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
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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
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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
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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)
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.
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
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
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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?
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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
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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
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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
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
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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
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
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• 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
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• 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. 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)
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• 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-theeu-ets
• Judging the effects of intervention – a useful check list
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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 costeffective 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)