Costs / Revenue
Negative Consumption Externality
The deadweight loss
triangle shows the amount
of welfare loss due to over
consumption of this
product at QFM
PMC = SMC
Vertical gap between SMB
and PMB = the cost on
third parties of consuming
QFM output
ie. –ve spillover cost of
consumption
PFM
PS
PMB
SMB1
QFM
Externalities of production
Output
MC / SMC
QS
Negative externality of
production (the social costs
added to private MC
SMC1
PMC= S
Private marginal cost (MC)
SMC2
Positive externality of
production (the social
benefits reduce to private
MC
Output
Yr 13 Economics
EAS 3.3 Describe and illustrate
resource allocation via the public
sector to compensate market
failure
External: 4 credits
Costs /
Revenue
Beer
Market
Supply
PMC = SMC
$2.40
PFM = $ 2.00
$1.40
PMB
SMB 1
QS
(3)
QFM
(4)
Output
Student : _________________________________
Teacher _____________________
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p1
Subject Reference
Economics 3.3
Title
Describe market failure and government interventions to
correct for market failure
3
Level
Credits
4
Assessment
3
The description or explanation of market failure will involve a selection from:
 Externalities
External
This achievement standard involves describing market failure and government interventions
used to correct for market failure.

Achievement Criteria
Achievement
Achievement with Merit
Achievement with
Excellence

Describe market
failure.

Explain market failure.

Explain market failure.

Describe government
interventions used to
correct for market
failure.

Explain government
interventions used to
correct for market
failure and their impact
on equity and
efficiency.

Fully explain
government
interventions used to
correct for market
failure and evaluate
their impact on equity
and efficiency.
Explanatory Notes
1
Economic models should be used to identify and compare the social equilibrium with
the private market equilibrium and to show the effects of allocation via the public
sector. Models may include: supply and demand, social marginal cost and benefit;
Lorenz curve, and cost curves.
2



4
Definitions
Describe means to give details about, an account of, relate, demonstrate knowledge
of; students may give descriptions in words, diagrams, flow charts, graphs or other
similar devices.
Explain means to say why or how, give reasons for, predict, interpret, compare, and
distinguish.
Fully explain means to explain in depth and/or breadth.
Evaluate means to assess/judge the impact of each intervention and could include
prioritising, making recommendations and/or justifying them.
Market failure occurs when the market does not result in efficient or equitable
outcomes.
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
– define and give examples of positive and negative externalities
– understand the significance of property rights
– derive social marginal cost curves and social marginal benefit curves.
Merit/demerit goods
– distinguish between social and private preferences for certain goods
– give examples of merit and demerit goods.
Public goods
– distinguish between public goods and private goods
– identify examples of public goods
– explain why public goods are not normally provided by the market.
Natural monopolies
– identify examples of natural monopolies
– explain how economies of scale can lead to natural monopolies
– discuss reasons why natural monopolies may or may not operate for the
good of society.
Income distribution
– distinguish between equity and equality
– explain why the free market solution is not always equitable.
The description or explanation of government intervention will involve a selection
from:

Externalities
– explain how subsidies, taxes, regulations, property rights and public
provision can be used to internalise positive and negative externalities.

Merit/demerit goods
– explain alternative means of increasing (decreasing) the consumption of
merit (demerit) goods.

Public goods
– discuss the collective provision of public goods.

Natural monopolies
– demonstrate how natural monopolies can be influenced by the use of
subsidies, regulations or public ownership.

Income distribution
– identify the means by which the state can attempt to achieve equity
– show how governments may intervene for equity at the cost of
efficiency and discuss the equity/efficiency trade off.
p2
Examine the achievement standard information on the
previous page and summarise it below
Summarise
the
knowledge
and skills
required for
achievement
Title / Expansion of title
Achievement
List the key
difference
that establish
the
increments
between
levels
Summarise
the key
information
Merit
Excellence
Explanatory notes
Content and Contexts:
Summarise
the key
information
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p3
UNIT STANDARD 10928 version 3
Elements and Performance Criteria
ECONOMICS
Present an economic argument in an essay
and another mode
level:
3
credit:
4
purpose: People credited with this unit standard are able to present an
economic argument in the form of an essay, and in another mode.
special notes:
1
2
3
4
5
6
7
For this unit standard the provider sets the
question. The question should require people to
communicate economic information in the form
of an economic argument. An economic
argument refers to analysing economic
information and drawing conclusions.
Mode other than an essay refers to forms of
presentation such as, but not limited to: a
seminar, display, newspaper front page,
magazine article, and role play.
Style refers to the manner of written and nonwritten expression.
Format of presentation refers to the way in
which the generalisations and economic
evidence are arranged.
Scope may refer to the economic concept,
economic entity, market setting, political issues,
events, and economic issues.
Economic conventions include: footnotes,
formality of language, correct use of economic
terms, and acknowledgement of sources.
Credit for elements 1 and 2 can be gained using
the same topic
T
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
element 1
Present an economic argument in the form of an essay.
performance criteria
1.1
Evidence and conclusions are communicated in established
essay structure.
Range:
structure - introduction, body, conclusion.
1.2
Paragraphs are sequenced to facilitate the development of an
argument.
1.3
Evidence and conclusions are in accordance with the scope of
the essay topic.
1.4
Economic conventions are observed.
element 2
Communicate an economic argument in a mode other than an essay.
performance criteria
2.1
Format and style are consistent with the mode of
communication.
2.2
An economic argument is developed in accordance with the
scope of the topic.
2.3
p4
Economic conventions are observed.
Examine the unit standard information on the previous page
and summarise it below
Summarise
the
knowledge
and skills
required for
achievement
Title / Expansion of title
Element 1
Element 2
Summarise
the key
information
PC’s for element 1
Summarise
the key
information
PC’s for element 2
Summarise
the key
information
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p5
INTRODUCTION
Important Definitions
Adam Smith, in the 18th century,
observed that in a perfectly competitive
market price would act as a signal to
guide producers and consumers, as if
lead by an invisible hand, to the most
efficient use of our scarce resources.
Economic efficiency =
making best use of scare
resources to produce those
goods and services most
valued by consumers and
requires:
 observations since then have shown
Note :
that for a great number goods and service markets the free
market does result in an allocation that gives the greatest
efficiency and the least amount of waste.
However, in the real world the free market doesn't always work
like this.
P208 st john + stewart
Productive efficiency where
firms deliver the highest possible
output from given inputs and so
produce at lowest unit cost
Allocative efficiency resources
are being allocated to the
production of the goods and
services most valued by society
ie. CS + PS maximised.
Pareto efficiency occurs when
resources cannot be reallocated
to make one consumer better off
without making someone worse
off.
ie. “ it’s as good as it gets”
Invisible hand
Deadweight loss is the lost CS
+ PS that results from not
operating at the allocatively
efficient output level
DEFINING MARKET FAILURE
Market failure occurs when free markets,
operating without any government intervention,
deliver an inefficient or inequitable allocation of
resources.
Market failure occurs because of either:
Productive inefficiency where firms are not maximising
output from given factor inputs. The lost output from inefficient
production could have been used to satisfy more wants and
needs
Allocative inefficiency where resources are misallocated and
producing goods and services and resources can be put to a
better use so that a higher level of CS + PS can be achieved
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p6
In 3.3 we identify the following causes of market failure

