PART 10 Market Failures Markets may fail to generate efficient results due to Monopoly Externalities Public Goods Open Access Markets may also have informational problems—adverse selection and moral hazard

Externalities An externality is a cost or a benefit that is not reflected in market demand or supply curves An effect external to the market Environmental pollution, congestion in cities, etc MSC $ S (MC) D (MB) Q* Q’ Output

Pollution and Abatement Pollution imposes costs Abatement of pollution is also costly “Optimal” amount of pollution is where MC of pollution is equal to its MB Marginal benefit of pollution is the abatement cost saved Can also think of this as the MC and MB of abatement

Pollution and Abatement Optimal quantity of pollution $ MC MB P* P’ Pollution If the affected parties cannot negotiate the market will produce P’ pollution

Pollution and Abatement Optimal quantity of abatement $ MC MB A* Abatement If the affected parties cannot negotiate the market would produce no abatement.

Externalities and Transactions Costs Externalities can be thought of a being caused by a lack of property rights or high transactions costs (costs of negotiation or litigation) The Coase Theorem Important point is that the world is a world of positive transactions costs, so that externalities are common

Externalities and Transactions Costs Example: A lake which can be used for recreation (by a fishing club) or waste discharge by a firm We can think of the costs and benefits of the abatement of pollution The costs are the costs of reducing waste discharge, the benefits are the better fishing

Externalities and Transactions Costs $ MC MB A* A’ Abatement 0 = no abatement A’ = complete abatement A* = optimal level of abatement

Externalities and Transactions Costs If the firm and the fishing club could negotiate without cost then regardless of who has the property right they would negotiate to A* If there are high costs to negotiating and the fishing club has the property right end up at A’ (MC>MB of abatement) If there are high costs to negotiating and the firm has the property right end up at 0 (MB>MC of abatement) Transactions costs are usually high, so the market results in inefficient allocation of resources

Policy Towards Externalities Regulation by standards If the standard to be achieved is the same for all firms this can result in inefficiency $ MB2 MB1 Pollution Standard

Policy Toward Externalities Charges – Polluter pays a per unit charge $ MB2 MB1 Unit charge Pollution

Policy Toward Externalities Tradable Permits: Set total pollution level and let firms trade $ P MB1+MB2 Pollution $ $ P MB2 MB1 Pollution 1 Pollution 2

Policy Toward Externalities Optimal (Pigovian) Taxes Set tax equal to excess of the marginal social cost over the marginal private cost $ MSC MC+ Tax MC MB Q Q*

Public Goods A public good is a good that has to be provided to everyone or to no one National defense, clean air, lighthouses, public health Pure public goods characterized by non-rival consumption and non-excludable use

Public Goods Rivalry and excludability Rival Non-rival Artificially scarce goods Excludable Most goods Non- excludable Open access Public goods Artificially scarce goods often have close to zero MC of production. Private producers have to find ways of limiting distribution to those who pay. Examples include computer software, downloadable music, pay per view TV. Some inefficiency in private provision.

Public Goods Public goods and the free rider problem If provided the good will be provided even to those who do not pay Lack of incentive to pay—people will try to free ride Provision by voluntary contribution Provision by government

Benefits of a Public Good One person’s consumption of a unit of a public good does not exclude others Marginal willingness to pay (MB) for the first unit of a public good is the vertical sum of the marginal willingness to pay of all individuals If I am willing to pay $100 for a one unit improvement in air quality and you are willing to pay $50 for a one unit improvement in air quality the MB of that improvement is $150

Optimal Provision of a Public Good The optimal level of provision for a public good is where MB=MC (economic efficiency) If left to the market the good will be under-provided (cannot capture people’s willingness to pay) Public provision—will government provide the optimal amounts of a public good?

Open Access Common property resources Problem of free entry and overuse of the resource “Tragedy of the Commons” Regulation, tax, assign some form of property right to individuals or groups System of tradable licenses Example of fisheries

Open Access Optimal level of effort Yield TC TR Effort Open access Max sustainable yield Max Econ Yield