What market failure means

Market failure is a concept within economic theory where the allocation of goods and services by a free market is not efficient. (less than optimum allocation of resources)

Causes of Market Failure Lack of provision of Public Goods Underprovision of Merit Goods Externalities Imperfect Competition

Public Goods (flood control, street lighting and national defence) Are unlikely to be provided by a free market due to their characteristics of: Non-excludability - the goods cannot be confined to those who have paid for it Non-rivalry in consumption - the consumption of one individual does not reduce the availability of goods to other This means that Public Goods have to be provided collectively in some way

Merit Goods Merit goods are those goods and services that the government feels that people will under-consume, and which ought to be subsidised or provided free at the point of use so that consumption does not depend primarily on the ability to pay for the good or service. Consumption of merit goods is believed often to generate positive externalities- where the social benefit from consumption exceeds the private benefit. In the UK health care is provided free at the point of consumption. Government health provision can be justified on the grounds of: Equity Efficiency

Equity and Equality Equity means fairness. Equity involves a fair or just distribution of income and wealth. This does not necessarily mean that income is distributed equally. Inequality and Market Failure – Severe inequality may be an aspect of market failure as poverty entails significant social costs

Application to Case Study Is Energy a Merit Good? This a tricky area. Energy is not so obviously a merit good in the same way that education or health is. At the same time it does have some of the characteristics and the government does subsidise energy consumption to some vulnerable consumers through its winter fuel allowance. Solar Panels and Energy Saving Measures (eg insulation) These can more easily be explained as merit goods The purchase benefits the consumers by reducing their long term energy bills The use of solar panels reduces our dependence on fossil fuels with their associated negative externalities. They also add to our sources of energy supply meaning consumers may be less affected by any energy shortages resulting from our dependence on oil and natural gas Energy saving measures reduce energy consumption, reducing externalities associated with energy production

Demerit Goods In economics, a demerit good is a good or service whose consumption is considered unhealthy, degrading, or otherwise socially undesirable due to the perceived negative effects on the consumers themselves. It is over-consumed if left to market forces. Examples of demerit goods include tobacco, alcoholic beverages, recreational drugs, gambling, junk food and prostitution.

What externalities are and how they affect an economy

Externality – a third party side effect or spill over effect in the production or consumption of a good or service These can be positive and negative!!!   Production Externalities – When production takes place there can be effects on people in society that are not part of the production process. Negative externalities or external costs arising from production include things like pollution. Consumption Externalities – Consumption can also lead to negative externalities. For example driving can lead to external costs such as pollution, congestion, accidents and even climate change. Positive Externalities – There may be external benefits from production or consumption of goods. An example is a vaccination against a contagious disease. Getting the vaccination not only benefits me but others as I will not be able to catch and pass the disease on.

Social Costs and Benefits Social Costs = Private Costs plus External Costs Social Benefits = Private Benefits plus External Benefits Be careful – sometimes the term social costs is used to mean external costs rather than external costs plus private costs

Graphical Representation If efficient production / consumption is the objective, the aim should be to produce/consume at the point where the extra cost to society (MSC) equals the extra benefit (MSB) of any consumption / production decision. Marginal Benefits are to do with consumption (demand!) Marginal Costs are to do with production (supply!)

Negative Externality in Production Example – Carbon Emissions / Pollution from energy production When negative production externalities exist, marginal social cost > marginal private cost. This is shown in the diagram where the marginal social cost of production exceeds the private costs faced only by the energy supplier. Energy production creates external costs to the environment arising from the production process. (in both the short and the long term – more of this later) If we assume that the producer is interested in maximising profits - then they will only take into account the private costs and private benefits arising from their supply of the product. They are not paying the true cost to society of the energy production The externality is represented by the shaded triangle. It is created because the marginal private cost is less than the marginal social cost. Therefore, the marginal private costs is further to the right.