externalities – positive and negative
 causes private and social costs &/or benefits
to diverge resulting in over production of goods with
negative externalities and under production of goods with
positive externalities
Important Definitions
Economic efficiency =
The output of goods
/services that maximises
society’s well being.

merit/demerit goods
 imperfect information means merit goods are
under produced while demerit goods are over produced

public goods
 markets cannot make a profit from producing
public goods so none would be produced as social and
private preferences differ
Economic equity =
Income distribution is
considered to be fair

natural monopolies
 market power causes a divergence between P
and MC resulting in higher prices and less output than
perfect competition

income distribution – horizontal and vertical
equity; equity – efficiency trade-off
 Markets can generate an 'unacceptable'
distribution of income and social exclusion where people
on low income - the relatively poor - are denied access to
essential goods and opportunities considered 'normal' by
a society eg food, clothing, housing, and education
How markets work
Principl.es of micro economics
Gans,king + manki
P84
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p7
Costs /
Revenue
Beer
Market
Supply
PMC = SMC
$2.40
PFM = $ 2.00
$1.40
PMB
SMB 1
QS
(3)
QFM
(4)
Output
Costs / Revenue
Negative Consumption Externality
The deadweight loss
triangle shows the amount
of welfare loss due to over
consumption of this
product at QFM
PMC = SMC
Vertical gap between SMB
and PMB = the cost on
third parties of consuming
QFM output
ie. –ve spillover cost of
consumption
PFM
PS
PMB
SMB1
QS
QFM
Output
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p8
TOPIC 1. IDENTIFYING AND EXPLAINING EXTERNALITIES
Important Definitions
Externalities are the unintended spill over effects on third
parties of economic activity.
Externalities =
Externalities are defined as
third party (or spill-over)
effects arising from the
production and/or
consumption of goods and
services for which no
appropriate compensation
is paid.
The economic actions of consumers and producers can often
affect third parties (other people). Generally producers and
consumers only take into account the private costs and
benefits of production or consumption – how they themselves
are affected – and ignore any unintended spill over effects on
third parties (someone not directly involved) of their decisions.
Externalities of production occur when production
inadvertently imposes costs or benefits on third parties e.g.:
Positive
- training staff gives workers more skills which
are taken with workers when they change jobs
Negative
- a factory owner pays little attention to the side
effects of manufacture: smoke noise and
pollution.
Negative externality of
production (the social costs
added to private MC
Externalities of production
MC / SMC
SMC1
PMC= S
Private marginal cost (MC)
SMC2
Positive externality of
production (the social
benefits reduce to private
MC
Output
Externalities of consumption occur when consumption
inadvertently imposes costs or benefits on third parties e.g.:
Negative
- smokers ignore the unintended but harmful
impact of ‘passive smoking’ on non-smokers.
Positive
- using public transport reduces congestion
Externalities of consumption
Mixed goods =
Goods that have private
benefits and spill over or
external effects for others
not directly involved in their
production or consumption
Private marginal cost =
The share of marginal costs
paid by the individual or firm
who carry out the economic
activity
= producers supply curve
External (spill over) cost =
estimated cost of economic
activity on third parties
Social marginal cost = the
total cost to society of
producing an extra unit of a
good
=PMC + spill over costs
Note positive production
spill overs mean SMC is to
the right of PMC (ie. SMC2)
Negative production
spillovers mean SMC is to
the left of PMC (ie. SMC1)
MB / SMB
Private marginal benefit =
The dollar price that would be
Positive externality of
offered by consumers to buy
consumption
Private benefits plus
successive units of a good. It
spillover benefits
is the maximum amount that
SMB
would be offered rather than
PMB= D
forgo the extra unit. (It is
Private marginal benefit (MB)
equivalent to MU and hence
SMB
represents the individuals
Output
Negative externality of
consumption
demand curve graphically)
Private benefits less
spillover benefits
ie. MU benefit for individual
MB benefit for society
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p9
2
1
The efficient allocation of resources requires output to be
increased up to the point where social marginal benefit =
social marginal cost
In a free market firms only take into account the private cost of
their production and consumers only take into account the
private benefits of their consumption an consequently an
unregulated free market equilibrium will diverge from the social
equilibrium
Social equilibrium
SMC/
SMB
SMC
External (spillover) benefit =
benefits to others ( firms /
consumers) of an economic
activity
Social marginal benefit =the
total benefits to society of an
economic activity
=PMB + spill over benefits
Note positive consumption
spill overs mean SMB is to the
right of PMB (ie. SMB2)
Negative consumption
spillovers mean SMB is to the
left of PMB (ie. SMB1)
P*
SM B
Q*
Output
Skill Using SMC / SMB diagrams to show externalities
1st
Label axes
ie. Y axis = costs/benefits
X axis = output
2nd
Identify free market equilibrium
ie. demand =PMB + supply = PMC
 intersection of PMB + PMC = free market equilibrium
3rd
Decide if externality is a production or consumption externality
ie. - if the spillover is the result of producing goods =production externality and results
in shift of supply curve
Note the new curve is labelled SMC
- if the spillover is the result of using (consuming) goods = consumption externality
and results in shift of demand curve
Note the new curve is labelled SMB
4th
Decide if the externality is positive or negative
 beneficial spillovers = positive externalities and curve shift will result in a social
equilibrium with larger output than free market equilibrium
 negative spillovers = negative externalities and curve shift will result in a social
equilibrium with smaller output than free market equilibrium
5th
Identify the social equilibrium
ie. intersection of shifted curve in step 4 and other curve
6th
Identify the deadweight loss of the free market equilibrium
ie. deadweight loss = triangle whose base is the vertical gap between curves at free
market and whose point = the social equilibrium
 label Es before drawing your DWL triangle
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p10
A. NEGATIVE EXTERNALITIY OF PRODUCTION.
Negative Production Externality
MC/
MB
The deadweight loss
triangle shows the amount
of welfare loss due to over
production of this product
at QFM
SMC
PMC
Vertical gap between SMC
and PMC = the cost of
production on third parties
when producing QFM output
ie -ve spillover cost
PS
Important Definition
Negative externality of
