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Market Failure and Government Intervention

in the public sector is parallel to the concept of total revenue in the private sector.  Similarly the concept of social cost is parallel to the concept of total cost in the private sector.  However, benefits or costs accruing to anyone and everyone, not just the stockholders, must be included in the measurement of net social benefits.  The market failure of “externalities” occurs when third parties besides the buyer and seller in a market are affected by the occurrence of market transactions.

Society may value consumption differently than an individual consumer.  Generally, if there are parties other than the consumers of a product who are affected by the consumption of the product, then the private and social demand curves diverge.  The difference between the social private and social demand curves are a measure of the consumption externalities from the consumption of the good.  If the externalities benefit third parties- besides the producer or consumer- then the social demand curve will be above the private market demand curve.  However, if the consumption externalities hurt third parties, then the social demand curve will be below.  Each point on the social demand curve represents the marginal social value of consumption.

Similarly society may value production differently than an individual producer.  Generally, if there are parties other than the producers who are affected by the supply of a good or service, then the private and social cost curves diverge.  The difference between the social private and social marginal cost (or social supply) curves are a measure of the production externalities from the supply of the good.  If the externalities benefit third parties then the social marginal cost curve will be below the private marginal cost curve.  However, if the production externalities hurt third parties, then the social marginal cost curve will be above.

The social optimum occurs where social demand and supply intersect.  When market and social demand (or marginal cost) curves diverge, the social optimum is not the same as the private market equilibrium and the market will fail to achieve the social optimum.  For example, there may be many reasons for society valuing an individual's education more than the individual alone does.  Education may contribute to greater stability, growth potential, and social acceptability.... while an individual may think getting educated just means getting a better paying job.  Suppose society recognizes $5000 more of benefits than each person who receives the education.  In figure 17-4 the social demand curve would therefore be $5000 above the private market demand curve.  Each point on the social demand curve would represent the marginal social value of education.  The difference between the private and social demand curves is the positive consumption externality from education, measured as $5000 per person.  

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