Market Failure and Resource
Allocation
(Externalities)
1
Market failure
–
What do we mean by market failure?
–
Just that the market fails to arrive at the “correct”
price and quantity
–
Something is interfering with the guiding function of
prices.
–
The most common form of market failure is
externalities.
–
Today we are going to explore how externalities
stop market achieving an allocatively efficient
equilibrium
2
Externalities
–
An externality is a cost or benefit that arises from
production and falls on someone other than the
producer, or a cost or benefit that arises from
consumption and falls on someone other than the
consumer.
–
A negative externality imposes an external cost
and a positive externality creates an external
benefit.
3
Externalities
• The four possible types of externality
are:
–
Negative production externalities
–
Positive production externalities
–
Negative consumption externalities (not discussed)
–
Positive consumption externalities (not discussed)
4
Externalities
• Negative Production Externalities
–
Negative production externalities are common.
–
Examples are noise from aircraft, logging and
clearing of forests, and pollution
–
There is an incentive for firms to produce negative
externalities, correcting externalities adds to costs
and reduces profits.
–
Pollution lowers costs and increases profits.
5
Externalities
• Positive Production Externalities
–
Positive production externalities are less common
than negative externalities.
–
Example: a beekeeper locates beehives in an
orange-growing area, the bees primary purpose is
to collect nectar to make honey, but they also
assist in pollination so increase the productivity of
orchards and vineyards.
–
This increase production and profits for the
farmers.
6
Externalities
• Negative Consumption Externalities
–
Negative consumption externalities are a common
part of everyday life.
–
Smoking in a confined space poses a health risk to
others; noisy parties or loud car stereos disturb
others.
7
Externalities
• Positive Consumption Externalities
–
Positive consumption externalities are also common.
–
When you get a flu vaccination, everyone you come
into contact with benefits.
–
When the owner of an historic building restores it
the value of nearby houses increase, so house prices
and rents rise.
8
Negative Externalities:
Pollution
• Private Costs and Social Costs
–
A private cost of production is a cost that is borne
by the producer, and marginal private cost (MC)
is the private cost of producing one more unit of a
good or service.
–
An external cost of production is a cost that is not
borne by the producer but is borne by others.
–
Marginal external cost is the cost of producing
one more unit of a good or service that falls on
people other than the producer.
9
Negative Externalities:
Pollution
• Private Costs and Social Costs
–
Marginal social cost (MSC) is the marginal cost
incurred by the entire society and is the sum of
marginal private cost and marginal external cost.
MSC = MC + Marginal external cost.
–
Marginal private cost, marginal external cost, and
marginal social cost increase with output.
10
An External Cost
Cost ( dollars per tonne)
300
Marginal
Social cost
Figure 16.2
MSC
225
Marginal External
cost
150
MC
100
75
Marginal
Private cost
2
4
6
Quantity (thousands of tonnes per month)
11
Negative Externalities:
Pollution
• Production and Pollution: How Much?
–
In an unregulated market with an externality, the
pollution created depends on the market
equilibrium price and quantity of the good
produced.
–
But P<P* and Q>Q* so too many resources are
allocated to production.
12
Inefficiency with an
External Cost
Price and cost ( dollars per tonne)
300
Marginal
Social cost
Figure 16.3
MSC
225
Deadweight loss
Efficient
equilibrium
Inefficient
Market
equilibrium
150
S= MC
100
75
D=MSB
Efficient
quantity
Marginal
Social
Benefit
2
4
6
Quantity (thousands of tonnes per month)
13
Correcting Negative
Externalities:
• Two major approaches
• Command and control policies
• Market intervention
14
Correcting Negative
Externalities
• Command and control policies
• These usually take the form of regulations
that
–
–
forbid certain behaviours
require certain behaviours.
• Examples:
–
Regulations on pollution emission levels
• Internalise the externality, force the polluter
to either not pollute or not discharge
pollution.
15
Internalising externalities lead
to an Efficient Outcome
Price and cost ( dollars per tonne)
300
Price equals
marginal social
cost and MSB
S = MC =MSC
225
Cost of pollution
Borne by polluter
Efficient market
equilibrium
MC excluding
