values.
Negative Externalities. On the other hand, when negative externalities occur, they impose extra costs to the third parties without any compensation. For instance, factories and cars generate air pollution that otherwise affects the people’s health.
Policy Approaches for Dealing with Externalities
In fact, there are direct controls that the government can employ to reduce the effects of negative externalities. As such, the whole concept is to establish property rights that touch the sea, air, and the roads. Under those premises, the third parties can negotiate with organizations or individuals that create the negative externalities.
Another aspect is the use of specific taxation by the government to combat negative externalities. For instance, in the case of pollution, the government may initiate taxation to the polluters by establishing levies on carbon and plastic bags. In this case, car taxes for pollution make the owners employ the fuel-efficient strategies. Ultimately, the government would receive additional revenue through taxation that is aimed at reducing negative externalities (Mankiw 11).
Finally, there can be the use of subsidies and other government provisions in dealing with positive externalities. Indeed, the state may offer subsidies and grants to producers that generate a positive externality, hence encouraging them to produce more. In fact, subsidies, in this case, enhance the supply of merit goods and fund social housing, education, and healthcare sectors. For instance, when the tuition fee is subsidized, many young people will join the university; hence, such a tendency will produce positive externality for the future generations.
Optimal Reduction of an Externality
It is worth noting that the society must decide which externality it would like to reduce. In fact, the MC (Marginal Cost) to the society and the firm would bring the opportunity costs, As such, the extra resources that will be used as an externality will be reduced more and more. In essence, the Marginal Cost may increase to a point where it exceeds Marginal Benefit of the society while abating the negative externality such as pollution. Therefore, the optimal reduction of an externality as exemplified by Equilibrium Quantity, MB, and MC occur when the MB and MC of the society are at balance. However, the equilibrium values may shift over the time, especially when there are changes in technology or when the society “wants” to affect the Marginal Benefits towards further reduction of a negative externality.