Market Failure
Market Failure
• Definition:
• Where the market mechanism fails to allocate
resources efficiently
– Social Efficiency
– Allocative Efficiency
– Technical Efficiency
– Productive Efficiency
OR is a situation in which the invisible hand
pushes in such a way that individual decisions
do not lead to socially desirable outcomes
Market Failure
• Market Failure is a situation in which the
market does not provide the ideal or
optimal amount of a particular good.
• Example: When goods are produced and
consumed, side effects occur. These side
effects are called externalities because the
costs or benefits are external to the
person(s) who caused them.
Market Failure
• Social Efficiency = where external costs and benefits are
accounted for (MSC=MSB).
• Allocative Efficiency = resources cannot be readjusted
to make one consumer better off without making another
worse off – zero opportunity cost! i.e. Society produces
goods and services at minimum cost that are wanted by
consumers (P = MC) – Pareto Efficient allocation (demand
or MB = Supply or MC).
• Technical Efficiency = production of goods and services
using the minimum amount of resources.
• Productive Efficiency = production of goods and
services at lowest factor cost (P=Min ATC).
Market Failure
• Market fails to produce the right amount of
•
the product
Resources may be
• Over-allocated
• Under-allocated
Demand and Supply-Side
Failures
Demand-Side Failures
-Impossible to charge consumers what they are
willing to pay for the product
- Some can enjoy benefits without paying
Supply-Side Failures
• Occurs when a firm does not pay the full cost
of producing its output
• External costs of producing the good are not
reflected in the supply
Market Failure
• Market Failure occurs where:
– Knowledge is not perfect – ignorance
– There is resource immobility
– There is monopoly power
– Services/goods would or could not be
provided in sufficient quantity by the market
– External costs and benefits exist
– Inequality exists
Efficiency
• Allocative efficiency
–Also referred to as Pareto Efficient
Allocation.
–Resources cannot be readjusted to make
one consumer better off without making
another worse off … zero opportunity cost!
–Named after Vilfredo Pareto (1848–1923).
Causes of Market Failure
• Market Failure occurs where:
1.Knowledge is not perfect - ignorance
2.Goods are differentiated
3.Resource immobility
4.Market power - price making behavior
5.Services/goods would or could not be provided
in sufficient quantity by the market
6.Existence of external costs and benefits
7.Inequality exists
Imperfect Knowledge
1.Imperfect Knowledge/ Asymetric
information
–a situation in which one party engaged in an
economic transaction has better information
about the good or service traded than the other
party
Immediately after purchase the value of a car
drops substantially. Why?
A seller has more information about the car than a
buyer
Asymmetric Information
• Asymmetric information
exists when either the
buyer or the seller in a
market exchange has
some information that
the other does not
have.
• Information can cause
the buyer or seller to
lower the demand or
supply of the good in
question.
Asymmetric
Information
in a Product
Market
Initially, the seller has some information that the buyer does not have;
there is asymmetric information. As a result, D1 represents the
demand for the good and Q1 is the equilibrium quantity. Then, the
buyer acquires the information that she did not have earlier and there
is symmetric information. The information causes the buyer to lower
her demand for the good so that now D2 is the relevant demand
curve and Q2 is the equilibrium quantity. Conclusion: Fewer units of
the good are bought and sold when there is symmetric information
than when there is asymmetric information.
Asymmetric
Information
in a Factor
Market
Initially, the buyer (of the factor labor), or the firm, has some information that
the seller (of the factor) does not have; there is asymmetric information.
Consequently, S1 is the relevant supply curve. W1 is the equilibrium wage,
and Q1 is the equilibrium quantity of labor. Then, sellers acquire the
information that they did not have earlier, and there is symmetric information.
The information causes the sellers to reduce their supply of the factor so that
now S2 is the relevant supply curve, W2 is the equilibrium wage, and Q2 is
the equilibrium quantity of labor. Conclusion: Fewer factor units are bought
and sold and wages are higher when there is symmetric information than
when there is asymmetric information
Is There Market Failure?
• Asymmetric information seemingly resulted in “too
much” or “too many” of something – either too much of
a good being consumed or too many workers working
for a particular firm.
