© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 14: Market Failures and Government Policy Prepared by: Kevin Richter, Douglas College Charlene Richter, British Columbia Institute of Technology

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 2 Chapter Objectives 1. Explain what is meant by market failure. 2a. Explain what an externality is. 2b. Show how an externality affects the market outcome. 3. Describe three methods of dealing with externalities.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 3 Chapter Objectives 4. Distinguish four types of goods. 5. Define a public good and explain the problem with determining the value of a public good to society. 6. Explain how informational problems can lead to market failure.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 4 Chapter Objectives 7. Explain how a market for information can solve a market failure. 8. List five reasons why government’s solution to a market failure could worsen the market failure.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 5 Introduction The private market framework presented so far may be called the invisible hand framework. Invisible hand framework – perfectly competitive markets lead individuals who maximize their own benefit to make voluntary choices; these choices also turn out to be in society’s best interest.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 6 Introduction There are two cases where the market does not yield an appropriate outcome:  Market failure, where the market fails to produce an efficient outcome, and  Market outcome failure, where the market outcome, although efficient, is not socially optimal.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 7 Externalities Externalities are the effect of a decision on a third party that is not taken into account by the decision-maker. Externalities can be either positive or negative.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 8 Negative Externality When there is a negative externality, social marginal cost is greater than private marginal cost.  A steel plant benefits the owner of the plant and the buyers of steel.  The plant’s neighbours are made worse off by the pollution caused by the plant.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 9 Negative Externality Social marginal cost includes all the marginal costs borne by society. It is the private marginal costs of production plus the cost of the negative externalities associated with that production.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 10 Negative Externality When there are negative externalities, the competitive price is too low and equilibrium quantity too high to maximize social welfare.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 11 Negative Externality D = social marginal benefit S = private marginal cost S 1 = social marginal cost Price Quantity0 Q0Q0 P0P0 Q1Q1 P1P1 Marginal cost from externality

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 12 Positive Externality Social marginal benefit equals the private marginal benefit of consuming a good plus the positive externalities resulting from consuming that good.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 13 Positive Externality Price Quantity0 Marginal benefit of an externality D 0 = private marginal benefit Q0Q0 P0P0 Q1Q1 P1P1 S = S ocial marginal cost D 1 = Social marginal benefit

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 14 Direct Regulation Direct regulation –the amount of a good people are allowed to use is directly limited by the government.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 15 Tax Incentive Policies A tax incentive program uses a tax to create incentives for individuals to structure their activities in a way that is consistent with the desired ends. The tax often yields the desired end more efficiently than direct regulation.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 16 Regulation Through Taxation Social marginal benefit Private marginal cost Social marginal cost Price Quantity0 Q0Q0 P0P0 Q1Q1 P1P1 Efficient tax

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 17 Market Incentive Policies A market incentive program differs from a regulatory solution. Individuals who reduce consumption by more than the required amount receive marketable certificates that can be sold to others.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 18 Optimal Policy An optimal policy is one in which the marginal cost of undertaking the policy equals the marginal benefit of that policy.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 19 Optimal Policy Optimal level of pollution – the amount of pollution at which the marginal benefit of reducing pollution equals the marginal cost.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 20 Property Rights Property rights are a set of use and ownership rules in society which dictate who may use or enjoy a particular resource.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 21 Coase Theorem states that the optimal allocation of resources can always be achieved through market forces, regardless of the initial assignment of property rights. Property Rights

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 22 Four Types of Goods RivalNonrival (jointly consumable) Excludable Private market goods. Examples: shirts, haircuts Congestion. Examples: art exhibits, roads and bridges. Non- excludable Common Property. Examples: fishery, atmosphere. Public Goods. Examples: national defense, national parks

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 23 With rival goods, other people are automatically prevented from consuming the good. Goods are excludable if access to them can be controlled. Private Market Goods

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 24 Congestion Nonrival excludable goods do not trade well in an ordinary market. These goods can be jointly consumed, and access to them can be controlled.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 25 Common Property Nonexcludable goods are difficult for markets to handle, because nonpayers cannot be excluded. Nonexcludable rival goods are those goods whose access cannot be controlled and one person’s use of it precludes the use of it by another.  The fishery is an example.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 26 Public Goods A public good is nonexcludable and nonrival.  Nonexcludable – no one can be excluded from its benefits.  Nonrival – consumption by one does not preclude consumption by others.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 27 Market Value of a Public Good 5 Price 123Quantity Market demand DBDB DADA

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 28 Asymmetric Information Asymmetric information is a situation in which one person has information relevant to the exchange, but the other person does not. Asymmetric information can be a cause of market failure.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 29 Adverse Selection Some market failures result from adverse selection problems. Adverse selection occurs when a buyer or a seller has more information about the good for sale, and uses this information to swing the deal in their favour.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 30 Adverse selection is often a problem when the good is an experience good, a good where the person must use it to learn its characteristics. Adverse Selection

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 31 Moral Hazard Market failure can arise from moral hazard problems. Moral hazard occurs when one of the parties to the exchange can misrepresent his intentions and behave differently than what was agreed to.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 32 Moral Hazard Drafting a complete contract – where all behaviour is specified -- can reduce moral hazard.  Can be prohibitively costly. Long-term relationships can also reduce moral hazard.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 33 Market in Information A market in information is one solution to the information problem. Information is valuable, and is an economic product in its own right.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 34 Licensing of Doctors Providing information rather than licensing would give rise to consumer sovereignty. Consumer sovereignty – the right of the individual to make choices about what is consumed and produced.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 35 Government Failures Government failure occurs when the government intervention in the market to improve the market failure actually makes the situation worse.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 36 Reasons for Government Failures Governments do not have an incentive to correct the problem. Governments do not have enough information to deal with the problem. Intervention in the markets is almost always more complicated than it initially looks.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 37 Government Intervention Although government failure can occur, government intervention often can improve a poorly functioning market, or correct a market failure.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.38 Market Failures and Government Policy End of Chapter 14