1. © Pilot Publishing Company Ltd. 2005 Chapter 16 Market Failure?

2. © Pilot Publishing Company Ltd. 2005 Contents: Examples of Market Failure Counter Argument – the Market Works! Government Intervention is Unnecessary and InappropriateGovernment Intervention is Unnecessary and Inappropriate

3. © Pilot Publishing Company Ltd. 2005 Examples of Market Failure

4. © Pilot Publishing Company Ltd. 2005 Definitions:  Market failure  Externality  is the situation in which the invisible hand (the market price) fails to allocate resources efficiently.  is the situation in which one’s action affects others (in a non-pecuniary way) without compensation.

5. © Pilot Publishing Company Ltd. 2005 Private cost  is the cost borne by the decision maker. External cost  is the uncompensated cost borne by others. Social cost  is the total cost borne by the whole society  = private cost + external cost. External cost

6. © Pilot Publishing Company Ltd. 2005 Divergence between private and social costs Example: Noise from a construction site  is the situation in which the private cost is different from the social cost due to the presence of external cost

7. © Pilot Publishing Company Ltd. 2005 Deadweight loss MEC QsQs QpQp MPB = MSB MPC MSC S Q 0 Equilibrium & efficiency: Social optimum:  Q s (MSB = MSC) Social optimum:  Q s (MSB = MSC) Private optimum:  Q p (MPB = MPC) Private optimum:  Q p (MPB = MPC) Over-production

8. © Pilot Publishing Company Ltd. 2005 External benefit Private benefit  is the benefit obtained by the decision maker. External benefit  is the uncompensated benefit obtained by others. Social benefit  is the total benefit obtained by the whole society  = private benefit + external benefit.

9. © Pilot Publishing Company Ltd. 2005 Divergence between private & social benefits Example: Fundamental education  private benefit  social benefit  due to the existence of external benefit

10. © Pilot Publishing Company Ltd. 2005 Deadweight loss QsQs QpQp Social optimum:  Q s (MSB = MSC) Social optimum:  Q s (MSB = MSC) Private optimum:  Q p (MPB = MPC) Private optimum:  Q p (MPB = MPC) MPB MPC = MSC S Q 0 MSB MEB Equilibrium & efficiency: Under-production

11. © Pilot Publishing Company Ltd. 2005 Result (by invisible hand) Remedy (by visible hand) External cost (e.g., congestion & pollution) Over-production (Qp > Qs) Impose unit tax (to internalize the external cost) External benefit (e.g., public goods & make-up) Under-production (Qp < Qs) Impose unit subsidy (to internalize the external benefit) Effects of externality

12. © Pilot Publishing Company Ltd. 2005 Definitions: Private good  is a good of which its consumption by any individual reduces the amount available for others  it is exclusive in consumption

13. © Pilot Publishing Company Ltd. 2005 (Pure) Public good  its consumption by any individual does not reduces the amount available for others  it is non-exclusive in consumption Example: National defense Pure public good:

14. © Pilot Publishing Company Ltd. 2005 Impure public good Examples: Radio broadcast Stage performance Impure public good  can be consumed by many but not all individuals at the same time  not all individuals can consume it (or the whole amount of it) because usually an additional cost is involved in its consumption

15. © Pilot Publishing Company Ltd. 2005 Q16.3: Explain why the above are examples of pure public goods & impure public goods.

16. © Pilot Publishing Company Ltd. 2005 Q16.4: Distinguish between public goods & public services.

17. © Pilot Publishing Company Ltd. 2005 Q16.5: Some economists define public good as a good of which the marginal cost of serving an additional consumer is zero. Comment.

