Market failure, Externalities, the Enviroment, and Public goods

1
Market failure Externalities Public goods
2
Part I Externalities
3
Price
Supply Sum of MC
The Competitive Situation
MC
MB MC
PC
PC
d MR MB
Demand MB
qC
Quantity
QC
quantity
Competitive Market
Competitive firm in Market

• Competitive markets achieve Allocative efficiency
  (maximum satisfaction) when the highest price the
  consumer is willing to pay the cost of
  producing the next unit of the good
  (P MB MC)...
• this means the market price reflects ALL
  benefits received and ALL costs of production.
• In many circumstances, there are costs or
  benefits from producing or consuming a good that
  go to others that are not involved in this
  market. This results in MARKET FAILURE.

4
Market Failure

• Competitive markets become Allocatively
  inefficient because buyers and sellers do not
  take into account all benefits and/or all costs
  from production of a good...
• because they have no incentive to take into
  account EXTERNAL COSTS and BENEFITS which accrue
  to someone besides themselves (buyers sellers).
• Why? Because they either dont have to pay
  for them(costs) or dont receive the benefit.
• Therefore, the market price of the good will not
  reflect ALL costs or benefits (ignore external
  costs or benefits)
• These external costs or benefits are called
  EXTERNALITIES or spillover effects...
• they represent the impact on third parties from
  market transactions.

5
Price
Supply MC
Negative Externality
MC


MEC
MEC
PC
PC
d MR MB
Demand MB
qC
Quantity
QC
quantity
Competitive Market
Competitive firm in Market
Negative Externality (external cost) a cost
(beyond the firms cost) imposed on others in the
production of a good or service...
...this cost is called the marginal external (or
damage) cost (MEC or MDC)...
...and is defined
as the extra cost imposed on third parties when a
negative externality is present.
Examples Dumping waste products into the air and
water, secondhand smoke, traffic congestion, loud
music played at 300 in the morning, airplane
noise, etc
6
Price
Supply MC
Negative Externality
MSC
MCMEC MSC
MC


MEC
MEC
PC
PC
d MR MB
Demand MB
qC
Quantity
QC
quantity
Competitive Market
Competitive firm in Market
To find the cost to EVERYONE, we must add the MEC
to the MC of the firm...
which gives us the total cost of production.
This is called

MARGINAL SOCIAL COST(MSC)
MC (from firms) MEC
(additional external cost imposed on
others)
7
Price
Supply MC
Negative Externality
MSC
MCMEC MSC
MC


PE
PE
MEC
MEC
PC
PC
d MR MB
Demand MB
qC
qE
Quantity
QC
quantity
QE
Competitive Market
Competitive firm in Market
Allocative efficiency occurs when ALL cost and
benefits are considered. This will now occur when
MSC MB. At Qc with price Pc , MSC gt MB (because
of the external costs) Competitive equilibrium is
no longer efficient because of the negative
externality. MSC gt MB indicates that the
competitive market overproduces the good at a
price lower than the total (social) cost of
production To reach efficiency, price must
rise and quantity decline.


8
Price
Positive Externality
Supply MC
MC


MEB
MEB
PC
PC
d MR MB
Demand MB
qC
quantity
Quantity
QC
Competitive Market
Competitive firm in Market
Positive Externality (external benefit) a
benefit (beyond the consumers benefit) that is
bestowed on others in the production or
consumption of a good or service which we call...
...the marginal external benefit (MEB)...
...the extra benefit bestowed on third parties
when a positive externality is present.
Examples Smoke detector in an apartment,
vaccinations, college education, Christmas
decorations on a house.
9
Price
Positive Externality
MSB MB MEB
Supply MC
MC
MSB


MEB
MEB
PC
PC
d MR MB
Demand MB
qC
quantity
Quantity
QC
Competitive Market
Competitive firm in Market
To find the benefit to EVERYONE, we must add the
MEB to the MB of the consumer...
which gives us the total benefit of production.
This is called
MARGINAL SOCIAL BENEFIT(MSB)
MB (from consumers) MEB (bestowed on others)
10
Price
Positive Externality
MSB MB MEB
Supply MC
MC
MSB