production =
As a result of production
spill-over costs (like clean
up costs and health costs)
are imposed on third parties
PFM
PMB =SMB
QS
QFM
Output
Task
1. In the space above
draw a SMC / SMB
diagram to show a
negative externality of
production
2. Label free market
equilibrium price (PFM and
QFM)
3. Label social equilibrium
price (Ps and Qs)
4. Shade in the
deadweight loss that would result from operating at the free
market equilibrium
5. Suppose a chemical factory emits wastage as a by-product
into nearby rivers and into the atmosphere.
 explain why this is an example of a negative
externality of production and use it to explain market failure
Negative externality of production because :
As a result of production of chemicals spillover costs
(like clean up costs and health costs) are imposed on
third parties
Market failure because :
If we assume that the chemical producer is aiming to maximise profits – then they
only take into account the private costs and private benefits from their supply of
chemicals so they will produce at the output level QFM.
However, the socially efficient level of production after considering the spillover
costs on third parties is QS where SMB = SMC
ie. in this example a free market would over-produce chemicals because the
chemical firm wont take account of the negative spillover costs causing a
deadweight loss of the purple shaded area and so result in market failure.
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p11
B. NEGATIVE EXTERNALITIY OF CONSUMPTION.
Consumers can create externalities when they purchase and
consume goods and services.
o
o
o
o
o
o
o
Pollution from cars and motorbikes
Litter on streets and in public places
Noise pollution from using car stereos or ghettoblasters
Negative externalities created by smoking and
alcohol abuse
Externalities created through the mis-treatment of
animals
Vandalism of public property
Negative externalities arising from crime
In these situations the social marginal benefit of
consumption will be less than the private marginal benefit of
consumption. (i.e. SMB < PMB) This leads to the good or
service being over-consumed relative to the social optimum.
Important Definition
Negative externality of
consumption =
As a result of consumption
spillover costs (like clean
up costs and health costs)
are imposed on third parties
:
Without government intervention the good or service will be
under-priced and the negative externalities will not be taken
into account. Again there will be a deadweight loss of
economic welfare.
Negative Consumption Externality
MC /
MB
The deadweight loss triangle
shows the amount of welfare
loss due to over
consumption of this product
at QFM
PMC = SMC
Vertical gap between SMB
and PMB = the cost on third
parties when consuming
QFM output
ie -ve spillover cost of
consumption
PS
PFM
PMB
SMB
QS
QFM
Output
Task
1. In the space above draw a SMC / SMB diagram to show a
negative externality of consumption
2. Label free market equilibrium price (PFM and QFM)
3. Label social equilibrium price (Ps and Qs)
4. Shade in the deadweight loss that would result from
operating at the free market equilibrium
5. In the right hand column explain why the examples above
are negative externalities of consumption and use cigarette
smoking to explain why negative externalities of consumption
cause market failure
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p12
NEGATIVE externality of consumption because
As a result of consumption spillover costs (like
additional public health care for passive nonsmokers who get ill) are imposed on third
parties
Market failure because :
If cigarette consumers only consider their own
private costs and benefits of consumption, then
there will be over-consumption of cigarettes (QFM)
If the negative effects on other consumers is
considered the socially desirable level of
consumption would be QS
ie. free market consumers over consume
cigarettes as they don’t consider external costs
causing a deadweight loss of the purple shaded
area and so result in market failure
Note
Another example of higher social costs comes from the
problems caused by traffic congestion in towns, cities and on
major roads and motorways.
It is important to note though that the manufacture, purchase
and use of private cars can also generate external benefits to
society.
cost-benefit analysis can be useful in measuring
and putting some monetary value on both the social costs and
benefits of production (particularly if the govt is considering
intervening in the market
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p13
C. POSITIVE EXTERNALITIY OF CONSUMPTION.
Important Definition
Positive externalities exist when the marginal social benefit of
consumption exceeds the marginal private benefit
i.e. consumption generate external benefits go under-valued
by the market
Positive externality of
consumption =
As a result of consumption
spillover benefits are
gained by third parties
eg. Education:
A well educated labour force can increase efficiency and
produce other important social benefits. Increasingly policymakers are coming to realise the increased returns that might
be exploited from investment in human capital at all ages.
Positive Consumption Externality
MC/
MB
Vertical gap between SMB
and PMB = the benefits
received by third parties of
consuming Q FM output
ie. +ve spillover benefits
PMC = SMC
The deadweight loss
triangle shows the
amount of welfare loss
due to under
consumption of this
product at Q FM
PFM
SMB
PS
PMB
QFM
QS
Output
Task
1. In the space above draw a SMC / SMB diagram to show a
positive externality of consumption
2. Label free market equilibrium price (PFM and QFM)
3. Label social equilibrium price (Ps and Qs)
4. Shade in the deadweight loss that would result from
operating at the free market equilibrium
5. Explain why education is positive externality of consumption
and use it toexplain why positive externalities of consumption
cause market failure
POSITIVE externality of consumption because
As a result of consumption of education by students
spillover benefits (like improved productivity) are
gained by third parties
eg. future employers gain through greater output per
worker or more tax earned by government as more
productive workers earn higher incomes so pay more
tax
Market failure because :
If education consumers
only consider their own
private costs and benefits
of consumption, then
there will be underconsumption of
education (QFM)
If the positive benefits of
education on others is
considered the socially
desirable level of
consumption would be QS
ie. free market consumers
under consume education
as they don’t consider
external benefits causing
a deadweight loss of the
purple shaded area and
so result in market failure
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p14
D. POSITIVE
EXTERNALITIY OF
Important Definition
Positive externality of
production =
PRODUCTION.
As a result of production
spillover benefits are
gained by third parties
There are plenty
of examples of
economic
activities that
can generate
positive
production
externalities:

Industrial training by firms: This can reduce the costs
faced by other firms and has important effects on labour
productivity. A faster growth of productivity allows more
output to be produced from a given amount of resources
and helps improve living standards throughout the
economy.

Research into new technologies, which can then be
disseminated for use by other producers. These
technology spill-over effects help to reduce the costs of
other producers and cost savings might be passed onto
consumers through lower prices

Health provision: Improved health provision and health
care reduces absenteeism and creates a better quality of
life and higher living standards.


Employment creation by new small firms
Flood protection systems and spending on
improved fire protection in schools and public arenas
Positive Production Externality
MC/
MB
Vertical gap between SMC
and PMC = the benefits
missed out on by third
parties due to under
production of this product
at QFM
PMC
SMC
The deadweight loss
triangle shows the amount
of welfare loss due to under
production of this product
at QFM
PFM
PS
PMB =SMB
QFM QS
Output
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p15
Task
1. In the space on the previous page draw a SMC / SMB
diagram to show a positive externality of production
2. Label free market equilibrium price (PFM and QFM)
3. Label social equilibrium price (Ps and Qs)
4. Shade in the deadweight loss that would result from
operating at the free market equilibrium
5. Explain why the examples above are positive externalities of
production and use to explain why producer research and
development is an example of market failure
POSITIVE externality of Production because
As a result of production spillover benefits (like greater
output or improved quality) are gained by third parties
eg. technological advances resulting from R+D of a firm
can be adopted by other firms increasing production
capabilities of other firms
Market failure because :
If producers undertaking research and development
only consider their own private costs and benefits,
then there will be under-production of R + D (QFM)
If the positive benefits of R + D on others is
considered the socially desirable level of production
would be QS
ie. free market producers undertake less R + D than is
socially desirable as they don’t consider the external
benefits causing a deadweight loss of the purple
shaded area and so result in market failure
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p16
IDENTIFYING AND EXPLAINING THE IMPACT OF
GOVERNMENT POLICIES FOR EXTERNALITIES
A. (PIGOUVIAN) TAXES AND SUBSIDIES
Taxes can be used to correct negative externalities and
subsidies to correct positive externalities.
Pigou recognised that taxes and subsidies would increases
economic well-being by forcing decision-makers to take into
account the benefits and costs of all resources affected by the
decision
Example
Technology Spillover in the Production of
Computer Chips
Computer Chip Market
Costs/
Benefits
Costs/
$
Revenue
Computer Chip Market
PMC
MPC
$
15
15
MSC
SMC
10 10
5
Subsidy per unit
required to produce
Qs
5
= S sub
Demand
MPB = MSB
Demand
PMB = SMB
QFM
QS
QFM
Output
QS
Output
Because of the positive externality of production there is a
divergence between PMC and SMC
ie. the true cost of producing computer chips to society is lower
than the private supply (PMC) as the free market firms don’t
take account of the spillover cost savings for other
producers of this technological breakthrough.
 a subsidy from government for each computer chip
would internalise the externality and encourage Qs to be
produced
Questions
10 per unit
1. How large would the subsidy need to be $ ____
2. On the computer chip market graph show the effect of a
subsidy that fully internalises the externality
3. Explain
a. How the subsidy internalises the positive production
externality
Producers receive $10 on top of the selling price so
they are getting compensation (payment) that fully
meets social + private costs of supplying the
product and will result in them increasing supply to
the socially desirable output level Qs
Arthur Cecil Pigou
personified the
"Cambridge
Neoclassicals" - the
heart of the Marshallian
orthodoxy in the first
third of the century.
His main claim to fame
is his Wealth and
Welfare (1912, 1920),
which brought social
welfare into the scope of
economic analysis. In
particular, Pigou is
responsible for the
famous distinction
between private and
social marginal products
and costs and the idea
that governments can,
via a mixture of taxes
and subsidies, correct
such market failures - or
"internalize the
externalities".
Important Definition
Internalising an externality
= Altering incentives so that
decision-makers take
account of the external
effects of their actions
eg. Give producers who
have positive externalities
higher revenue (eg.
subsidy)
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p17
b. How the government intervention (ie. subsidy) improves
econonmic efficency / resource allocation.
The higher price received by producers $15
encourages more to be produced and hence more
resources allocated to computer chip production
and allocative efficiency will be achieved as Qs
output (the socially desirable level) is sold at $5
c. How the government intervention (ie. subsidy) affects equity.
4. Use the information on the next page - advantages and
disadvantages of subsidies to evaluate their effect.
Equity
Good points