18. © Pilot Publishing Company Ltd. 2005 Demand for a public good MUV 1 MUV 2 MUV 1 +MUV 2 = MSB $ Q 0 Public good is non-exclusive in consumption. Once produced, all individuals consume & pay for the same stock of public good. Market demand curve for a public good = vertical sum of MUV curves of all individuals in the market (= MSB curve)

19. © Pilot Publishing Company Ltd. 2005 The social optimum QsQs P2P2 P1P1 MSC MUV 1 MUV 2 MSB = MUV 1 +MUV 2 $ Q 0 MSC P2P2 P1P1 = Optimal pricing scheme: Perfect price discrimination (i.e., P i = MUV i ) then  P i =  MUV i = MSC Optimal output: MSB(=  MUV) = MSC(=MC)

20. © Pilot Publishing Company Ltd. 2005 Private optimum If uniform pricing is practised:  In equating MR=MC, private optimum is much smaller than social optimum  To high MUV users: MUV > P To low MUV users: MUV < P and refuse to consume  MR collected (  P) is much smaller than MSB (  MUV)  Under-production and allocative inefficiency result 1. Cannot attain allocative efficiency 2. Cannot attain consumption efficiency  Once produced, no additional cost is incurred in consumption, but low MUV users are excluded from consumption  Under-consumption and consumption inefficiency result

21. © Pilot Publishing Company Ltd. 2005 If perfect price discrimination is practiced:  Under-production & allocative inefficiency result.  It is extremely costly for a producer to investigate the MUV of every individual & charge them accordingly.  Individuals may pretend to be low MUV users to bargain for a lower price.  The revenue collected from perfect price discrimination would also be smaller than MSB.

22. © Pilot Publishing Company Ltd. 2005 The free rider problem:  As public good is non-exclusive in consumption, it is difficult to recognize & prevent free-riders (non-payers) from consuming the good.  This free-rider problem may appear under all kinds of pricing schemes.  Under-production  As a result, the revenue collected would be further reduced.

23. © Pilot Publishing Company Ltd. 2005 Any remedy? Pricing Zero pricing  Under-production  Under-production  The visible hand faces similar problems as the invisible hand.  Finance the production of public good by tax revenue  Unfair to taxpayers who bear the cost but do not consume the public good.  The sectors being taxed suffer inefficiency  When the gov’t estimate MSB from surveys, consumers may overstate their MUVs and cause over-production

24. © Pilot Publishing Company Ltd. 2005 Q16.7: “To achieve consumption efficiency, a private good should be consumed by the individual with the highest MUV, while a public good should be consumed by all individuals with positive MUVs.” Comment.

25. © Pilot Publishing Company Ltd. 2005 Q16.8: Radio broadcast is a public good. What are the problems in its pricing? What are the ways to overcome the problems so that it can be provided privately? Is the situation efficient?

26. © Pilot Publishing Company Ltd. 2005 Counter Argument --- the Market Works

27. © Pilot Publishing Company Ltd. 2005 Coase theorem ( 高斯理論 ) Zero transaction cost – Coase theorem  regardless of the initial assignment of property rights  the market equilibrium is identical and efficient  provided that property rights are well-defined and transaction costs are negligible.

28. © Pilot Publishing Company Ltd. 2005 A factory in upstream A farm in downstream Illustration of the theorem Mr. B Ms. A

29. © Pilot Publishing Company Ltd. 2005 The bleaching factory discharges sewage into the river. The sewage pollutes the river and brings loss to the farm. Initial situation:

30. © Pilot Publishing Company Ltd. 2005 Case I: The farm does not have the right of enjoying clean water.  Max. amount that Mr. B is willing to offer to Ms. A is the marginal external cost he borne = MSC - MPC Assumptions: 1. No law restricting water pollution (pollution continues) 2. To min. loss, farm owner Mr. B negotiates with Ms. A and pay her to cut her output and pollution.  Min. amount that Ms. A is willing to accept is her net receipt from producing that unit = MPB - MPC = MSB - MPC

31. © Pilot Publishing Company Ltd. 2005 (Max. amount offered by Mr. B = External cost) MSC - MPC = (Min. amount accepted by Ms. A = Net receipt) MSB - MPC In equilibrium, MSC = MSB

32. © Pilot Publishing Company Ltd. 2005 Case II: The farm has the right of enjoying clean water  Max. amount that Ms. A is willing to offer to Mr. B is the her net receipt from production = MPB - MPC = MSB - MPC Assumptions: 1. A law restricting water pollution (& prod. is banned) 2. To min. loss, factory owner Ms. A negotiates with Mr. B and pay him to allow her production & pollution.  Min. amount that Mr. B is willing to accept is the external cost he borne = MSC - MPC

33. © Pilot Publishing Company Ltd. 2005 (Max. amount offered by Ms. A = Net receipt) MSB - MPC = (Min. amount accepted by Mr. B = External cost) MSC - MPC In equilibrium, MSB = MSC

34. © Pilot Publishing Company Ltd. 2005 If transaction cost is zero, by Coase theorem, private contracting would occur. As a result, the private optimum is the social optimum. Conclusion  Efficiency is achieved. Notice that the initial assignment of property rights has no influence on the allocation of resources.  N o deadweight loss.

