With the help of a diagram, assess the view that government intervention can be used successfully to correct market failure caused by positive externalities. [20]
Positive externalities or spillover effects, occurs when the actions of consumers or producers give rise to benefits on other people who are not part of these actions and whose interests are not taken into consideration by the market. For example in the case of positive consumption externalities, external benefits are created by the consumers. An example of positive consumption externalities is education. When a person is educated, he helps the society with his skills and contributes to the growth of the economy. When there is a positive consumption externality, the free market underallocates resources to the production of the good, and too little of it is produced relative to the social optimum. This is shown by Qm < Qopt and MSB > MSC at Qm in Figure 1. Due to underallocation of resources, the social surplus is not maximised. The market faces welfare loss as shown by the shaded area c + f. This decreases consumer surplus limiting to area b +d and producer surplus is only area g.
There are several reason for this underalocation of resources. One of the reasons is consumer ignorance. In the case of education, consumers are not aware of the benefits of education and lack knowledge on how to pursue this. Another reason is due to poverty and low income households may not be able to afford these goods.
Figure 2
To reduce market failure by improving the allocative efficiency, the government may provide a few solutions. Governments can use advertising to try to persuade consumers to buy more goods with positive externalities. For example, they can try to encourage families in the rural areas to enroll children in school. The objective is to increase demand. The effect is shown in Figure 2, D1 shifts to D2 = MSB and Q opt is produced and consumed, while price increases to Popt.
In the case of education and healthcare, often the government will resort to direct provision of the said good. Most countries do provide education and healthcare because they are merit goods with external benefits so large, they should not be left to the private sector alone.
Direct government provision is shown in Figure 3, and has the effect of increasing supply and therefore shifting the supply curve S rightward (or downward) to S + government provision. To achieve the social optimum Q opt, the new supply curve must intersect MPB at the level of output Q opt, as seen in the figure. At the new equilibrium, price falls to Pc, Q opt is produced and allocative efficiency is achieved.
Lastly, the government could provide subsidies to the producer. It has the same effect as direct provision by the government. It results in increasing supply and shifting the supply curve rightward (or downward), as shown in Figure 4 (which is the same as Figure2)below. If the subsidy is equal to the external benefit, the new supply curve is MPC − subsidy, and it intersects MPB at the Popt level of output. Again, price falls from Pm to Pc, Q opt is produced and allocative efficiency is achieved.
Figure 4
Though the above methods shows, market failure in the form of positive externalities can be corrected, it is challenging in reality. This is because it is very difficult to measure the size of the external benefits, and therefore to calculate precisely which goods and services should be supported and the level of support they should receive. Therefore, in the real world it is very unlikely that governments are able to shift the MPC or MPB curves by the amount necessary to correct the positive externalities.
Advertising and subsides have the advantage that they are simpler, but they too have their disadvantages. Both of these involve the cost to the government, which are funded out of tax funds, meaning there are less funds available for use elsewhere in the economy (there are opportunity costs). As it is not possible for the government to directly provide or subsidise all goods and services with positive externalities, choices must be made on which goods should be supported, and by how much they should be supported.
Lastly, government intervention can also lead to unintended negative consequences. For example, subsidies can create a moral hazard, where producers become dependent on government subsidies and lack incentive to innovate to keep the costs of production low.
In conclusion, market failure does not necessarily lessen the market’s significance as a mechanism that can advance the well-being of societies. It suggests that for markets to realise their potential, they must be supported by appropriate government policies. Government intervention can be used successfully to correct market failure caused by positive externalities. Choices should be made on the basis of economic criteria, which would specify the amount of social benefits expected in relation to the cost of providing them, the objective being to maximise the benefits for each good and service to be provided or subsidised for a given cost.