Market Failure and Resource Allocation 2012

Market failure What do we mean by market failure? Just that the market fails to arrive at the “correct” price and quantity Something is interfering with the guiding function of prices. The most common form of market failure is externalities. Today we are going to explore how externalities stop market achieving an allocatively efficient equilibrium No man (or woman) is an island. The main theme in this chapter is how to analyze the impact of negative or positive externality on the market allocation of resources, as well as the government’s ability to enhance efficiency: Cost externalities cause social costs to be under appreciated by resource allocation decision makers in the market, causing too much of the activity creating the externality to be produced. Benefit externalities cause social benefits to be under appreciated by resource allocation decision makers in the market, causing too little of the activity that creates the externality to be produced. There are some correcting policies that the government can use to increase efficiency, but some are more effective than others.

Externalities An externality is a cost or benefit that arises from production and falls on someone other than the producer, or a cost or benefit that arises from consumption and falls on someone other than the consumer. A negative externality imposes an external cost and a positive externality creates an external benefit. No man (or woman) is an island. The main theme in this chapter is how to analyze the impact of negative or positive externality on the market allocation of resources, as well as the government’s ability to enhance efficiency: Cost externalities cause social costs to be under appreciated by resource allocation decision makers in the market, causing too much of the activity creating the externality to be produced. Benefit externalities cause social benefits to be under appreciated by resource allocation decision makers in the market, causing too little of the activity that creates the externality to be produced. There are some correcting policies that the government can use to increase efficiency, but some are more effective than others.

Externalities The four possible types of externality are: Negative production externalities Positive production externalities Negative consumption externalities (not discussed) Positive consumption externalities (not discussed)

Externalities Negative Production Externalities Negative production externalities are common. Examples are noise from aircraft, logging and clearing of forests, and pollution There is an incentive for firms to produce negative externalities, correcting externalities adds to costs and reduces profits. Pollution lowers costs and increases profits.

Externalities Positive Production Externalities Positive production externalities are less common than negative externalities. Example: a beekeeper locates beehives in an orange-growing area, the bees primary purpose is to collect nectar to make honey, but they also assist in pollination so increase the productivity of orchards and vineyards. This increase production and profits for the farmers.

Externalities Negative Consumption Externalities Negative consumption externalities are a common part of everyday life. Smoking in a confined space poses a health risk to others; noisy parties or loud car stereos disturb others.

Externalities Positive Consumption Externalities Positive consumption externalities are also common. When you get a flu vaccination, everyone you come into contact with benefits. When the owner of an historic building restores it the value of nearby houses increase, so house prices and rents rise.

Negative Externalities: Pollution Private Costs and Social Costs A private cost of production is a cost that is borne by the producer, and marginal private cost (MC) is the private cost of producing one more unit of a good or service. An external cost of production is a cost that is not borne by the producer but is borne by others. Marginal external cost is the cost of producing one more unit of a good or service that falls on people other than the producer.

Negative Externalities: Pollution Private Costs and Social Costs Marginal social cost (MSC) is the marginal cost incurred by the entire society and is the sum of marginal private cost and marginal external cost. MSC = MC + Marginal external cost. Marginal private cost, marginal external cost, and marginal social cost increase with output.

Cost ( dollars per tonne) An External Cost Figure 16.2 300 Marginal Social cost MSC 225 Marginal External cost Cost ( dollars per tonne) 150 MC 100 75 Marginal Private cost 2 4 6 Quantity (thousands of tonnes per month)

Negative Externalities: Pollution Production and Pollution: How Much? In an unregulated market with an externality, the pollution created depends on the market equilibrium price and quantity of the good produced. But P<P* and Q>Q* so too many resources are allocated to production.

Inefficiency with an External Cost Figure 16.3 300 Marginal Social cost Social Benefit MSC 225 Inefficient Market equilibrium Deadweight loss Efficient equilibrium D=MSB Price and cost ( dollars per tonne) 150 S= MC 100 75 Efficient quantity 2 4 6 Quantity (thousands of tonnes per month)

Correcting Negative Externalities: Two major approaches Command and control policies Market intervention

Correcting Negative Externalities Command and control policies These usually take the form of regulations that forbid certain behaviours require certain behaviours. Examples: Regulations on pollution emission levels Internalise the externality, force the polluter to either not pollute or not discharge pollution.

Internalising externalities lead to an Efficient Outcome 300 Price equals marginal social cost and MSB S = MC =MSC 225 Cost of pollution Borne by polluter Efficient market equilibrium D=MSB Price and cost ( dollars per tonne) MC excluding pollution cost 150 100 75 2 4 6 Quantity (thousands of tonnes per month)

Negative Externalities: Pollution The Coase Theorem The Coase theorem is a proposition that if property rights exist, if only a small number of parties are involved, and if transactions costs (defined below) are low, then private transactions are efficient. There are no externalities because all parties take into account the externalities involved. The outcome is independent of who has the property rights.

Negative Externalities: Pollution Transactions costs are the opportunity cost of conducting a transaction. Example: the transactions costs of buying a home include fees for a real estate agent, and the legal cost associated with the transfer. When a large number of people are involved then the transactions costs tend to be high, the Coase solution is not available.

