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Discuss the view that the free market economy encourages negative externalities and thus the size of the public sector should be increased.

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Discuss the view that the free market economy encourages negative externalities and thus the size of the public sector should be increased. "Almost everything we do has some third-party effects, however small and however remote" said Milton Friedman. External effects have been studied by economists ever since the days of Marshall and Pigou. Often, the existence of externalities has been cited as one of the reasons why markets fail. Because of the existence of externalities, it is claimed that the market will fail to achieve a Pareto optimal allocation of resources and that the government must intervene and use taxes, subsidies, restrictions, quotas, etc to remedy the situation. However, it is spurious to claim that the problem of externalities is a result of the free market economy. The failure is not in the market but in the failure to clearly define and enforce property rights and the problem of negative externalities is not unique to the free market economy. Furthermore, the question presents a logical fallacy; even if the free market economy does encourage negative externalities, it does not follow that the size of the public sector should be increased, as the government may not be the best candidate for intervention. To prove the validity of this statement, one must prove that firstly, the problem of negative externalities is unique and is innate to the free market economy. Secondly, that the problem of negative externalities is detrimental enough to warrant intervention, thirdly that the government is necessarily the best candidate to intervene and lastly that the current level of intervention is insufficient and thus inadvertently, the size of the public sector should be increased. During the course of my essay I would prove how the problem of negative externalities lies not in the failure of the market, secondly, how negative externalities do warrant intervention and how the government should intervene to a certain extent. ...read more.


Mises pointed out that "some people choose certain modes of want satisfaction merely on account of the fact that a part of the costs incurred are debited not to them but to other people". The inherent selfish nature of people that while on one hand guides the market economy, on the other hand causes external costs. However, it is virtually impossible to define property rights for everything such as the environment. It is terribly difficult to define property rights for the air that we breathe or the oceans, this will be elaborated upon later. The fact that it is impossible to define and enforce property rights for everything coupled with human nature renders the problem of negative externalities a persistent one, one that is hard to eliminate completely. In the neo-classical externalities theory as explored earlier, negative externalities cause a difference between marginal social cost and marginal private cost and thus the resulting output level is greater than the Pareto optimal level, there is and over production or consumption of goods with negative externalities. As shown in the diagram below, assuming no external benefits, due to the presence of external costs, the marginal private cost is less than the marginal social cost. The resulting output level of Qe is more than the ideal Pareto outcome of Q* and the deadweight loss incurred by moving from Q* to Qe is shown by the shaded triangle. Hence, negative externalities are detrimental as they result in a less than optimal allocation of resources. Too much of society's scarce resources are diverted into the production of this good, representing a waste of society's resources which could have been put to better use somewhere else. ...read more.


Property rights define who owns property, to what uses it can be put to, the rights other people have on nit, etc. Property rights can be extended completely such that everyone would be able to prevent others from imposing costs on them. The Coase theorem states that in a perfectly competitive market with no transaction costs, the sufferers from the externalities can make deals with the perpetrators, the externality would be internalised and the socially efficient level of output would be achieved. In practice however, this can be totally impractical. Especially in instances where a large group of people is slightly inconvenienced, it is virtually impossible to expect all the sufferers to make bargains with the perpetrators. Also, it is impossible to define property rights for entities like air or oceans as mentioned before. In this case, the state is the best to set up such an institution as the state has the legislative, executive and judicial powers to enforce property rights and thus allow the free market to function. However the second part of the statement in the question is also fallacious, as even if the government should intervene, it does not mean that the size of the public sector, which includes everything in the public domain from public utilities to public provision of health services, should be increased. Hence in conclusion, the existence of negative externalities should not be blamed on the free market as the failure is in defining and enforcement of property rights and while the onus is on the government to provide an institution of properly defined and enforced property rights, it does not mean that the size of the public sector should be increased. Perhaps efforts at solving the problem of negative externalities could be improved especially in the area of pollution. ...read more.

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