Positive– Example renewable energy In the case of renewable energy ,the associated externalities in production are much lower, with the damage to the environment and climate less. It can be argued that provision of energy from these sources benefits society because: It reduces the impact of negative externalities associated with non renewable energy sources It widens our energy mix improving supply and making us less reliant on energy sources from outside the UK / EU)

Solar Panels – A Merit Good? Solar panels might be argued to be a merit good The purchase benefits the consumers by reducing their long term energy bills The use of solar panels reduces our dependence on fossil fuels with their associated negative externalities. They also add to our sources of energy supply meaning consumers may be less affected by any energy shortages resulting from our dependence on oil and natural gas

External Costs & Market Failure A Summary A misallocation of resources will occur if market prices and profits do not accurately reflect the costs and benefits to society of economic activity. This may mean we get too much consumption of some goods (eg Cigarettes, Alcohol, Unhealthy Food) or side effects from the production of others (eg Pollution)

How do externalities affect the economy? Taken together external costs and external benefits are known as externalities. Both external costs and benefits can lead to market failure In an industry that generates significant external costs, the industry will, under free market conditions grow to above its optimum size In an industry that generates significant external benefits, the industry will, under free market conditions, be below its optimal size. Application to Case study It can be argued that too much of our energy comes from fossil fuels as the production of energy in this way generates significant external costs It can be argued that too little of our energy comes from renewable sources where there might actually be external benefits. (the main benefit is that energy from these sources generates less external costs than from fossil fuels) MARKET FAILURE – As a result of the above we might argue the energy market is failing with market prices and profits not accurately reflecting the costs and benefits to society of the different ways of generating energy. There is an over allocation of resources towards fossil fuels and an under allocation towards other energy sources

Fossil Fuels – External Costs Pollution – including poor air quality and damage to health associated with this Climate Change Dependence on fossil fuels (which are typically imported) reduces energy security – may lead to external costs due to risk of quantity and price disruptions of energy supply Renewable Energy – External benefits Reduces external costs such as pollution and climate change associated with energy from fossil fuels Increases energy security by broadening UK energy mix Energy security is about making sure consumers can access the energy they need at prices that are not excessively volatile.

Difficulties in Measuring Externalities More often than not measuring external costs is difficult. It is hard to put a monetary value upon them and attempts to express their monetary value have to be treated with caution. Application to case study – how do you accurately measure the external costs of energy generation to the economy? Costs associated with climate change etc are very hard to estimate How do you put an economic value on someone becoming ill due to pollution?

Short Run V Long Run

The Long & the Short of It Many activities have even higher external costs when taken over a long period of time. For example carbon emissions have had (until recently?) little real impact now on our quality of life (??) but could have huge repercussions for the future Short term externalities associated with fossil fuel energy generation my be much less significant than long term BUT need a coordinated global approach to deal with long term externalities

Application to case study Short-term local externalities The good thing about short-term local externalities is that citizens experience the negative and positive externalities in a fairly equitable manner, thereby enabling them to weigh these positives and negatives with reasonable accuracy. For example, if the negative effects of air pollution from coal-fired power plants begin to outweigh the positive effects of cheap and reliable electricity, citizens will start to resist further coal-fired plants or demand that existing plants be upgraded with pollution control mechanisms. Naturally, this implies a trade of more expensive energy for cleaner air, but, since both the electricity price and the air pollution are short-term local effects, this will be a reasonably well-informed trade Long-term global externalities This category of externalities (predominantly climate change) is completely different. In this case, there is a very poor connection between the negative externality of climate change and the positive externality of rapid economic development - a discrepancy which definitely should be corrected. For example, the 17% of people living in developed nations are currently enjoying the material affluence granted by 76% of cumulative CO2 emissions up to 2002, while the negative effects of these emissions will have a disproportionate effect on the lives of developing world citizens. While this global nature of climate change is a serious concern, the primary problem with the climate change externality is its long-term nature. This means that the world as a whole can easily pass the buck to future generations.