MEB
MEB
PC
PC
d MR MB
PE
A firm would not produce more at a lower price
Demand MB
qC
quantity
Quantity
QC
QE
Competitive Market
Competitive firm in Market
At Qc with price Pc , MSB gt MC (because of the
external benefits) Competitive equilibrium is no
longer efficient because of the positive
externality.
Allocative efficiency occurs when MSB MC
MSB gt MC indicates that the competitive market
underproduces the good at a higher price than is
efficient.
To reach efficiency, more of this good must be
produced and sold.
However, Consumers need a price lower than PC in
order to buy more of this good.
11
Correcting Externalities

• Problem Private individuals and firms have no
  incentive to take into account external
  costs(MEC) or external benefits(MEB)...
• ...that is they dont have to pay for the damage
  caused or receive the extra benefits of others.
• Solution Have individuals and firms incorporate
  (give them an incentive) or INTERNALIZE the
  external costs or benefits into their own
  cost-benefit calculations.
• If this occurs the firm will adjust their MC so
  it reflects the MEC and will equal the MSC
• ...if this is done then the market price and
  quantity WILL reflect both private and external
  costs.
• Internalizing an externality can be done in
  numerous ways...

12
Correcting Externalities

• 1. Persuasion(Can work at a personal level)
• If a roommate is playing a stereo at 300 am,
  you can ask that person to stop so you and others
  can sleep.
• You can ask someone not to smoke by
  you.
• Dont Drink and Drive is an attempt to get
  people to consider the external costs of this
  action.
• 2. Government intervention
• a) Direct regulation
• Government telling firms or individuals
  what to do and exactly how to do it.
• Why? In some cases the externality is
  too dangerous for any amount to occur, like
  plutonium or some chemicals
• Examples Specific equipment on cars,
  tailpipe emission tests, use of a cleaner
  gasoline

13
Correcting Externalities

• 2. Government intervention, cont
• b) Indirect intervention
• 1) Legal rules and procedures
• Various Product liability laws allow
  people to sue manufacturers if their product
  is defective
• Firms have greater incentive to
  improve their product so they dont pay
  damages
• 2) Corrective taxes Subsidies
• Firms ignore the MEC they impose on
  others
• The government can tax firms to
  simulate the external costs to
  others(society).
• By subsidizing a product that has a
  positive externality, the government can
  simulate the MEB and encourage more
  production.

14
Price
Supply MC
New supply MSC(MC Tax)
MC Tax MSC firms cost
MC


Tax
dT MRT MBT
PT
Tax
PT
PC
PC
d MR MB
Demand MB
qC
qT
Quantity of Dry cleaning
QC
quantity
QT
Competitive Market
Competitive firm in Market
Correction of a negative externality
A per unit tax adds to the cost of production for
business firms that impose a negative externality
The market supply curve will decrease (shift to
the left) because the tax has increased the cost
of production to business firms. This raises the
market price and lowers market quantity.

The per unit tax forces firms to take into
account the external costs they impose on
others ...the MSC to society becomes the
internal or private MC to the firm
Because consumers pay a higher price, quantity
does not go down the maximum amount
15
What have we learned from this?

• 1)For efficient use of resources the Tax MEC.
• It can be difficult to measure external
  costs and to get the Tax rate MEC
• In fact, it may only be possible by
  trial and error.
• 2)The cost of reducing pollution is lower output
  and/or higher prices (ceteris paribus)
• Of course, a firm has an incentive to choose
  the least costly option.
• If paying the full amount of taxes and not
  reducing output is the least costly, then the
  firm will do that.
• 3) If Tax MEC then tax revenue generated is
  large enough to pay for all damages from the
  externality.
• If the government could find people directly
  affected by the negative externality it could
  transfer the revenue to them.....
• since this is not likely, many would like to see
  reductions beyond the efficient level, because
  they still have to bear the external costs (i.e.
  the pollution)

16
Price
Supply MC
Competitive Market
Competitive firm in Market
MC
4,000
4,000
d MR
Demand MB
Quantity of Students
quantity of students
qC
QC
Correction of a positive externality

• A well educated workforce tends to be more
  productive, which means more output for the
  economy and lower inflation.
• but students dont take this positive
  externality in effect when deciding to go to
  college.
• The government can make students (and colleges)
  take these external benefits into account by
  subsidizing production.