• The point is whether or not the asymmetric information
fundamentally changes the outcome from what it
would be if there were symmetric information.
• The presence of asymmetric information does not
guarantee that the market fails. What matters is
whether the asymmetric information brings about a
different outcome than the outcome that would exist if
there were symmetric information. If this occurs, the
case for market failure can be made.
Adverse Selection
• Some economists argue that under certain
conditions, information problems can eliminate
markets or change the composition of markets.
• Adverse selection exists when the parties on one
side of the market, who have information not known
to others, self – select in a way that adversely
affects the parties on the other side of the market.
• Asymmetric Information leads to adverse selection.
• Adverse selection occurs when products of
different qualities are sold at the same price
because of asymmetric information.
– This is apparent in insurance markets.
Moral Hazard
• Asymmetric information
can also exist after a
transaction has been
made. If it does, it can
cause a moral hazard
problem.
• Moral Hazard occurs
when one party to a
transaction changes his
behavior in a way that is
hidden from and costly to
the other party.
Moral hazard
• Moral hazard occurs when an insurance
policy or some other arrangement
changes the economic incentives we face,
thus leading us to change our behavior,
usually in a way that is detrimental to the
market.
• To limit the moral hazard problem,
insurance companies will place restrictions
on individual behavior in some contracts.
Q&A
• Give an example that illustrates how asymmetric
information can lead to more of a good being
consumed than if there is symmetric information.
• Adverse selection has the potential to eliminate
some markets. How is this possible?
• Give an example that illustrates moral hazard.
Differentiated Goods & Services
2. Goods & Services are differentiated
–Branding
–Designer labels - Cost 3 times as much but
are they 3 times the quality?
–Technology – lack of understanding of the
impact
–Labelling and product information
Resource Immobility
3. Resource Immobility
– Factors are not fully mobile
– Labour immobility – geographical and
occupational
– Capital immobility
– Land – cannot be moved to where it might be
needed
Monopoly power
4. Monopoly power
–Existence of monopolies and oligopolies
–Collusion
–Price fixing
–Abnormal profits
–Barriers to entry
A monopolist producing less than the social optimum
R
MC
P1
MC1
AR
MR
O
Monopoly output
Q1
Q
A monopolist producing less than the social optimum
R
MC = MSC
P1
P2 = MSB
= MSC
MC1
AR = MSB
MR
O
Monopoly output
Q1
Q2
Q
Perfectly competitive output
Monopoly power
Monopoly power
– Produces less than the social optimum
– Deadweight loss under monopoly
• The demand curve under monopoly
– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
• total surplus
Deadweight loss under monopoly
R
MC
(= S under perfect competition)
Consumer
surplus
a
Ppc
Producer
surplus
AR = D
O
Qpc
(a) Industry equilibrium under perfect competition
Q
Monopoly power
• The demand curve under monopoly
– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
• total surplus
– the effect of monopoly on total surplus
Deadweight loss under monopoly
R
Pm
Ppc
MC
(= S under perfect competition)
Consumer
surplus
Deadweight
welfare loss
b
a
Producer
surplus
AR = D
MR
O
Qpc
Qpc
(b) Industry equilibrium under monopoly
Q
Deadweight loss under monopoly
R
MC
(= S under perfect competition)
Perfect
competition
Consumer
surplus
a
Ppc
Producer
surplus
AR = D
O
Qpc
(a) Industry equilibrium under perfect competition
Q
Deadweight loss under monopoly
R
MC
(= S under perfect competition)
Monopoly
Pm
Ppc
Consumer
surplus
Deadweight
welfare loss
b
a
Producer
surplus
AR = D
MR
O
Qm
Qpc
(b) Industry equilibrium under monopoly
Q
Monopoly power
• The demand curve under monopoly
– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
• total surplus
– the effect of monopoly on total surplus
• Other problems with monopoly
Monopoly power
• The demand curve under monopoly
– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
• total surplus
– the effect of monopoly on total surplus
• Other problems with monopoly
• Possible advantages from monopoly
Public Goods and Common
Resource
• Free goods provide a special challenge for
economic analysis.