35. © Pilot Publishing Company Ltd. 2005 If pollution cannot be avoided in production, (because the cost of preventing or eliminating pollution is extremely high) Remarks: 1. Optimal level of pollution  it is efficient to allow pollution provided that the MSB of production can cover the MSC (including the loss brought by pollution).  So there exists an optimal level of pollution.

36. © Pilot Publishing Company Ltd. 2005 Remarks: 2. Reciprocal nature of the problem  There exists no reason why someone should have the right of a resource (e.g., clean water) instead of others.  Yet, whoever has the right will gain and whoever has to buy the right will lose.  Which party bears the loss is reciprocal, depending on the assignment of rights.

37. © Pilot Publishing Company Ltd. 2005  If TC in reallocating resources to restore efficiency & eliminate the deadweight loss > the deadweight loss itself,  no private contracting or reallocation of resources is worth taking place. Prohibitively high transaction cost Achieving efficiency without reallocating resources  Although the private optimum is different from the ideal social optimum (under zero TC) & deadweight loss results, the resource allocation is still efficient (cannot be improved).  No market failure results & no government intervention is needed.

38. © Pilot Publishing Company Ltd. 2005 Deadweight loss MSC $ Q of factory 0 MPC MPB=MSB QSQS Q P1 If the farm does not have the right and the TC is prohibitively high, If the farm does not have the right and the TC is prohibitively high, Assignment of property rights affects the allocation of resources (when TC is prohibitively high)  the factory will produced at Q P1  the factory will produced at Q P1

39. © Pilot Publishing Company Ltd. 2005 Deadweight loss 0=Q P2 MSC $ Q of factory MPC MPB=MSB QSQS If the farm has the right and the TC is prohibitively high,  the factory will be banned from production, i.e., Q P2 = 0  the factory will be banned from production, i.e., Q P2 = 0

40. © Pilot Publishing Company Ltd. 2005 Government Intervention is Unnecessary and Inappropriate

41. © Pilot Publishing Company Ltd. 2005  As resource allocation by the invisible hand must be efficient, there is no market failure. Gov’t intervention is unnecessary and inappropriate  No government intervention is needed  The use of visible hand may be of undesirable motive, involve high administrative and information cost, and restrict individual freedom.  So even if there were “market failure”, the use of visible hand might not be appropriate.

42. © Pilot Publishing Company Ltd. 2005 Correcting Misconceptions: 1. Public good is a good produced by the government. 2. The market demand curve for a public good is the horizontal sum of MUV curves of all individuals in the market. 3. To achieve efficiency, private goods should be provided by the private sector and public goods should be provided by the public sector.

43. © Pilot Publishing Company Ltd. 2005 4. To achieve efficiency, pollution should be eliminated. 5. The existence of deadweight loss implies inefficiency. 6. Pareto efficiency requires zero transaction costs. Correcting Misconceptions: 7. Pareto efficiency requires an even distribution of wealth.

44. © Pilot Publishing Company Ltd. 2005 8. Pareto efficiency implies the maximization of social welfare. 9. To achieve efficiency, a polluting firm should be banned from production or it should compensate the victims. Correcting Misconceptions: 10. There is no divergence between private and social costs. 11. As the market fails to allocate resources efficiently, the government should intervene.

45. © Pilot Publishing Company Ltd. 2005 Survival Kit in Exam Question16.1: “A price-searching market allocates resources inefficiently.” Comment.

46. © Pilot Publishing Company Ltd. 2005 Survival Kit in Exam Question16.2: The construction of a rubbish collection point causes a fall in the value of nearby properties. To attain economic efficiency, which of the following options should be adopted? (a) The rubbish collection point should compensate the nearby property owners. (b) The rubbish collection point should install pollution reduction device. (c) The rubbish collection point should be relocated. (d) The nearby properties should be relocated.