17
Price
Supply MC
Competitive Market
Competitive firm in Market
Subsidy to firms MEB
MC
MC - Subsidy

MEB

Supply after Subsidy
4,000
4,000
d MR
d MR
3,000
3,000
Demand MB
Quantity of Students
quantity of students
qS
qC
QC
QS
Correction of a positive externality
In this case the subsidy goes directly to the
firm, which lowers cost ..and causing the Supply
curve to increase (shift to the right).
By lowering the price of education, more students
will go to college. As long as the subsidy MEB,
efficiency will be achieved. This occurs whether
the firm or the consumer receives the subsidy.
18
Correcting Externalities

• 3. Market Solutions....
• ...Assigning property rights
• If the government can assign property
  rights to resources where there were none
  before....
• ...and allowing owners of these
  property rights to bargain, negotiate, and
  sell them...
• ...the market itself will be able to
  internalize an externality and achieve
  efficiency....
• An economist named Ronald Coase first
  developed this idea...

19
Coase Theorem
Common Land
Rancher
Up to 800 cows
Who causes an externality is not always obvious.
It takes at least two or more to cause
externalities.
Example The octagon above represents open common
land
Suppose a rancher sets up a few buildings and an
area for his cows to graze on.
Assume the grazing area has the capacity to fully
feed up to 800 cows
20
Coase Theorem
Common Land
Rancher Up to 800 cows
Farmer Carrots
Next, a farmer begins to plant his crop, carrots,
on another part of this common land
There are no fences between these two, so if the
rancher has more than 800 cows, some of those
cows stray off the blue area in order to feed
themselves (i.e. Ranchers firm gets bigger)
Occasionally, some cows stray onto the land where
the farmer planted his crops and they eat them!
(This is the MEC) This lowers the amount of
production for the farmer and will cost him
revenue and profits.
21
Coase Theorem
Common Land
Rancher Up to 800 cows
Farmer Carrots
Farmer is upset about the damages, but, since
rancher was there first, claims it is not his
fault.This is a negative externality
Solutions for this negative externality

• 1) Farmer can move Rancher can move
• 2) Build a fence (either around rancher
  or farmer)
• 3) Rancher can keep cows to less than
  800 (voluntarily or through government
  regulation and/or taxes)
• Coase By assigning property rights to the common
  land, these two can solve the negative
  externality for themselves.
• It will be done in the same way no matter who
  gets the property rights

22
Coase Theorem

• Suppose we collect the following information from
  the rancher and farmer
• The rancher will maximize his profit by raising
  1000 cows.
• But this leads to straying cattle and an
  external cost on
  the Farmer.
• Cost to the rancher to cut production back to 800
  cows is 10,000 lost profit (200 x 50/cow)
• Cost to move cows or move the farm 25,000
• Cost to build a fence around ranch or farm
  16,000
• Maximum damage to farmers crops from straying
  cows is 20,000 (200 x 100/cow)

23
Coase Theorem
Cost to cut production back to 800 cows is
10,000 (50/cow) Cost to move cows or move the
farm 25,000 Cost to build a fence around ranch
or farm 16,000 Max damage to farmers crops
from is 20,000 (MEC100/cow)

• Which alternative will be chosen?
• Suppose the rancher gets the property rights...
• the rancher will keep only 800 cows! Why?
• Because the MEC gt profit/cow, the farmer is
  willing to pay 10,000 to the rancher if he will
  limit his cows.
  (It is better to lose 10,000 than 20,000)
• What if the farmer gets the property rights?
• The rancher will keep only 800 cows! Why?
• Because it is cheaper than paying 100/cow to the
  farmer for each cow over 800.
• Practical application In some circumstances
  there is no need for taxes and/or government
  regulation to correct externalities. If property
  rights can be assigned then the market system may
  be able to correct them.

