1. Resource allocation by markets
A competitive market system will result in a socially efficient allocation of economic resources
The ‘right’ or ‘optimum’ amount of resources is allocated to each good or service
Consumers choose their desired (affordable) goods and services
The ‘right’ or ‘optimum’ output is produced
Producers respond to market incentives (price signals) to maximize profits. E.g. if prices are high – produce more
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2. Resource allocation by markets
To achieve a market equilibrium, certain conditions must hold, for example:
All benefits and costs of the activity are fully reflected in the market demand and supply curves
Market participants have perfect information about the product and prices
Well-assigned property rights
Assumption of divisibility (that only those who are willing to pay for the good or service will be able to consume it and can exclude others)
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3. Property Rights Efficient property right structures
Exclusivity – all benefits and costs accrue to the owner
Transferability – all property rights should be transferable in voluntary exchange
Enforceability – property rights should be secure form involuntary seizure
Assuming well-defined property rights - exchange in a market economy facilitates efficiency.
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4. Market Equilibrium
The diagram illustrates market equilibrium, that is the point where demand for the good is equal to supply of the good
Demand is also characterized as the marginal social benefit (MSB)
Moving down along the curve the marginal benefit of additional units of consumption declines
Supply is also characterized as the marginal social cost (MSC) (assuming no externalities)
Intuitively as you produce more it costs more
At equilibrium demand = supply and the MSB = MSC
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5. Market equilibrium
Price
S = SMC CS P PS
D = SMB Q*
Quantity
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6. Market Equilibrium
The shaded triangles in the diagram represent consumer surplus (CS) and producer surplus (PS)
Consumer surplus is the excess over price that consumers receive
For example if I was willing to pay (WTP) $30 for a new vinyl record – but only had to pay $20 – the surplus is $10.
Producer surplus is the excess that producers receive over price (It is combination of profits + fixed costs)
In the long –run economics profits tend to zero (through competition) but natural resource sectors give rise a scarcity rent and producer surplus is not eliminated by competition.
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7. Sources of Market Failure
Externalities
Public goods
Monopoly power
Divergence of private and social discount rates
Imperfect (or asymmetric) Information
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8. Externality
Steel Factory
Resort Hotel
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9. Externality
Exists whenever the welfare of some agent, depends not only on his or her activities but also on activities of some other agent.
‘An external effect exists when a decision-maker’s choice of action has effects on the wellbeing of other members of society and those effects are not reflected in the costs and benefits of the action to the decision-maker’ (Borland, , p.129)
Externality is a source of market failure – markets fails to allocate resources efficiently
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10. Types of externalities
Positive externality (external benefits)
A benefit of activity is received by people other than those who pursue the activity
E.g. Benefits to an orchard owner whose neighbour is a beekeeper
Negative externality (external costs)
A cost of an activity that falls on people other than those who pursue the activity
E.g. Costs to a downstream fisherman affected by upstream pollution by a steel factory
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11. Market Equilibrium (not optimal)
The diagram illustrates market equilibrium and includes the illustration of a negative externality in production
That is, the private marginal cost of production (PMC) is no longer equal to the social marginal cost (SMC)
The difference is the external cost, the negative externality that is imposed on society
So is the presence of a negative externality the market solution is no longer optimal
There is overproduction at Q, MSB = PMC, but MSB > SMC
Taking into account the negative externality the optimal level of production is Q* where MSB = MSC
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12. External costs and market failure
SMC
Price
S = PMC
External cost P* P
D = SMB Q* Q
Quantity
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13. GHG emissions as an externality
GHG emission problem is a negative externality (spillover cost/external cost)
GHG emitters impose costs on the world and future generations
But producers (or consumer) do not directly face the full consequences of their actions
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14. Salient features of Climate Change (CC)
CC is an externality that is global in both its causes and consequences
The impacts of CC are persistent and develop over time
Considerable uncertainties exist about the potential size, type and timing of impacts
The impacts can potentially cause irreversible damage with non-marginal changes
Source: Stern (2007)
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15. Correcting negative externalities
Approaches to correct for externalities:
Legislative actions
E.g. Emission standards, such as a legal limit on pollution
Market-based Instruments (MBIs)
E.g. Specific taxes (Pigouvian taxes)
Subsidy (if it is a positive externality)
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16. Correcting negative externalities
3. Property rights and individual bargaining
The Coase theorem suggests that externalities do not require government intervention where:
Property rights are clearly defined;
The number of people involved is small; and
Bargaining costs are negligible
Ronald Coase
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17. Can you think of 2 reasons why you wouldn’t run this business?

18. Private Good Excludable: Rivalry: Possible to exclude use by prices
Consumption by one person limits that of others
Consumption is divisible
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19. What is a public good? Non-excludable: Non-rival:
Impossible to exclude others from using (enjoying) it
Non-rival:
Consumption by one person doesn’t interfere with that of others
Consumption is indivisible
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20. Public Good
If made available to one person, others cannot be excluded from using it.
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21. Other examples of public goods
At a local (or country) level:
Clean air
National defence
Free-to-air television signals
Biodiversity
Clean water
At a global level:
Preventing global warming
Preserving ozone layer
Some ocean fisheries
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22. Public ‘bads’ Non-excludable and non-rival nasties Examples:
Greenhouse gas emissions (GHGs)
Urban air pollution
Noise pollution
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23. Private goods vs Public goods
Efficiently provided by markets
Demand for them is reflected in Willingness to Pay (WTP)
Inefficiently provided
Under-provision
People can enjoy them without paying so don’t need to reveal true WTP
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24. Some intermediate categories
Excludable goods which are non-rival (sometimes called club goods):Club Goods
Cable TV, fire protection, uncongested toll roads, private nature reserves, zoos
Rival goods which are non-excludable (Common property resources): Common Property
Forests, ‘environment’, non-toll roads, whales in international waters
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25. Under- and over-provision
Public goods are under-provided by private markets since consumption is non-rival
Consumers can free-ride – taking advantage of public goods without making adequate contributions to their creation
Public bads are over-provided – individuals have personal but not social reasons to cut back pollution
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26. GHG as a Public bad (aka GHG mitigation – a Public good)
Those who fail to pay for GHG mitigation cannot be excluded from enjoying the benefits of avoiding adverse climate impacts
Unfettered markets do not provide the right quantity of a public good
Thus CC is an example of market failure involving externalities and public goods
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27. Efficient provision of public good
Consider a society with 2 persons (A and B)
Let MWTPi = MWTP of person i
Suppose respective MWTP of individuals are known (MWTPA, MWTPB)
MWTP given by the height of the respective Demand curves
*MWTP = Marginal Willingness to Pay
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28. Efficient provision of public good
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29. Efficient provision of public goods
Samuelson rule requires aggregate marginal WTPs equating to MC
BUT people may not reveal their true MWTPs
Paul Samuelson (1954)
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30. Public provision
Governments may try to measure the benefits and compare with costs using Benefit-Cost Analysis and then provide them using tax funds
However, agents may not reveal their true preferences if anticipate public provision
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