The Issue of Externalities, Its Implications and Market Failure in the Economy

The Issue of Externalities, Its Implications and Market Failure in the Economy

"The word externalities were created by Arthur Cecil Pigou (1877-1959), which was developed earlier by fellow English economists Henry Sidgwick (1838-1900) and Alfred Marshall (1842-1924) into an important feature of modern economic theory." (1)

In a market economy this generally means that an externality occurs where there is a direct effect of the actions of one person or firm on the welfare of another person or firm in a way which is not transmitted by market prices. This externality can arise from the effects that consumption of an item by one consumer may have on the welfare of others or from the effects that the production of one product may have on the production possibilities of others. As a result, in a competitive market too much or too little of the good will be consumed from the point of view of society.

Two types of externalities exist, positive externalities and negative externalities.

"Positive externalities exist when the marginal social benefit (MSB) of production and or consumption exceeds the marginal private benefit (MPB) i.e. production and/or consumption generate external benefits that may go under-valued by the market. Examples include industrial training by firms, research by companies into new technologies, education and etc." (2)

For instance on 16 Jun 2004, entomologists have described and named over 1,000,000 species of insect. In the UK it was estimated that the value of the pollination services provided by honey bees and bumble bees was around £170 million for outdoor crops (fruit, oil seed rape etc.) and £30 million for greenhouse crops (tomatoes, peppers etc). However, the populations of bees in the UK are in decline. Commercial bee operations have been hit by infestations of a tiny arachnid called the varroa mite. This mite has resulted in some bee keepers losing 90% of their hives. It's not good news for Britain's wild bees either. The decline of bee populations is so dramatic that the public are being asked to help, as part of National Insect Week." (3)

At places where substantial positive externalities exist, the good is under consumed or under provided as the free market fails to take into account their effects. This is because marginal social benefit of consuming the good is greater then marginal private benefit. In case of external benefits from production, the marginal social cost would be marginal private costs.