24
Summary Externalities

• An Externality is a cost or a benefit that
  affects others not involved with a market
  transaction.
• Negative Externality a cost imposed on society
• Positive Externality A benefit bestowed on
  society
• Correcting Externalities (Internalizing)
• Government solutions
• 1) Direct Regulation
• 2) Indirect intervention
• a) Legal Rules and Procedures
• b) Corrective taxes Subsides
• Must be equal to MEC or MEB to achieve
  efficiency
• Market Solutions
• Assigning property rights
• Coase theorem No matter who gets them, if
  the conflicting parties can negotiate and trade,
  the efficient outcome is achieved.

25
An application Pollution, a negative externality
26
Pollution A negative externality

• Two questions must be answered
• 1)What is the optimal(MSCMSB) reduction in
  pollution?
• 2)What is the lowest cost way to reach that
  reduction?
• Government could directly lower pollution by
  telling firms how much they must reduce it and
  exactly how it must be done...
• but some firms are in a better position
  (technology) to reduce pollution than others,
  direct regulation is not the most
  efficient(cheapest) way to reduce pollution...
• ...Pollutants that are not immediately hazardous
  to human health can be reduced cheaper by using
  more market based methodsfor example...
• the polluter is given property rights to
  pollute...
• ...BUT THEY MUST PAY FOR THAT RIGHT

27
Market Solutions for reducing pollution

• 1. Emission charges
• Firms are charged for each unit of waste products
  they dump into the air or water.
• Need to measure the emissions or effluent of a
  firm.
• These charges are similar to corrective taxes,
  but charge directly for emitting pollutants
  rather than producing the good...
• the difference is that emission charges give
  firms an incentive to reduce emissions (and not
  output)...
• ...so they dont have to pay the emissions
  charges.
• Moreover, firms have the responsibility to find
  ways to reduce pollution.
• Recently, the EPA has found that costs can be
  reduced even more by auctioning off certificates
  to emit pollution...
• ...and allow firms to buy and sell these rights
  to pollute...
• Tradable emission permits

28
MB Price
Tradable emission permits
Supply of Permits
Suppose the EPA decides that emissions of sulfur
dioxide should be limited to 150,000 tons per
year...
B
150
The EPA could issue 150,000 emission permits and
auction them off to firms...
Marginal Benefit of emitting
Tons of sulfur dioxide emissions per year
A
Number of emission permits issued
150,000
280,000
...who will need one of these permits for each
ton of sulfur dioxide they emit. What
determines the price that is paid?
The Demand for the permits!

Interaction between the buyers for these
permits establishes the price!
Once a firm purchases a permit it may use it to
emit pollution or to Re-sell it to another firm
for profit if it does not need it. Those firms
that find it cheapest to reduce emissions will do
so and sell their unused permits to firms who
find it too expensive.
29
MB Price
Supply of Permits
Tradable emission permits
C
250
B
150
MB emitting 3
MB emitting 2
D
50
MB emitting
Tons of sulfur dioxide emissions per year
A
Number of emission permits issued
150,000
280,000
If demand for the product rises, firms may find
it more beneficial to emit more pollutants, the
MB of emitting shifts to the right...
...then the price of permits is driven up
If firms can find better(improvement in
technology) ways to reduce emissions of
pollutants then Marginal benefit of emitting goes
down...
and so will the price!
30
MB Price
Supply of Permits
Tradable emission permits
This allows the government to have control over
the total amount of pollution.
220
A
150

MB emitting
Tons of sulfur dioxide emissions per year
B
Number of emission permits issued
150,000
280,000
100,000
If the government ever want to further reduce
emissions then they simply buy up permits and
retire them shift the supply curve to the left.
Moreover, any environmental groups who wish to
lower emissions may buy up permits and hold them
(this lowers total
emissions)
31
Part II Public Goods their provision
32
Characteristics of goods

• Many goods have the following characteristics
• 1. If one person consumes a unit of a good (such
  as an apple) then no one else can consume that
  unit of the good (no one can eat that apple)
• This is called rivalry in consumption
• ...consumption of a good by one person reduces
  the consumption by others.
• 2. If you dont pay for it, you dont get the
  good or service.
• This is called excludability it is easy to
  prevent someone from consuming a good once it has
  been produced if they dont pay for it.
• Goods with these two characteristics are
  called Private goods

