MONASH BUSINESS SCHOOL ECF1100 Microeconomics Week 6 – Market Failure and Government Intervention Dr. George Rivers We are up to week 6 Week Topic Reading/Reference 1 Introduction to economics Chapters 1, 2 and 3 2 The market forces of supply and demand Chapter 4 3 Elasticity and its application Chapter 5 4 Supply, demand and government policies, market efficiency and costs of taxation Applications of supply and demand: international trade and labour markets Market failure and government intervention Chapters 6,7,and 8 5 6 3 Chapters 9 and 18 Chapters 10 and 11 MONASH BUSINESS SCHOOL Learning objectives 1. Define the characteristics of public goods and common resources. 2. Explain why private markets fail to provide public goods. 3. Explain why people tend to overuse common resources. 4. Understand what an externality is and why it makes a market inefficient. 5. Look at various government policies and private solutions used to tackle externalities. 4 MONASH BUSINESS SCHOOL Benefits of competitive markets • Output produced at a minimum average cost (productive efficiency). Economic problem of how to produce is addressed. • Output produced where marginal benefit to society equals the marginal cost to society (allocative efficiency) Economic problem of what or how much to produce (i.e. where resource should be allocated) is addressed. • Surplus is maximised. 5 MONASH BUSINESS SCHOOL Reasons for intervention • Maintaining the legal system or rule of law (protection of property rights) • Merit goods (merit bads) • Equity • Stabilisation policy (macroeconomic fiscal and monetary policy) • Market failure: when the market does not result in an economically efficient outcome. • Public goods • Externalities • Market power (to be considered another time) • Information failure 6 MONASH BUSINESS SCHOOL Characterisation of goods/services • Non-excludable – person can’t be prevented from using or obtaining benefits from a good or service • Problem – can’t charge there will be free riding leading to under production of goods/services. • Non-rival – consumption does not reduce availability to others • Problem – $0 additional cost of consumption hence goods/services will be under consumed if charge for. 7 MONASH BUSINESS SCHOOL Four types of goods Rival in consumption? Yes Yes Excludable? No No Private goods Ice creams Clothing Congested toll roads Club goods Fire protection Cable TV Uncongested toll roads Common Resources Fish in the ocean The environment Congested non-toll roads Public goods National Defence Knowledge Uncongested non-toll roads 8 MONASH BUSINESS SCHOOL Pure public good Nonexcludable Non-rival 9 MONASH BUSINESS SCHOOL Common resources: non-excludability = under production Rival Nonexcludable 10 MONASH BUSINESS SCHOOL Club goods: Non-rivalry = under consumption Non-rival Excludable 11 MONASH BUSINESS SCHOOL Private goods/services Rival Excludable 12 MONASH BUSINESS SCHOOL Externalities • Externality: Where a person’s activity effects the wellbeing of a bystander and yet the bystander neither pays nor receives any compensation for that effect. 13 MONASH BUSINESS SCHOOL Examples of production and consumption/positive and negative externalities • A person’s activity effects the wellbeing of a bystander (positively or negatively) who neither pays or receives compensation for that effect. Positive externality from effect Negative externality from effect Keeping of beehives Helps to pollinate nearby orchards reducing costs Steel manufacturing Releases carbon emissions creating global warming Consumption Education Improves social cohesion and productivity and reduces reliance on social security Smoking Results in passive smoking health effects on those nearby Production • Problem – positive externalities lead to too little activity and negative externalities lead to too much activity – neither is allocatively efficient 14 MONASH BUSINESS SCHOOL Example of a positive externality • Sue is a beekeeper and has a neighbor, Tom, who grows apples. • Sue determines the number of beehives where her MC = MB • But society’s marginal benefit (SMB) = Sue’s private marginal benefit (PMB) plus external benefit to Tom since her bees can help pollinate Tom’s trees. • So SMB > Sue’s PMB. • As a result, Sue keeps less than socially optimal number of beehives. 