pollution cost
150
100
75
D=MSB
2
4
6
Quantity (thousands of tonnes per month)
16
Negative Externalities:
Pollution
• The Coase Theorem
–
The Coase theorem is a proposition that if
property rights exist, if only a small number of
parties are involved, and if transactions costs
(defined below) are low, then private transactions
are efficient.
–
There are no externalities because all parties take
into account the externalities involved. The
outcome is independent of who has the property
rights.
17
Negative Externalities:
Pollution
• Transactions costs are the opportunity
cost of conducting a transaction.
–
Example: the transactions costs of buying a home
include fees for a real estate agent, and the legal
cost associated with the transfer.
–
When a large number of people are involved then
the transactions costs tend to be high, the Coase
solution is not available.
18
–
Also if people cannot be compensated for the effects
of the pollution, then the Coase solution will not
work, so-called corner solution, Coase theorem will
not work.
–
The parties need to be negotiating in good faith, if
not then no agreement will be met or transaction
costs are higher.
–
Information asymmetry, the costs of disclosure may
increase transaction costs.
19
Negative Externalities:
Pollution
• Taxes
–
The government can set a tax equal to the
marginal external cost.
–
The effect of such a tax is to make marginal
private cost plus the tax equal to marginal social
cost:
MC + Tax = MSC.
–
This tax is called Pigovian Tax, in honour of the
British economist Arthur Cecil Pigou, who first
proposed dealing with externalities in this fashion.
20
A Pollution Tax (ad valorum)
Price and cost ( dollars per tonne)
300
Marginal social
cost and MSB
S = MC + tax = MSC
225
Pollution tax
Efficient market
equilibrium
150
MC
88
75
D=MSB
Tax
revenue
2
4
6
Quantity (thousands of tonnes per month)
21
A Pollution Tax (per unit)
Price and cost ( dollars per tonne)
300
Marginal social
cost and MSB
S = MC + tax = MSC
225
Pollution tax
Efficient market
equilibrium
150
MC
88
75
D=MSB
Tax
revenue
2
4
6
Quantity (thousands of tonnes per month)
22
An example
• Cigarette taxws
23
An example
• Tax on alcopops
24
Positive Externalities:
Knowledge
• Private Benefits and Social Benefits
–
A private benefit is a benefit that the consumer of a
good or service receives. Marginal private benefit
(MB) is the private benefit from consuming one
more unit of a good or service.
–
An external benefit is a benefit that someone other
than the consumer receives. Marginal external
benefit is the benefit from consuming one more
unit of a good or service that people other than the
consumer enjoy.
25
Positive Externalities:
Knowledge
–
Marginal social benefit is the marginal benefit
enjoyed by the entire society and is the sum of
marginal private benefit and marginal external
benefit. That is:
–
MSB = MB + Marginal external benefit.
26
Correcting Positive
Externalities: Knowledge
• Government Action in the Face of
External Benefits
–
There are three main methods that the government
uses to cope with external benefits:

Public provision

Private subsidies

Vouchers
29
Correcting Positive
Externalities: Knowledge
• Three possible goals of policy
• First get both P and Q correct.
• Second get Q correct and not worry about
P being wrong.
• Third get P correct and not worry about Q
being wrong.
30
Correcting Positive
Externalities: Knowledge
• Public Provision
–
Under public provision, a public authority that
receives its revenue from the government produces
the good or service.
–
Education services produced by the public
universities and schools are examples of public
provision
31
Positive Externalities:
Knowledge
• Private Subsidies
–
A subsidy is a payment by the government to
private producers. The government can induce
private decision makers to consider external
benefits by making the subsidy depend on the
level of output
–
If the government pays the producer an amount
equal to the marginal external benefit for each unit
produced, the quantity produced increases to that
at which marginal cost equals marginal social
33
benefit—an efficient outcome.
Positive Externalities:
Knowledge
• Vouchers
–
–
A voucher is a token that the government
provides to households, which can be used to buy
specified goods or services.
A school voucher allows parents to choose the
school their children will attend and to use the
voucher to pay part of the cost. The school cashes
the voucher to pay its bills.
35
An example
• The triangle waistshirt company
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