33
Public Goods

• Some very necessary goods DO NOT HAVE these
  characteristics
• instead they have the opposite...
• 1) Non-rival in consumption
• The consumption of a good by one person does
  NOT reduce the consumption by others...
• ...these goods are COLLECTIVLEY consumed...
• ...everyone can consume the good or service at
  the same time and not detract from anyone elses
  consumption.
• Examples National defense, Air, TV, Movies(up
  to a point), Education, Fireworks display, Air
  traffic control, Police and Fire protection

34
Public Goods

• 1) Non-rival in consumption
• 2) Non-excludable
• it IS NOT possible or at least extremely
  expensive to exclude someone from consuming the
  good once it has been produced...
• ...whether you pay for the good or not you will
  be able to consume the good.
• Examples National defense, Air, Fireworks
  display, Air traffic control, Police and Fire
  protection
• Goods that have the characteristics of collective
  consumption and non-excludability are called
  PUBLIC GOODS
• Market Failure Private firms will not produce
  public goods because there is no profit to be
  made...
• ...because no one will willingly pay for the
  good.

35
Public Goods and their provision

• Since Public goods are consumed collectively,
  there is usually only one level of production for
  that good...
• Problem is getting people to voluntarily
  contribute(pay) for production of a public good.
  Why? Two reasons
• a) Free-rider problem...people can benefit from a
  public good even if they do not help pay for
  it...
• ...because a public good is non-excludable...
• ...therefore people have an incentive to enjoy
  the benefits without paying for them...a FREE
  RIDER!
• b) A drop in the bucket problem...since public
  goods tend to be expensive their provision does
  not depend on any single individual...
• the more people needed to contribute, the
  greater the incentive to free ride because you
  believe someone else will pay for the good.

36
Public Goods and their provision

• Solution Since most people believe this good is
  necessary the government can provide for the
  production of the good...
• either by producing it themselves...
• ...or hiring a private firm to produce the good.
• The government pays for the good by taxing
  (charging) people in order to pay for it.
• How much of the good to produce and what to
  charge for it is determined by the system of
  government in place.
• The reason many people are unhappy with these
  taxes is that they may pay more in taxes than
  their marginal benefit from the public good.

37
Public or Private goods?

• In the real world there is not a clear
  distinction between public and private goods
• Example Education is supported by government
  although it is excludable.
• Television programs are a mix of collective
  viewing and excludability.
• There are private security firms in addition
  to police.
• Some goods are non-rival only up to a certain
  point, then adding another consumer WILL REDUCE
  enjoyment of other consumers
• A public park or swimming pool, exercise club,
  etc...
• ...or even an expressway...

38
Public or Private goods?

• Goods that are non-rival for some levels of
  consumption tend to be overused... because the
  marginal cost of using these goods is close to
  (if not) zero.
• Example In the case of an expressway there tends
  to be congestion at certain peak use times
• but at other times there is no congestion.
• Economic solution Charging for use of an
  expressway when you use it would prevent
  congestion
• ...for example, efficient use of an expressway
  would be to charge a higher price at rush hour
  than normal times.

39
Traffic Choice An Experiment was conducted with
400 drivers that were given 600 to 3,000 and
were allowed to keep whatever was left over as
they paid for the use of roads over an 8-month
period. Results The participants did use
freeways less often and undertook other actions
to save money.
40
Locally provided public goods

• Tiebout hypothesis
• Consider two identical towns except for police
  protection...
• One town spends a lot of money on police and
  is likely to have lower crime rates
• Households that do not want to take a risk of
  being a victim of crime will move into this town
  and will pay higher taxes to avoid crime...or
• ...if a town finds a way to reduce crime without
  higher taxes so many households will try to move
  in they bid up housing prices
• ...these higher housing prices are the price of
  lower crime.
• Those households that willing to bear greater
  risk would choose the lower tax/ higher crime
  risk town.