Efficiency
Good points


Bad points
Bad points
4th Draw
 a reasoned conclusion about a policy the government

could use to improve resource allocation in a natural monopoly
market if it wanted:
An efficient outcome


 Make a justified recommendation about why / why not the
govt should use the policy:
(ie. provide a reason [not just repeat good /bad points above]
why goods outweigh bads or vice versa) based on equity or
efficiency
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p18
GENERAL EFFECTS OF (ENVIRONMENTAL) SUBSIDIES
Advantages
Disadvantages
 They increase economic well-being by
forcing firms to take into account the spill-over
benefits of their production
 unlike other subsidies (Pigouvian) subsidies
do NOT cause a reduction in the total surplus
since no DWL as firms operate at socially
desirable output level
 Hard to set precise value of subsidy as
govt does NOT have precise information on
MC/MB and spillover benefits
 realistically all that can be expected is an
increase in production (rather than the socially
desirable output level)
 Equitable since the greater the spillover
benefit the greater the amount of subsidy you
receive
 Economists prefer subsidies over
regulation as they let firms decide how to
internalise the spillover benefits (ie. least cost)
------------------------------------------------------------ May reduce cost push inflation (if flow on
effects cause a decrease in the average price
level) which should have a positive spillover
effects on other industries (eg. will reduce
interest rates and hence encourage productive
investment)
 If the item uses a large % of income the
effect of the price decrease will be an increase
in buying power and so will be able to buy
more g+s from other produces
 Increased sales (from 2 above) 
increased prodn and so more labour will be
required reducing unemployment
 Per unit subsidies need to be adjusted whenever
market conditions change if they are to remain
socially efficient. (Ideally the subsidy should PMC
to SMC at all output levels and then the social
equilm will result even if there is a change in
demand
 an advalorum subsidy may be better than a per
unit one if higher output gives more benefit)
 Size of effect of sudsidy on output will depend
on price elasticity of demand
 Subsidising one activity thought to create
positive externalities can distort the market
mechanism and thus resource allocation
(particularly if the govt is slow to respond to
changing market circumstances
ie. other new activities that have spillover benefits
NOT being subsidised will result in under
production of them and perhaps over production of
the subsidised good with the positive production
externality
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p19
Exam Preparation Task
OF
NEGATIVE EXTERNALITY
PRODUCTION
Tasks
1. Identify an example of a market with a negative
externality of production
Anyone that is polluting and NOT paying the full
(social) cost of doing so as spill-over costs are being
borne by other produces
eg. effluent from one firm into a river causes less fish
to be caught
7. Use the information below
(on effect of environmental
taxes) to help you evaluate
the policy by identifying good
and bad points on efficiency
and equity and then drawing
an overall conclusion
Efficiency:
2. Explain why the free market would overproduce this
product
Private firms don’t take a/c of the spillover costs of
their prodn on third parties so PMC is to the RIGHT of
SMC resulting in an overproduction of this product
ie. QFM >QS
3. Use the SMC / SMB axis below to draw this market
- clearly indicate the free market and socially desirable
prices and quantities
Costs/
Costs/
Benefits
Revenue
$ $
Equity:
SMC = STAX
SMC
PMC
PMC
PSPS
PFM
PFM
PPR
Demand
Demand
PMB
= SMB
PMB
= SMB
QS =QFM
QFM
QTAX
Output
Output
4. Identify a government policy that could be used to
internalise the negative externality of production
Sales Tax
5. Clearly show the full effect of your policy on the graph
above
Draw a reasoned conclusions
as to why the govt should /
should not use the policy
(based on equity or efficiency)
- show any curve shifts, lthe $ effect of the policy, the new
eqilm P + Q, the impact of the policy on consumers and
producers
6. Explain how your policy improves social well-being
Sales Tax  socially desirable P + Q as private firms
forced to internalise the external costs of their
production  offer less for sale as revenue received at
each price level is lower (PPR)  S shifts left to SMC
and an allocatively efficient level of production is
achieved
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p20
Example
Negative externality of Consumption
When there is are externalities of consumption the demand
curve (PMB) does not reflect the social value of the good
Costs
Costs //
Benefits
Revenue
Beer Market
Market
STAX
Supply
PMC
==
SMC
PMC
SMC
Important Definition
Excise Duty =
A tax imposed on the
production, sale, or
consumption of a
commodity or the use of a
service within a country: eg.
excises on tobacco, liquor
$$2.40
2.40
P
PFM
= $$2.00
2.00
FM=
$1.40
$1.40
PMB
PMB
SMB
SMB11
Q
QSS
(3)
(3)
Q
QFM
FM
(4)
(4)
Output
Output
$2
Suppose you begin to drink beer. The market price is _____
,but the more you consume the greater the chance that other
people will be adversely affected
 give some examples of how your drinking could adversely
affect others
1.
2.
3.
4.
-kill them in road crash
-ruin night out due to noisy behaviour
- damage to property as walk passed
- increase taxes to fund hospital treatment
due to over drinking
When deciding how much to drink yopu probably take any
ill effects you’ve personally experienced from drinking into
account.
eg. you may weigh up the immediate pleasure from another
drink against the likelihood of feeling ill or not being able to
concentrate at school the next day
BUT you (probably) won’t take account the effect your
drinking has on others.
 the divergence between SMB and PMB reflects these
negative spillover effects on others
Note the higher your consumption the greater the chance
of harm on others so the wider the gap between SMB +PMB
The government intervenes in the beer drinking market by
imposing an alcohol tax (called an excise duty)
Exercises
1. Add the additional information to your graph to show the
effects of an alcohol tax that fully internalises the
spillover effects
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p21
2. From societies point of view how many cans should you
have drunk ?
3
_________________________
3. How much does the tax have to be on each can for you
to fully internalise the negative consumption externality
and so drink the socially desirable number of cans
$1
$ ____________
per can
4. Explain how a sales tax can be used to compensate for
market failure in the beer market
Sales tax  price paid by consumers to Ps ($2.40)
and so forces the consumers to cut back
consumption to the socially desirable Qs
It also  P received by producers to Ppr ($1.40) so
they are only willing to supply Qs the socially
desirable amount and allocative efficiency
achieved (ie. the DWL is removed )
5. Use the information below (on effect of environmental
taxes) to help you evaluate the policy by identifying good and
bad points on efficiency and equity and then drawing an
overall conclusion
Efficiency
Equity
Draw a reasoned conclusions as to why the govt should /
should not use the policy (based on equity or efficiency)
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p22
GENERAL EFFECTS OF (ENVIRONMENTAL) TAXES
Advantages