Possible Questions Explain why the government subsidises renewable energy(4 marks) To what extent should the government subsidise renewable energy(20) Explain two externalities associated with energy generation (4 marks) Explain the external benefits associated with fossil fuel energy generation (4 marks) Explain the difficulties with measuring externalities associated with energy generation (6 marks) To what extent is the energy market failing (20 marks) Explain why externalities associated with energy generation may be more of a problem in the longer term (4marks) A large proportion of UK energy sources are from non renewable fossil fuels. Analyse why this might be considered to be a market failure (8 marks)

To what extent are externalities acceptable

Economic Theory suggests we shouldn’t just cut out demerit goods altogether

To what extent are externalities acceptable? The fact that a good or service generates an external cost in either its production or consumption is not a reason to prohibit the good altogether. Application to Case Study This is particularly the case with energy market where the underlying product – energy – is essential to human life and the operation of the economy. The UK energy mix may need to be altered to reduce the amount of energy that comes from high externality sources such as fossil fuels but this needs to be balanced against the need for energy security and to ensure that energy is affordable for both business and consumers. Reducing externalities is also likely to require significant investment in infrastructure that is both costly and will take a long time.

Cost Benefit Analysis Is basically an appraisal technique that tries to place monetary values on all benefits arising from a project and then compares the total value with the project's total cost. It can often be difficult assess and to attach a monetary value to the costs and benefits arising

CBA – Some Limitations Difficult to assess and to attach a monetary value to the costs and benefits arising Individuals will value costs and benefits differently Circumstances may change CBA may not cover everyone affected Hard to discount the future (work out the present value of future income or costs)

Application to case study This may well be relevant when looking at methods of energy generation. For example a new nuclear powerstation or wind farm is likely to involve a CBA of some description

What can the government do about it?

Department of Energy and Climate Change works to make sure the UK has secure, clean, affordable energy supplies and promote international action to mitigate climate change.

DECC - Responsibilities energy security – making sure UK businesses and households have secure supplies of energy for light and power, heat and transport action on climate change – leading government efforts to mitigate climate change, both through international action and cutting UK greenhouse gas emissions by at least 80% by 2050 (including by sourcing at least 15% of our energy from renewables sources by 2020) renewable energy – sourcing at least 15% of our energy from renewable sources by 2020 affordability – delivering secure, low-carbon energy at the least cost to consumers, taxpayers and the economy Equity - fairness – making sure the costs and benefits of our policies are distributed fairly so that we protect the most vulnerable and fuel poor households and address competitiveness problems faced by energy intensive industries supporting growth – delivering our policies in a way that maximises the benefits to the economy in terms of jobs, growth and investment, including by making the most of our existing oil and gas reserves and seizing the opportunities presented by the rise of the global green economy managing the UK’s energy legacy safely, securely and cost effectively Great slide for evaluation - context

Priorities supporting investment in the UK’s energy infrastructure – including through the Energy Bill, which will set in place the framework to bring forward the £110 billion needed in our electricity infrastructure over the next decade supporting consumers and keeping energy bills down, including through implementation of the Green Deal promoting action in the EU and internationally to maintain energy security and mitigate dangerous climate change as we chart the way towards a global deal on climate change in 2015

Energy Market Rationale for Intervention – Market Failure! Negative Externalities –Energy production generates significant external costs. Producers are not paying the full cost to society of energy production due to these negative externalities. These are particularly high with energy that comes from fossil fuels Protect Vulnerable Groups – Imperfect Competition – There is some evidence that the energy market may not be working in the interests of the consumer Imperfect Information – consumers may not have the necessary information to make rational informed decisions Time Inconsistent Preferences – consumers, energy companies and governments are likley to have time inconsistent preferences that may lead to increased environmental damage, diminished energy security and perhaps even higher prices in the long term

Strategies to Reduce Market Failure Legislation Regulation Taxation Subsidies Tradeable Permits

Legislation Legislation is the act or process of making or enacting laws.

Regulation A principle, rule or law designed to govern conduct It needs to assess accurately costs and benefits and act accordingly Application to case study DECC Policy OFGEM – energy regulator Case study – what forms might regulation take and why – eg labelling to tackle info failure

Taxation Governments need to assess the cost to society of activity Tax rates should be set so that the tax is equal to the value of the external cost (internalise the externality) As costs of production increase firms reduce output As costs to buy increase consumers reduce the quantity demanded

Raises costs for business affecting our international competitiveness   Reduces consumption towards allocatively efficient level Encourages producers and consumers to be more energy efficient Internalises externality Raises revenue for the government to be spent on green initiatives If a tax on fossil fuels may encourages substitution by energy companies to alternative energy sources If demand is price inelastic may be ineffective at reducing consumption greatly unless tax increase is high Regressive tax – Inequality and may push vulnerable groups into fuel poverty Raises costs for business affecting our international competitiveness

Impact of green taxes on price of a unit of energy Impact of green taxes on price of a unit of energy. We will be paying much more! Impact of green taxes on energy bills - We will be paying much less!?????