41
Locally provided public goods

• Tiebout hypothesis
  
• The efficient mix of public goods (police,
  fire, schools, roads, etc) is produced when local
  housing prices and/or taxes reflect consumer
  preferences...
• this means local taxes and housing prices act
  like market prices...
• and equilibrium is reached by consumers
  voting with their feet

42
Summary of Public Goods

• Public goods have two characteristics
• 1) Non-rival in consumption
• 2) Non-excludable when produced
• Problem Firms wont produce them because there
  is no way to make a profit.
• Why?
• Free-rider problem
• Drop in the bucket problem
• Solution Government raises funds through
  taxation so they can provide for public goods

43
Market Failure Imperfect Information
A lack of symmetrical information between buyers
and sellers can cause markets to be inefficient
or not work at all This leads to the problem of
Adverse Selection. Example Used Car market and
the Lemons problem Suppose half of used cars
are lemons(bad cars) and half are cherries(good
cars) Buyers are willing to pay 7,000 for a
cherry, but only 1,000 for a lemon. Since you
have a 50/50 chance of buying a lemon or a cherry
and dont know ahead of time what you are going
to get the price of used cars is the average of
the price of a lemon and a cherry (7,000
1,000) / 2 4,000 Owners of used cars know the
type of car they have. Lemon owners would love
to get 4,000 for their car and will enter the
used car market. Cherry owners will not get
fair value for their car and not enter the
market. Therefore, with asymmetrical info there
tends to be more lemons than cherries and the
market function barely if at all.
44
Market Failure Imperfect Information
Adverse Selection is a problem in insurance
markets Those who tend to have more accidents or
bad health are more likely to demand insurance
than those less accident prone or with good
health if rates are the same for everyone. To
counter this insurance companies are very nosy
and charge different rates to customers with
differing characteristics. This also explains why
health insurance companies need to charge
different rates depending on health, or only
those with bad health will want insurance.
45
Market Failure Imperfect Information
Another asymmetrical info problem comes after the
two parties agree to a contract Moral Hazard
One party to a contract passes the cost of its
behavior onto the other party. Why a problem
Cant tell the future behavior of the party you
have entered into a contract with. Another
problem in the insurance markets. The very fact
that you are covered by insurance may lead you to
increase risky behavior that causes the insurance
company to have to pay up. Insurance companies
write into contacts behaviors they will not pay
out for, such as suicide for Life Insurance or
the need to have smoke detectors before agreeing
to fire insurance.
46
Market Failure Imperfect Information

• Market Solutions to imperfect and asymmetric
  information
• 1. Provide more information.
• Companies sell information about products, etc
  to consumers.
• The internet has increased the ability to gather
  information tremendously.
• In labor markets, recruiters or Headhunter are
  hired by business firms to avoid going through a
  job search.
• 2. Government solutions
• Create laws, rules, and regulations that require
  companies to make information available to
  consumers.
• Food labeling, and especially financial reports
  in equities markets are subject to these
  government dictates.

47
Arrows Impossibility Theorem
48
Suppose society has 3 individuals, Amy ,Bob,
Charlie Three proposals are put before them.
Their preferences are ranked for each proposal.
Which one will they agree on?
Proposal
Individual
X
Y
Z
Amy 1 2 3
Bob 3 1 2
Charlie 2 3 1
Results of Voting on Proposals
Votes of
Amy Bob Charlie
Vote
Results
X
X
X beats Y
Y
X vs. Y
Y
Z
Y beats Z
Y
Y vs. Z
X vs. Z
Z
Z
Z beats X
X
The outcome is inconsistent, no proposal
dominates the other
49
Impossibility Theorem
Kenneth Arrow no system of aggregating
individual preferences into social decisions will
always yield consistent, non-arbitrary
results. Voting Paradox An example of the
impossibility theorem. Importance Who sets the
agenda has power to determine the outcomes of
votes. Logrolling occurs when congressional
representatives trade votes, agreeing to help
each other get their pieces of legislation
passed. A person only has the incentive to gather
info up to the point where their marginal benefit
marginal cost. Since the cost of government is
spread over everyone, the marginal cost of
government policy is very small for an
individual, giving little incentive to keep up on
issues facing society.