• Most goods in our economy are allocated in
markets…
• When goods are available free of charge, the
market forces that normally allocate resources in
our economy are absent.
• When a good does not have a price attached to
it, private markets cannot ensure that the good is
produced and consumed in the proper amounts.
Public Goods and Common
Resource
• In such cases, government policy can
potentially remedy the market failure that
results, and raise economic well-being.
THE DIFFERENT
KINDS OF GOODS
• When thinking about the various goods in the economy,
it is useful to group them according to two
characteristics:
– Is the good excludable?
– Is the good rival?
• Excludability
– Excludability refers to the property of a good whereby
a person can be prevented from using it.
• Rivalry
– Rivalry refers to the property of a good whereby one
person’s use diminishes other people’s use.
THE DIFFERENT
KINDS OF GOODS
• Four Types of Goods
– Private Goods
– Public Goods
– Common Resources
– Natural Monopolies
THE DIFFERENT
KINDS OF GOODS
• Private Goods
– Are both excludable and rival (Ice Cream Cones,
Clothes).
• Public Goods
– Are neither excludable nor rival (National Defense,
Fireworks).
• Common Resources
– Are rival but not excludable (Fish in the ocean, the
environment).
• Natural Monopolies
– Are excludable but not rival (Fire Protection, Cable TV).
• A road is which of the four kinds of goods?
• Hint: The answer depends on whether the
road is congested or not, and whether it’s
a toll road or not. Consider the different
cases
Answer
• Rival in consumption? Only if congested.
• Excludable? Only if a toll road.
Four possibilities:
Uncongested non-toll road: public good
Uncongested toll road: natural monopoly
Congested non-toll road: common resource
Congested toll road: private good
Merit Goods and Public Goods
• Inadequate Provision:
– Merit Goods – Could be provided by the
market but consumers may not be able to
afford or feel the need to purchase – market
would not provide them in the quantities
society needs
– Sports facilities?
Merit Goods
• Education –
nurseries, schools,
colleges, universities
• All education – could
all be provided by the
market but would
everyone be able to
afford them?
Schools: Would you pay if the
state did not provide them?
Public Goods
Markets would not provide
such goods and services
at all!
• Non-excludability – Person
paying for the benefit cannot
prevent anyone else from
also benefiting - the ‘free
rider’ problem
• Non-rivalry – Large external
benefits relative to cost –
socially desirable but not
profitable to supply!
A non-excludable good?
Would you pay for this?
The Free-Rider Problem
• Public goods are difficult for private markets to provide
because of the free-rider problem.
• A free-rider is a person who receives the benefit of a
good but avoids paying for it.
– If good is not excludable, people have incentive to be
free riders, because firms cannot prevent non-payers
from consuming the good.
• Result: The good is not produced, even if buyers
collectively value the good higher than the cost of
providing it.
The Free-Rider Problem
• Since people cannot be excluded from
enjoying the benefits of a public good,
individuals may withhold paying for the
good hoping that others will pay for it.
• The free-rider problem prevents private
markets from supplying public goods.
The Free Rider Problem
• Solving the Free-Rider Problem
– The government can decide to provide the public
good if the total benefits exceed the costs.
– The government can make everyone better off by
providing the public good and paying for it with tax
revenue.
• If the benefit of a public good exceeds the cost
of providing it, govt should provide the good and
pay for it with a tax on people who benefit.
• Problem: Measuring the benefit is usually
difficult.
Cost-benefit analysis
• Cost-benefit analysis: a study that compares
the costs and benefits of providing a public good
• Cost-benefit analyses are imprecise, so the
efficient provision of public goods is more
difficult than that of private goods.
Some important Public Goods are:
• National Defense
• Knowledge created through basic research
• Fighting Poverty
De-Merit Goods
• De-Merit Goods
• Goods which society over-produces
• Goods and services provided by the market
which are not in our best interests!
– Tobacco and alcohol
– Drugs
– Gambling
Common Property Resources
• Common resources, like public goods, are
not excludable. They are available free of
charge to anyone who wishes to use them.
• Common resources are rival goods
because one person’s use of the common
resource reduces other people’s use.
