Market Failure Essay - Explain the Concept of Negative Externalities of Consumption

1.

a. Explain the concept of negative externalities of consumption.

Market failure is when resources are not located in an optimal manner and community surplus is not maximized. It happens when there is a lack of public goods, under-supply of merit goods, over-supply of demerit goods, or the existence of externalities.

An externality is when the production or consumption of a good or service has an effect upon a third party. A positive externality is when the effect is beneficial and there is an external benefit to add to the private benefits of the producer or consumer. A negative externality is when that effect is harmful and there is an external cost that must be added to the private costs of the producer or consumer to reflect the full cost to society. Marginal social costs (MSC) is the marginal private cost(MPC) plus or minus the external costs or benefits of production. Marginal social benefit (MSB) is the marginal private benefit plus or minus the external costs or benefits of consumption. If no externalities exist in a market, then the marginal social cost is equal to the marginal social benefit and there is maximum community surplus. However, if they are not equal, then there could be one of the four types of externalities, which are: negative externalities of production, positive externalities of production, positive externalities of consumption, or negative externalities of consumption.

A negative externality of consumption is when the consumption of a good or service has a negative effect upon a third party, such as cigarettes or noise pollution. The negative externalities of consumption produced make the marginal social benefits less than the marginal private benefits, and the private utility is diminished by the negative utility suffered by the third party.

A negative externality of consumption

For example, people who smoke cigarettes enjoy the private benefits of smoking, but this creates external costs for people around them. This may include the discomfort from the smell of the cigarettes, lung cancer, bronchial illnesses, and asthma. However, because there is a free market, consumers will maximize their private utility (benefit) and consume at the level where MSC =MPB. They will over consume cigarettes by smoking Q1 cigarettes at the price of P1. The socially efficient output is at Q*, so there is over-consumption of Q1 to Q*. Since MSC is greater than MSB for these units, there is a welfare loss to society and a market failure.

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