15 MONASH BUSINESS SCHOOL Positive externality of beehive consumption Marginal benefit, Marginal cost External benefit to Tom Sue’s MC SMB Sue’s PMB Q1 Q2 Sue chooses the number of hives where her MB = her MC, hence Q1. But SMB > Sue’s PMB by the amount of external benefit to Tom. When SMB = Sue’s MC, the optimal number of hives is Q2. Without proper incentives, Sue keeps too few hives. # of hives 16 MONASH BUSINESS SCHOOL Negative externality of paint production SMC Marginal benefit, Marginal cost External cost to Hugh Bob’s PMC Bob chooses the level of paint production where his MB = his MC, hence Q1. But SMB > Bob’s PMC by the amount of external cost to Hugh. When SMC = Bob’s MB, the optimal level of production is Q2. Bob’s MB Q2 Q1 Without proper incentives, Bob produces too much paint. Quantity (paint) 17 MONASH BUSINESS SCHOOL Private solutions to negative externalities • • • • Moral codes and social sanctions Charitable organisations Integrating different types of businesses Contracts (the Coase theorem) between interested parties but not easy with large numbers 18 MONASH BUSINESS SCHOOL The Coase Theorem • If private parties can bargain costlessly over the allocation of resources, then they can solve the problems of externalities on their own, independent of the initial allocation of property rights. • Conditions for Coase Theorem o Efficacy of bargaining – no transactions costs o Effective legal system that can implement and enforce contracts 19 MONASH BUSINESS SCHOOL Government solutions to externalities • Command-and-control policies: usually in the form of regulations. Examples: • All students must be immunised • All marine mammal tour operators must have a permit • Maximum residue limits on chemicals in agriculture 20 MONASH BUSINESS SCHOOL Government solutions to externalities – Market-based instruments: policies intended to influence the behaviour of people in markets to achieve the targeted outcome • Price based instruments (e.g. taxes (for negative externalities) and subsidies (for positive externalities)) • Quantity based instruments (e.g. emissions permit) 21 MONASH BUSINESS SCHOOL Negative externality and pollution tax SMC Marginal benefit, Marginal cost External cost Bob’s PMC Bob chooses the level of paint production where his MB = his MC, hence Q1. When SMC = Bob’s PMB, the optimal level of production is Q2. If there is a tax per unit equal to the amount of external cost, then Bob’s PMC increases to SMC and Bob will produce Q2. Pollution tax Bob’s MB Q2 Q1 Quantity (paint) 22 MONASH BUSINESS SCHOOL Emissions permit • Emissions permit has the same effect as pollution tax. • How the permit system works – Step 1: Set a quantity cap that limits allowable emissions in a certain area. – Step 2: Sell (auction) permits to relevant parties. – Step 3: Allow the secondary market where unused permits can be traded. • Emissions trading market was expected to grow to $400 billion by 2015* *(see Asia-Pacific Emission Trading Forum website, http://aetf.net.au) 23 MONASH BUSINESS SCHOOL Information failure and preference failure (merit goods) Efficient allocation of resources requires that everyone be informed about everything. Is this realistic? This raises 3 questions: 1. Do markets generate optimal amounts of information? 2. What happens when some agents have information not available to others (i.e. asymmetric information)? 3. Do individuals act in their best interests (i.e. merit goods)? 24 MONASH BUSINESS SCHOOL Information failure (insufficient supply of information) 1) Markets and supply of information: – Markets do not generate information in an optimal way given that once produced, knowledge is non-rival in consumption and has positive externalities. – Hence firms are likely to under-invest in research or knowledge. 25 MONASH BUSINESS SCHOOL Information failure (Asymmetric information) 2) Asymmetric information: • Product markets: consumers pay more for goods or by more of these goods than otherwise would be the case. • Labour markets: manager knows more than shareholder or employer knows more than employee. • Capital markets: borrowers may misinform financial institutions about their ability to make repayments. • Insurance markets – consumer knows more than insurer. 26 MONASH BUSINESS SCHOOL Solutions to information failure Information Failure Possible policies Product information Regulation of advertising (Consumer Act) Product safety Quality of supply regulation Professional services Licensing of services (entry regulation) Financial services Regulation of financial institutions Health and Safety in the workplace Regulation of workplace standards Information on individual health Public health insurance Income uncertainty Public loans to tertiary students 27 MONASH BUSINESS SCHOOL Preference failure (merit goods) 3) Merit Goods (preference failure): • Merit goods (compulsory education and seat belts) government considers individuals should consume even though they do not demand them: • De-merit goods (Alcohol, gambling, tobacco) government considers individuals should consume in smaller amounts; 28 MONASH BUSINESS SCHOOL