Tragedy of the Commons
• The “tragedy of the commons” arises when an
open-access resource is overused.
– Ocean fisheries are an example. Because
no one “owns” the stock of ocean fish, there is
not an incentive to preserve its value.
• The “tragedy of the anticommons” arises when
one owner of a resource can block development
of a good that would have benefits to many,
such as an airport.
Tragedy of the Commons
– The Tragedy of the Commons is a parable
that illustrates why common resources get
used more than is desirable from the
standpoint of society as a whole.
– Common resources tend to be used
excessively when individuals are not charged
for their usage.
– This is similar to a negative externality.
• Role for govt: ensuring they are not overused
Tragedy of the Commons
• Elephant - common resource
– No owners
– Poachers - numerous
• Strong incentive to kill them
• Slight incentive to preserve them
• Cows - private good
– Ranches - privately owned
– Ranchers
• Great effort to maintain the cattle population on his
ranch
• Reaps the benefit
• Government intervention – help elephant population
– Kenya, Tanzania, and Uganda
• Illegal to kill elephants; Illegal to sell ivory
• Hard to enforce
• Elephant population – still diminishing
– Botswana, Malawi, Namibia, and Zimbabwe
• Elephants – private good
• Allow people to kill elephants
– Only those on their own property
• Landowners - incentive to preserve elephants
• Elephant population – started to rise
The tragedy of the commons
– Negative externality
• One person uses a common resource
– Diminishes other people’s enjoyment of it
• Common resources tend to be used excessively
because Social and private incentives differ
– Government - can solve the problem
• Regulation or taxes
– Reduce consumption of the common resource
• Turn the common resource into a private good
Policy options for common
resources
• What could the townspeople
(or their government)
have done to prevent the tragedy?
• Try to think of two or three options.
Answers
• Impose a corrective tax on the use of the
land to “internalize the externality.”
• Regulate use of the land (the “commandand-control” approach).
• Auction off permits allowing use of the
land.
• Divide the land, sell lots to individual
families; each family will have incentive
not to overgraze its own land.
Policy Options to Prevent
Overconsumption of Common Resources
• Regulate use of the resource
• Impose a corrective tax to internalize the externality
– example: hunting & fishing licenses,
entrance fees for congested national parks
• Auction off permits allowing use of the resource
• If the resource is land, convert to a private good
by dividing and selling parcels to individuals
Common Resources
• Some firms use spam emails
to advertise their products.
• Spam is not excludable:
Firms cannot be prevented
from spamming.
• Spam is rival: As more
companies use spam, it becomes less effective.
• Thus, spam is a common resource.
• Like most common resources, spam is overused –
which is why we get so much of it!
CONCLUSION
• Public goods tend to be under-provided, while
common resources tend to be over-consumed.
• These problems arise because property rights
are not well-established:
– Nobody owns the air, so no one can charge
polluters. Result: too much pollution.
– Nobody can charge people who benefit from
national defense. Result: too little defense.
• The govt can potentially solve these problems
with appropriate policies.
THE IMPORTANCE OF
PROPERTY RIGHTS
• The market fails to allocate resources
efficiently when property rights are not
well-established (i.e. some item of value
does not have an owner with the legal
authority to control it).
• When the absence of property rights
causes a market failure, the government
can potentially solve the problem.
Externality
• A cost or benefit that occurs when the activity of
one entity directly affects the welfare of another
in a way that is outside market mechanism
• Externalities arise between producers, between
consumers, or between producers and
consumers
• Externalities are the effects of production and
consumption activities not directly reflected in
the market
– They can be negative or positive
Negative Externality
• Negative
– Action by one party imposes a cost on
another party
• Plant dumps waste in a river, affecting those
downstream, Second-hand smoke and carbon
monoxide emissions
• The firm has no incentive to account for the
external costs that it imposes on those
downstream
• When goods are produced and consumed,
side effects occur. These side effects are
called externalities because the costs or
benefits are external to the person(s) who
caused them.
Costs & Benefits: Private &
External
• A Negative Externality exists when a person’s or
group’s actions cause an adverse side effect to
be felt by others.