Subsidies a sum of money usually paid by the government to help an industry or business keep the price of a product or service low Application – Subsidy for solar panels Subsidy paid to wind farms (evidence D) WHY – Merit Good? - renewables have much lower negative externalities. Increases UK energy security. (see earlier diagram)

  Encourages investment in renewable forms of energy Works alongside a tax by changing relative prices. Creating a substitution effect. As price falls the quantity demanded increases Helps with UK energy security Helps meet climate change targets Cost of paying a subsidy is high Benefits of subsidies in this case may be going to foreign companies Opportunity Cost UK has a large budget deficit May not create a large increase in quantity demanded

Tradeable Permits – EU Emissions Trading System The EU ETS is the largest multi-country, multi-sector greenhouse gas emissions trading system in the world. It includes more than 11,000 power stations and industrial plants across the EU with around 1,000 of these in the UK. These include power stations, oil refineries, offshore platforms and industries that produce iron and steel, cement and lime, paper, glass, ceramics and chemicals. https://www.gov.uk/participating-in-the-eu-ets

Judging the effects of intervention – a useful check list To help your evaluation of government intervention – it may be helpful to consider these questions: Efficiency of a policy:  i.e. does a particular intervention lead to a better use of scarce resources among competing ends? E.g. does it improve allocative, productive and dynamic efficiency? For example - would introducing indirect taxes on high fat foods be an efficient way of reducing some of the external costs linked to the growing problem of obesity? Effectiveness of a policy: i.e. which government policy is most likely to meet a specific economic or social objective?  For example which policies are likely to be most effective in reducing the scale of the UK road congestion problem? Which forms of intervention are most effective in improving the incentives of consumers to actively search for work in the labour market? Which policies are more effective in preventing firms from exploiting their monopoly power and damaging consumer welfare? Evaluation can also consider which policies are likely to have an impact in the short term when a quick response from consumers and producers is desired. And which policies are likely to prove most cost-effective in the longer term? For example, how best to encourage recycling in the long run and also provide incentives to increase the supply of energy in the long run that comes from renewable sources such as wind power. Equity effects of intervention: i.e. is a policy thought of as fair or does one group in society gain more than another? For example it is equitable for the government to offer educational maintenance allowances for 16-18 year olds in low income households to stay on in education after GCSEs? Would it be equitable for the government to increase the top rate of income tax to 50 per cent in a bid to make the distribution of income more equal? Sustainability of a policy: i.e. does a policy reduce the ability of future generations to engage in economic activity? Inter-generational equity is an important issue in many current policy topics for example decisions on which sources of energy we choose to rely on in future years.

Context – the price of oil The idea of renewable energy is that it is actually more expensive then conventional energy. But subsidy is worthwhile because the benefits to society are better than the external costs of conventional fossil fuel based energy. That’s all fine until the oil price goes to low levels like today. This means the subsidy needed for renewable energy would be even higher.

Possible Questions Assess the case for increasing renewable energy production (12 marks) Assess the extent to which the UK government should subsidise wind farms (evidence D) (20 marks) Assess the benefit of subsidising windfarms to the economy (20 marks) Assess the case for cutting the wind farm subsidy (evidence D) (12 marks) Evaluate the potential impact of the government’s wind farm subsidies(12 Marks) Assess the case for the UK government’s green taxes(20) Evaluate strategies that might be used by the government to tackle negative externalities associated with energy production(20) Assess the likely effectiveness of UK government policies in correcting market failure associated with energy production (30) Evaluate the extent to which the government should intervene to reduce market failures associated with energy production(30 marks)