Improve resource allocation
- by forcing producers and consumers to internalise the full
cost of their activities (ie. higher prices give them an incentive to
reduce negative behaviour) and push the market towards the social
equilibrium output level and so achieve an allocatively efficient
resource allocation (ie. an appropriately set tax will shift PMC to
SMC and so eliminate effects of market failure)

Double dividends
- tax revenue earned from tax can be used to finance environmental
programmes (that have +ve spillover effects)
 double dividend (or benefit) since increased efficiency in market with –
ve externality and the spending in other areas also improves environmental
quality in other markets as well
Note if the tax earned is significant it could be used to instead of other taxes
that reduce market efficiency (eg. replace income taxes that decrease
consumer spending and so reduce total gains from trading)

Can encourage innovation and the development of new technologies
- as firms attempt to reduce pollution and so minimise tax to pay
they will adopt the most cost effective solution to the pollution abatement.
Note standards (regulations) on the other hand tend to encourage avoidance
mentality in firms as they try to find ways around the regulation
Disadvantages

Polluter Pays Principle =
requires polluter to bear
the cost of any pollution
abatement (ie. reducing
the degree or intensity of,
or eliminating, pollution)
necessary to maintain
environmental quality
Egs.
1. Emission charges =
based on the amount of
pollution discharged
(used if pollution easy to
measure)
2. Product charges or
levies (sales taxes) = cause
a mark up on price of
products produced with
negative spillover effects
(ideally markup =
spillover cost)
3. User charges = fee
levied on the user of
environmental resources
based on the cost of
treating emissions
Difficult to assign the right level of taxation
- may be difficult to measure the amount of pollution +/or the
value of the damage it causes (ie. the $value of the spillover effect).
 best that could be expected is a movement towards social
equilibrium output level
 taxes therefore have an uncertain effect on environmental
quality (as unlike regulations they do not set an emission standard)
instead they raise prices to provide an incentive for
producers/consumers to reduce polluting behaviours
 Appropriate level of tax will change with a change in market
conditions
- eg. as an economy grows emissions grow so the level of tax
may need to be adjusted
 must be regularly monitored and updated to ensure it is
achieving its social aims
Note -this may be expensive if calculating costs etc is difficult
- govt bureaucracy is much less flexible than market forces so
this may not happen in the real world
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p23
Disadvantages cont’d

NOT be equitable
- tax increases prices resulting a decrease in household
buying power so current dollars are able to buy fewer goods
 other markets that DON’T produce with inflation will face a
decrease in sales/profits (so it is important that before implementing
sales taxes the income effect of them needs to be calculated to
ensure the gains from correcting the externality are worth it
Note 1. Producers may be able to pass on the tax to consumers if
the Ped is inelastic (or supply is elastic) and as a result it may have
only a small effect on producers and output
2. Taxes on cigarettes (for eg) have a regressive effect on
lower income consumers who spend proportionately more of their
income on cigarettes so widening inequalities in income distribution
3. Pollution taxes in one country may cause multi national
companies (MNC’s) to shift prodn to other countries with lower
taxes. This will not reduce global polln and may result in structural
unemployment and loss of international competitiveness in the
country imposing the tax
 this may result in the exploitation of under developed
countries (“Poor” nations) who cannot afford to be environmentally
conscious as in order to decrease the absolute poverty they may be
prepared to sacrifice the environment
ie. MNC’s build factory because cheaper to produce without polln
taxes and so employment increases and poverty reduced

May cause cost push inflation
-if price rise results in a general increase in the price level the
sales tax causes cost push inflation
 inflation has a detrimental effect on other areas of the
economy affecting third parties who had nothing to do with the
pollution