• A consequence of a negative externality is that
social costs do not equal private costs and the
socially optimal level of production is not
naturally obtained.
• Socially Optimal Output is the output level that
takes into account and adjusts for all benefits
(external as well as private) and all costs
(external as well as private).
Marginal Costs & Benefits
• The sum of marginal private costs (MPC)
and marginal external costs (MEC) is
Marginal Social Costs (MSC).
• The sum of marginal private benefits
(MPB) and marginal external benefits
(MEB) is marginal social benefits (MSB).
Social Optimality or Efficiency
Conditions
• Socially Optimal Amount (output) is an
amount that takes into account and
adjusts for all benefits (external and
private) and all costs (external and
private).
• The socially optimal amount is the amount
at which MSB = MSC. Sometimes, the
socially optimal amount is referred to as
the efficient amount.
Three Categories
Category
Definition
1
No negative or positive
externality
2
MEC > 0 and MEB = 0;
Negative externality but
it follows that MSC >
no positive externality
MPC and MSB = MPB
3
MEC = 0 and MEB > 0;
it follows that MSC =
MPC and MSB > MPB
Positive externality but
no negative externality
Meaning In terms of
Marginal benefits and
costs
MEC = 0 and MEB = 0;
it follows that MSC =
MPC and MSB = MPB
A Negative Externality Example
• When there are negative externalities, the marginal
social cost differs from the marginal private cost
• The marginal social cost includes the marginal private
costs of production plus the cost of negative externalities
associated with that production
• It includes all the marginal costs that society bears
21-66
A Negative Externality Example
Cost, P
S1 = Marginal
If there are no externalities,
P0Q0 is the equilibrium
Social Cost
S0 = Marginal
Private Cost
P1
Cost of externality
P0
D = Marginal
Social Benefit
Q1 Q0
Q
If there are externalities,
the marginal social cost
differs from the marginal
private cost, and P0 is too
low and Q0 is too high to
maximize social welfare
Government intervention
may be necessary to
reduce production
21-67
Externalities in Consumption
and in Production
• Externalities can arise because someone
consumes something that has an external
benefit or cost for others or because
someone produces something that has an
external benefit or cost for others.
The Negative Externality Case
• Because of a negative externality,
marginal social costs (MSC) are greater
than marginal private costs (MPC) and the
market output is greater than the socially
optimal output.
• The market is said to fail in that it
overproduces the good.
The Negative Externality Case
The Triangle
• Q2 is the socially optimal output; Q1 is the market
output.
• If society moves from Q2 to Q1, buyers benefit by an
amount represented by the shaded area of Window
1, but sellers and third parties together incur greater
costs, represented by the shaded area in Window 2.
• The triangle, the difference between the two
shaded areas, represents the net social cost to
society of moving from Q2 to Q1 or producing Q1
instead of Q2.
A Positive Externality Example
• When there are positive externalities, the marginal
social benefit differs from the marginal private benefit
• The marginal social benefit includes the marginal
private benefit of consumption plus the benefits of
positive externalities resulting from consuming that good
• It includes all the marginal benefits that society
receives
21-73
Positive Externality
• Positive
– Action by one party benefits another party
• Homeowner plants a beautiful garden where all the
neighbours benefit from it
• Homeowner did not take their benefits into account
when deciding to plant
• A consequence of a positive externality is that
social benefits do not equal private benefits and
the socially optimal level of production is not
naturally achieved.
The Positive Externality Case
• Because of a positive externality, marginal
social benefits (MSB) are greater than
marginal private benefits (MPB) and the
market output is less than the socially
optimal output.
• The market is said to fail in that it
underproduces the good.
External Costs and Benefits
• External costs
– The cost of an economic decision to a third party.
Examples: Exhaust from automobiles, Barking dogs
• External benefits
– The benefits to a third party as a result of a decision
by another party. Examples: Restored historic
buildings, Research into new technologies.
