Unit 10: Market Successes and Failures: The Societal
Effects of Private Decisions
Negative externalities arise when firms' production decisions impose costs on others without compensation.
Examples include the environmental damage from chlordecone and PFOA, oil spills, and deforestation. These
externalities result in market failures, as firms’ failure to account for the full social costs of production and
consumption leads to overproduction of harmful goods and underinvestment in safety and environmental
protection. As a result, society bears the costs of environmental degradation, public health crises, and loss of
biodiversity, often with irreversible consequences.
Positive externalities occur when an action benefits others beyond the individual or entity responsible for it,
resulting in social benefits that exceed private benefit, such investing in R&D that other firms can adopt. These
beneficial actions often lead to resource misallocation because decision-makers may not act when they receive no
compensation for the benefits they provide to others. For instance, a farmer may not invest in irrigation if they alone
bear the cost, or a firm might underinvest in worker training if the benefits are captured by other employers.
The Chlordecone Crisis: A Case Study in Market Failure and Externalities
The use of the pesticide chlordecone on banana plantations in Guadeloupe and Martinique from 1972 to 1993
highlights the severe consequences of ignoring externalities in economic decision-making. Despite its effectiveness in
combating the banana weevil and boosting profits, the pesticide caused widespread environmental contamination,
devastating local fisheries and causing severe health problems among the population, including the world's highest
rate of prostate cancer among Martiniquean men.
This case exemplifies how private decisions that disregard social costs can lead to market failure, where the
allocation of resources becomes Pareto inefficient: there are allocations that would be better for everyone involved.
Plantation owners focused solely on the private costs and benefits, ignoring the external costs (a person’s action
that imposes a cost on others which is not taken into account by the individual taking the action) to the local
communities. The failure to account for these externalities resulted in a significant misallocation of resources (when
prices send incorrect signals), as the social costs of increased banana production far exceeded the social benefits.
The chlordecone crisis underscores the need for institutions or policies that can align private incentives with social
well-being. Potential solutions could include regulations, taxes, or the enforcement of property rights (e.g. right to
have clean water) to ensure that the true costs of harmful activities are borne by those responsible (plantation
owners could have been required to pay the damages that their pesticide use inflicted on others). This approach
would have likely reduced or eliminated the use of chlordecone, preventing the long-term damage experienced by
the fishing communities and the broader population.
The broader lesson from this case is the critical importance of addressing external effects in economic decisions to
prevent market failure and protect public health and the environment.
Addressing External Costs: The Case of Weevokil and Banana Production
In this scenario, we explore the impact of an external cost on a fictional Caribbean Island where a pesticide called
Weevokil is used to boost banana production but inadvertently pollutes coastal waters, harming the local fishing
, industry. This situation illustrates the concept of an external effect or externality, where the actions of one party
(the banana plantation owners) impose costs on another party (the fishermen) without those costs being accounted
for in the decision-making process.
If the banana plantations and fisheries were owned by the same company, the negative effects of Weevokil on fish
stocks would be internalized, meaning the company would balance the profits from banana production against the
losses in the fisheries. However, when these businesses are under separate ownership, the external costs are not
considered, leading to overuse of the pesticide and overproduction of bananas.
The marginal private cost (MPC) of banana production, represented by an
upward-sloping line, increases as the land is used more intensively. In
addition to the MPC, there is a marginal external cost (MEC) imposed on
fishermen due to pollution from the plantations, which reduces fish
numbers. The marginal social cost (MSC) is the sum of both the MPC and
MEC, reflecting the total cost of banana production to society. The MEC is
calculated as the difference between MSC and MPC. The total external cost
to the fishermen is represented by the sum of all MECs for each ton of
bananas produced, illustrated by the shaded area in the diagram for
producing 100,000 tons.
The economic model demonstrates that the marginal private cost
Figure 10.1: Marginal costs of banana production using
Weevokil.
(MPC) of producing bananas, which only includes the costs borne
by the producers, is lower than the marginal social cost (MSC),
which includes the external costs imposed on the fishermen. As production increases, so does the external harm,
making the MSC rise faster than the MPC.
Assuming that the global market for bananas is $400 per ton, Figure 10.2: The plantations’ choice of banana output.
when the plantation owners produce 80,000 tons of bananas
(A), they maximize their profits as their MPC is equal to their
marginal cost (Price), but this output level ignores the external
cost to the fishermen. The Pareto-efficient outcome, where the
marginal social cost equals the price of bananas, would be at a
lower production level—38,000 tons (B). This is the point where
society's overall welfare is maximized, reaching the marginal
social benefit, balancing the benefits of banana production with
the environmental costs.
Coasean Bargaining: A Potential Remedy for Market Failure
In situations where market allocation is not Pareto efficient, such as the banana production case where plantations
pollute and harm the fishing industry, a potential remedy lies in private bargaining, often referred to as Coasean
bargaining. This concept, introduced by economist Ronald Coase, suggests that private negotiations between
affected parties can lead to a more efficient allocation of resources than government intervention, especially when
the parties have better information about the costs and benefits involved.
Figure 10.3: The gains from bargaining. Reducing production from 80,000 to 38,000 tons shifts from A to Pareto Efficient B,
where the marginal social cost (MSC) equals the price. The total gain for the
fishermen is represented by the shaded area between MSC and marginal private
cost (MPC).
The output reduction decreases plantation profits, with the loss equal to the
shaded area below the price line, reflecting the surplus profit lost per ton of
bananas.
The net social gain, illustrated by the shaded area above the price line, is the
difference between the fishermen’s gain and the plantations’ loss, showing the
overall benefit of addressing the externality.