May cause job losses
- as firms minimise costs in order to fund costs of pollution
abatement workers may be laid off
 May result in less investment and lower levels of TGT in the
future
- reduced profits (resulting from lower revenues due to tax)
may also lead to less R + D that might have had long term beneficial
spillover effects on the environment and so reducing total surpluses
in the future
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p24
Exam Preparation Task
POSITIVE EXTERNALITY OF 7. Evaluate the policy by
identifying good and bad
CONSUMPTION
Tasks
1. Identify an example of a market with a positive
externality of consumption
points on efficiency and equity
and then drawing an overall
conclusion
Efficiency:
Education
2. Explain why the free market would underconsume this
product
Consumer would only take account of their private
benefits and costs and so PMB would be to the left of
SMB and so a lower level of consumption would
result than is socially desirable
3. Use the SMC / SMB axis below to draw this market
- clearly indicate the free market and socially desirable
prices and quantities
Equity:
Positive Consumption
Positive
Consumption Externality
Externality
MC/
MC/
MB
MB
Costs/
Revenue
$
PMC
PMC =
= SMC
SMC
Supply
PMC = SMC
SSUBSIDY
PPR
PFM
SM B
PS=
Psub
P
PM
MB
B
PMB
QFM
QS=Qsub
Output
Output
Output
4. Identify a government policy that could be used to
internalise the positive externality of consumption
Draw a reasoned conclusions
as to why the govt should /
should not use the policy
(based on equity or efficiency)
Subsidy
5. Clearly show the full effect of your policy on the graph
above
- show any curve shifts, lthe $ effect of the policy, the new
eqilm P + Q, the impact of the policy on consumers and
producers
6. Explain how your policy improves social well-being
Subsidy  shifts supply curve to the right as producers receive more revenue 
socially desirable Q as consumers internalise the external benefits of their
consumption due to lower price being charged (ie. Psub)  Qd  to Qsub as lower
price increases consumers purchasing power
Note producers prepare to supply Qsub as they receive Ppr per unit after subsidy
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p25
B. PROPERTY RIGHTS AND REGULATIONS
Important Definition
In 1961 Ronald Coarse (a law professor at the University of
Chicago) came up with the idea, known as the Coarse
Theorem (and for which he received a Nobel Prize), that
government intervention is not always necessary to correct
externalities. Parties should be able to negotiate an efficient
outcome provided property rights are clear.
Theoretical Extension – Negotiated Externality
Settlements
Given perfect information and zero (or minimal) transaction
costs the clear assignment of property rights will ensure
optimal resource allocation WITHOUT govt intervention
Example : 2 firms X and Y are both situated along a river
Y pollutes the river and affects X’s costs of production
Property Right =
Is a law that gives exclusive
rights of use and disposal
(eg sale) of property to
those who own it
Costs and Revenues for Firm Y
SMC
b
PMC
4
a
PY
1
f
3
2
e
D = AR
= MR
c
Ronald O.Coarse
0
QS
QFM
Qfirm Y
Questions
1. Why is D horizontal ?
Perfect competition so firm is a price taker
2. What does the gap between PMC and SMC represent ?
Negative spillover costs of firm Y’s prodn on firm X
3. What does area PYeQFM0 represent ?
Total revenue aerned by firm Y at market eqilm
4. What does area PYfe represent ?
Producer surplus for firm Y
SUPPOSE FIRM Y HAS PROPERTY RIGHTS TO THE RIVER
5a. If firm X wanted firm Y to produce Qs – what is the
minimum amount firm X would have to pay firm Y ?
Amount
area 3
Explanation
Area 3 = the lost PS that results from producing and
selling only Qs product
Coarses Theorem =
That if private parties can
bargain without transaction
cost over the allocation of
resources, then such
bargaining will always solve
the problem of externalities
on its own and allocate
resources efficiently
regardless of who owns the
property
5b. Would firm X be willing to
pay this amount ?
YES / NO
Explanation
Spillover costs of Qs to
QFM prodn = areas 3 + 4 so
if only has to pay area 3 is
area 4 better off
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p26
6a. If firm X wanted firm Y to  prodn from Qs to 0 – how much 6b. Would X be willing to pay
this amount
more would it have to pay firm why ?
Amount
Areas 1 + 2
Explanation
Areas 1 + 2 = the lost PS that results from cutting back
producing from Qs to 0
YES / NO
Explanation
Spillover = only area 2
 IF FIRM Y WAS GIVEN PROPERTY RIGHTS BARGAINING WILL TAKE
PLACE UNTIL QS (THE SOCIALLY DESIRABLE) OUTPUT ISPRODUCED
SUPPOSE FIRM X IS GIVEN THE PROPERTY RIGHT
7a. At output Qs how much does firm X require before it will
allow firm why to produce
Amount
Area 2
Explanation
Area 2= the spillover cost of ) to Qs prodn
1.
1= Negotiation may be too
expensive to take place –
eg if a firm pollutes the
environment hundreds of
thousands may be
affected. The
(transaction)cost of
organizing all these
people to negotiate with
the firm may be greater
than any benefit from
internalizing the
externality
b. Would firm Y be willing to pay this amount ?
YES / NO
Explanation
Still earning producer surplus (ie. area 1)
8. Beyond output Qs the cost of the negative externality that
would be charged by firm X will be greater than firm Y is
prepared to pay
 what effect will this have on production beyond Qs ?
Effect
wont be any prodn beyond Qs
Explanation
Firm X wont allow prodn beyond Qs since firm Y wont be
willing to pay enough to cover the spillover effect of its
prodn
 IF FIRM X WAS GIVEN PROPERTY RIGHTS BARGAINING WILL TAKE
PLACE UNTIL QS (THE SOCIALLY DESIRABLE) OUTPUT IS PRODUCED
Conclusion
Regardless of who gets the property right only the socially
desirble output will be produced.
Note the side payments made as a result of the bargaining
internalise the externality
Extension
Coarses main point was that private negotiation can solve
externalities but negotiations may not always be possible
Identify 2 limitations of coarses theorem