A Positive Externality Example
If there are no externalities,
P0Q0 is the equilibrium
Cost, P
S = Marginal
Private Cost
P1
Benefit of
externality
P0
D1 = Marginal
Social Benefit
D0 = Marginal
Private Benefit
Q0
Q1
Q
If there are externalities,
the marginal social benefit
differs from the marginal
private benefit, and both
P0 and Q0 are too low to
maximize social welfare
Government intervention
may be necessary to
increase consumption
21-78
Negative Externalities and
Inefficiency
• Scenario – plant dumping waste
– Marginal External Cost (MEC) is the increase
in cost imposed on fishermen downstream for
each level of production
– Marginal Social Cost (MSC) is MC plus MEC
– We can show the competitive market firm
decision and the market demand and supply
curves
• Assume the firm has a fixed proportions
production function and cannot alter its
input combinations
– The only way to reduce waste is to reduce
output
• Price of steel and quantity of steel initially
produced given by the intersection of
supply and demand
• The MC curve for the firm is the marginal
cost of production
• Firm maximizes profit by producing where
MC equals price in a competitive firm
• As firm output increases, external costs on
fishermen also increase, measured by the
marginal external cost curve
• From a social point of view, the firm
produces too much output
External Costs
• Decision makers do
not take into account
the cost imposed on
society and others as
a result of their
decision
e.g. pollution, traffic
congestion, environmental
degradation, depletion of the
ozone layer, misuse of alcohol,
tobacco, anti-social behaviour,
drug abuse, poor housing
External Costs
MSC = MPC + External Cost
Price
MPC
£12
Value of the negative
externality (Welfare Loss)
Social Cost
£7
£5
Socially efficient output is where
MSC = MSB
MSB
80
100
Quantity Bought and Sold
External Costs
• The Marginal Social Benefit curve (MSB)
represents the sum of the benefits to consumers
in society as a whole i.e. the private and social
benefits. The Marginal Private Cost (MPC) curve
represents the costs to suppliers of producing a
given output.
• The true cost therefore is the MSC (the MPC
plus the external cost). Current output levels
therefore (100) represent some element of
market failure – price does not accurately reflect
the true cost of production.
External Costs
• The MPC does not take into account the cost to
society of production. At an output level of 100,
the private cost to the supplier is £5 per unit but
the cost to society is higher than this (£12).
• The difference between the value of the MSB
and the MSC represents the welfare loss to
society of 100 units being produced.
• Negative externalities encourage inefficient firms
to remain in the industry and create excessive
production in the long run
Positive Externalities and
Inefficiency
• Externalities can also result in too little
production, as can be shown in an
example of home repair and landscaping
• Repairs generate external benefits to the
neighbours
– Shown by the Marginal External Benefit curve
(MEB)
– Marginal Social Benefit (MSB) curve adds
MEB +MPB
External benefits
• by products of
production and
decision making that
raise the welfare of a
third party
e.g. education and training,
public transport, health
education and preventative
medicine, refuse collection,
investment in housing
maintenance, law and order
External Benefits
Price
MSC
Value of the positive
externality (Welfare Loss)
£10
£6.50
There can be a position
where output is less than
would be socially desirable
(education for example?) In
this case, the sum of the
benefits to society is greater
than the private benefit to the
individual.
Social Benefits
£5
MSB
Socially efficient output
is where
MSC = MSB
MPB
100
140
Quantity Bought and Sold
coase theorem
• The efficient solution will be achieved
indpendently of who is assigned the property
rights, as long as someone is assigned property
rights (the right to clean air or the right to pollute)
Assumptions:
• The costs to the parties of bargaining are low
• The owners of resources can identify the source
of damages to their property.
• When there are well-defined property rights
Q&A
• What is the major
difference between
the market output and
the socially optimal
output?
• For an economist, is
the socially optimal
output preferred to
the market output?
Internalizing Externalities
• An Externality is Internalized if the persons or
group that generated the externality incorporate
into their own private or internal cost-benefit
calculations the external benefits (in the case of
a positive externality) or the external costs (in
the case of a negative externality) that third
parties bear.
• An externality has been internalized or adjusted
for completely if, as a result, the socially optimal
output emerges.
Persuasion and Assigning
Property Rights
• Many negative externalities arise partly because
persons or groups do not consider other
individuals when they decide to undertake an
action.