Also if people cannot be compensated for the effects of the pollution, then the Coase solution will not work, so-called corner solution, Coase theorem will not work. The parties need to be negotiating in good faith, if not then no agreement will be met or transaction costs are higher. Information asymmetry, the costs of disclosure may increase transaction costs.

Negative Externalities: Pollution Taxes The government can set a tax equal to the marginal external cost. The effect of such a tax is to make marginal private cost plus the tax equal to marginal social cost: MC + Tax = MSC. This tax is called Pigovian Tax, in honour of the British economist Arthur Cecil Pigou, who first proposed dealing with externalities in this fashion.

A Pollution Tax (ad valorum) 300 S = MC + tax = MSC Marginal social cost and MSB 225 Pollution tax Efficient market equilibrium D=MSB Price and cost ( dollars per tonne) 150 Tax revenue MC 88 75 2 4 6 Quantity (thousands of tonnes per month)

A Pollution Tax (per unit) 300 S = MC + tax = MSC Marginal social cost and MSB 225 Pollution tax Efficient market equilibrium D=MSB Price and cost ( dollars per tonne) 150 Tax revenue MC 88 75 2 4 6 Quantity (thousands of tonnes per month)

An example Cigarette taxws

An example Tax on alcopops

Positive Externalities: Knowledge Private Benefits and Social Benefits A private benefit is a benefit that the consumer of a good or service receives. Marginal private benefit (MB) is the private benefit from consuming one more unit of a good or service. An external benefit is a benefit that someone other than the consumer receives. Marginal external benefit is the benefit from consuming one more unit of a good or service that people other than the consumer enjoy.

Positive Externalities: Knowledge Marginal social benefit is the marginal benefit enjoyed by the entire society and is the sum of marginal private benefit and marginal external benefit. That is: MSB = MB + Marginal external benefit.

Price (thousands of dollars per student per year) An External Benefit Figure 16.6 40 MSB Marginal Social benefit External benefit Private 30 25 Price (thousands of dollars per student per year) 20 MB 10 50 100 150 200 300 Quantity (thousands of students per year)

Inefficiency With an External Benefit Figure 16.7 40 MSB S=MSC Deadweight loss 38 Inefficient Market equilibrium Marginal Social benefit 30 25 Price (thousands of dollars per student per year) Efficient quantity 20 D=MB 15 Marginal Social cost 10 50 100 150 200 300 Quantity (thousands of students per year)

Correcting Positive Externalities: Knowledge Government Action in the Face of External Benefits There are three main methods that the government uses to cope with external benefits: Public provision Private subsidies Vouchers Consumers Versus Private Producers Versus Government as Monitor in the Face of an Externality. In the case of benefit externalities like education, the government has three policy choices: public provision, subsidize private producer, subsidize private consumer with vouchers. All three policies require the government to initially assess the social marginal costs and benefits to find the optimal level of education to be consumed. But only the public provision policy forces the government to continually assess what type of education should be provided in a dynamic world of ever-changing technology. The policies of private education subsidies or educational vouchers force schools or students to determine what types of education would be best, because they now face an opportunity cost for their decisions as to what school to attend. An informed and motivated clientele, armed with vouchers to allocate across the different qualifying educational institutions, would drive the composition of educational opportunities supply by the different educational institutions.

Correcting Positive Externalities: Knowledge Three possible goals of policy First get both P and Q correct. Second get Q correct and not worry about P being wrong. Third get P correct and not worry about Q being wrong.

Correcting Positive Externalities: Knowledge Public Provision Under public provision, a public authority that receives its revenue from the government produces the good or service. Education services produced by the public universities and schools are examples of public provision

Public Provision to Achieve an Efficient Outcome 40 MSB S=MSC 38 30 MSB = MSC S=MSC + govt provision 25 Price and costs (thousands of dollars per student per year) 20 D=MB 15 Private provision 10 Public provision 50 100 150 200 300 Quantity (thousands of students per year)

Positive Externalities: Knowledge Private Subsidies A subsidy is a payment by the government to private producers. The government can induce private decision makers to consider external benefits by making the subsidy depend on the level of output If the government pays the producer an amount equal to the marginal external benefit for each unit produced, the quantity produced increases to that at which marginal cost equals marginal social benefit—an efficient outcome.

Private Subsidy to Achieve an Efficient Outcome 40 MSB S=MSC S=MSC 38 Efficient market equilibrium S=MSC-subsidy 30 MSB = MSC 25 Efficient quantity Subsidy of $15,000 per student Price and costs (thousands of dollars per student per year) 20 D=MB 15 10 Dollar price 50 100 150 200 300 Quantity (thousands of students per year)

Positive Externalities: Knowledge Vouchers A voucher is a token that the government provides to households, which can be used to buy specified goods or services. A school voucher allows parents to choose the school their children will attend and to use the voucher to pay part of the cost. The school cashes the voucher to pay its bills.

Vouchers Achieve Allocative Efficiency Figure 16.9 40 MSB S=MSC S=MSC 38 Efficient market equilibrium 30 MSB = MSC 25 Value of voucher Price and costs (thousands of dollars per student per year) 20 D=MB 15 10 Dollar price 50 100 150 200 300 Quantity (thousands of students per year)

An example The triangle waistshirt company