• Trying to persuade those who impose external
costs on us to adjust their behavior to take these
costs into account is one way to make the imposer
adjust for – or internalize – externalities.
Taxes and Subsidies
• Taxes and subsidies are sometimes used as
corrective devices for a market failure.
• A tax adjusts for a negative externality, a
subsidy for a positive externality.
• One way to deal with externalities is for
government to apply regulations directly to the
activities that generate the externalities.
• Critics of this approach note that regulations are
difficult to remove, may be inappropriate in every
circumstance and entail costs.
Inequality
– Poverty – absolute and relative
– Distribution of factor ownership
– Distribution of income
– Wealth distribution
Markets and Efficiency
• Markets are efficient mechanisms for
allocating resources.
• Efficient markets require
– Property rights
– Contracts
– Minimum of spillovers
– Competition
– Accurate information
made widely available
A Corrective Tax Gone Wrong
Government may miscalculate
external costs and impose a
tax that moves the supply
curve from S1 to S3, instead of
from S1 to S2. As a result, the
output level will be farther
away from the socially optimal
output than before the
“corrective” tax was applied.
Q3 is farther away from Q2
than Q1 is from Q2.
Assigning Property Rights

If someone owns a resource, then
actions that damage it have a price;
namely, the resource owner can sue for
damages.
 By having something owned, the owner
can then sue for damages.
Voluntary Agreements
• Externalities can
sometimes be
internalized through
individual voluntary
agreements.
• A negative externality
problem can be
successfully addressed
by entering into a
voluntary agreement if
the transaction costs
are low relative to the
expected benefits of the
agreement.
Coase Theorem
• In the case of trivial or zero transaction costs, the
property rights assignment does not matter to the
resource allocative outcome.
• In the case of trivial or zero transaction costs, a
property rights assignment will be undone if it benefits
the relative parties to undo it.
• In the case of trivial or zero transaction costs, the
resource allocative outcome will be the same no
matter who is assigned the property right.
• This theorem is important for two reasons: it shows
that under certain conditions the market can
internalize externalities; it provides a benchmark for
analyzing the externality problems.
Beyond Internalizing: Setting
Regulations
• One way to deal with externalities, in
particular with negative externalities, is for
government to apply regulations directly to
the activities that generate the externality.
• Critics of this approach often note that
regulations, once instituted, are difficult to
remove even if conditions warrant
removal.
• Regulation entails cost.
Q&A
• What does it mean to internalize an externality?
• Are the transaction costs of buying a house
higher or lower than the transaction costs of
buying a hamburger at a fast-food restaurant?
Explain your answer.
• Does the property rights assignment a court
makes matter to the resource allocative
outcome?
• What condition must be satisfied for a corrective
tax to correctly adjust for a negative externality?
The Environment
Economists have three
points about pollution:
1. It is a negative
externality.
2. No pollution is
sometimes worse
than some pollution.
3. The market can be
used to deal with the
problem of pollution
When Is No Pollution Worse
Than Some Pollution?
• When all other things are held constant, no
pollution is worse than some pollution.
• Pollution is a by-product of many goods and
services; with the current state of pollution
technology, no pollution means no products that
create pollution as an externality: steel mills,
automobile plants, computers.
• Zero pollution is not preferable to some positive
amount of pollution when the goods and
services must be forfeited to have less pollution.
Two Methods to Reduce
Pollution
• Government Sets Pollution
Standards: the effected businesses
must all meet the same standards, even
though some businesses pollute more
than others.
• Market Environmentalism at Work:
Government Allocates Pollution
Permits, Then Allows Them To Be
Bought and Sold: the effected
businesses buy and sell the permits to
lower the price of fighting pollution.
Q&A
• The layperson finds it odd that economists often
prefer some pollution to no pollution. Explain
how the economists reach this conclusion.
• Why does reducing pollution cost less by using
market environmentalism than by setting
standards?
• Under market environmentalism, the dollar
amount firm Z has to pay to buy the pollution
permits from firms X and Y is not counted as a
cost to society. Why not?
Market Failure
• Measures to correct market failure
– State provision
– Extension of property rights
– Taxation
– Subsidies
– Regulation
– Prohibition
– Redistribution of income