2.
2= Requires accurate
(perfect) information if an
allocatively efficient
outcome is to be achieved
ie. firm X needed to know
the actual cost that
resulted from firm Y’s
pollution
 scientific techniques
may not be accurate
enough to provide the
appropriate info
3= Free riders (ie. people
wont be prepared to pay
even though benefit from
a reduced externality
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p27
SOME APPLICATIONS OF PROPERTY RIGHTS IN NZ
Clear property rights can lead to an increase in efficiency
because they ensure :
 the right of the owner to use the resource
 that others can be prevented from using the resource
without payment
 that a profit can be derived from using the resource
 that there is an incentive to maintain an income flow
from the resource by preserving it so it can be used in the
future
 don’t pollute, over exploit or degrade the resource as
it reduces future earning potential
 the minimisation of waste and therefore efficiency
Case Study 1 : NZ Fisheries (ITQs- transferable rights)
Task
Fishing resources in NZ have historically been over-exploited
(ie. negative externalities of production occur – ie. future
generations miss out on them) because of a LACK of a clear
property right
What are the main negative
externalities in the fishing
industry
1.
1. By catch of
2 key problems result from this:
a. fish that are not targeted
1. When fishers increase their use of the resource they
 sales problems in terms
receive the full benefit of this (ie. all the extra fish they
of ITQ and  depletion of
catch can be sold) BUT only a share of the degradation 2.fish stocks
(ie. less available to catch)
b. marine mammals (eg
2. No one has a guaranteed future entitlement to the
seals) and birds
resource so the incentive to preserve or develop the
2. Pollution –
resource for the future is small
3.chemicals,plastic,disgarded
the incentive (signal sent) from a free market is that
gear (eg. nets)
fishers should race to catch the fish NOW as no one
3. Damage to fish nurseries
has a secure property right to future catches so no one
and spawning habits
has an incentive to concerve
through fishing techniques
or pollution
The NZ govt initially tried to reduce the overuse of the fisheries
by regulations (often referred to by economists as Command
and Control [CAC]) like limiting the number of fishers and
constraints on the type of gear that could be used
BUT these control measures resulted in fishers finding
innovative ways to avoid the legislation
eg.  boat size or keep boats at sea longer and these
measures actually resulted in greater catches (given the
legislation provides no incentive to conserve as no
future income is guaranteed to any particular individual
in 1986 the government adopted a market based
approach to internalising (making users bear the full cost of
prodn) externalities when they introduced the Quota
Management System (QMS)
The government allocated commercial fishers (based on catch
history) individual transferable quotas (ITQ’s) The Ministry of
Fisheries first determined fishing zones and total allowable
commercial catch (TACC) for each fishing species based on
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p28
scientific estimates of the minimum stock required to ensure
long term survival
(Note over time this could be amended if circumstances
deemed it necessary)
Second they allocated ITQ’s to fishers within TACC’s for each
species
fishers had the (property) right to catch a certain
amount
of fish each year
A clear property right (the ITQ) had been established and
fishers traded these ITQ’s in ways that increased the efficiency
of resource use in commercial fishing
 Inefficient fishers (those using old ships or poor
methods) sold their ITQ’s as they could gain more income
from selling than they could from fishing
 Efficient fishers could
(a). gain economies of scale by buying ITQ’s and so
increasing their allowable catch  fixed costs like ships are
now spread over greater output ing AC
(b) buy ITQ’s for particular species and so become
specialised  get better at catching just one type of fish
and make fewer mistakes so get greater output from same
or fewer inputs ing AC
(c) make long term investment decisions (like conservation)
as they have the potential for an income flow into the future
Task
In the space below use SMB/SMC analysis to clearly show the
NZ Commercial Fishing Market before and after the
introduction of ITQ’s.
Beneath the graph explain what has happened to resource use
and allocative efficieny as a result of giving fishers clear
property rights
Costs/
Benefits
$
SITQ’s
SMC
PMC
PS
PFM
Demand
PMB = SMB
QS = QFM
QITQ’s
Output
Explanation
ITQ’s limit fishing to the socially desirable output level
and firms must pay to purchase them so this cost
internalizes the externality and shifts PMC to SMC (up
to Qs output)
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p29
Task PRACTICING EXCELLENCE
1. What advantage does a market based approach (ITQ’s)
have over command and control (regulations) as a
method of conserving NZ’s fishing resources
1. Certain output result as quota sets limit on amount
of each species that can be taken
 social optimum output can be achieved (provided
accurate info available)
2. Provides incentive for innovative firms to develop
least cost solutions (ie. using fewer resources) to
internalizing the externality as this will increase their
profits
3. Provides incentive for long term conservation as
clear property right (ie. ITQ) gives firms a potential
income flow into the future 9as long as species still
around)
Note this future income stream also provides an
incentive for fishers to self monitor resource use (ie.
report those exceeding quota) as overuse affects their
future earning potential
Task
We briefly examined
regulations controlling NZ
fishing in this section. The
current controls include the
following:
- Permits
- Closed areas
- Closed season
- Size limits
- Gear restrictions
- Marine reserves
- Taiapure
- Maitaitai reserves
 can you think of any other
activities in NZ that have
externalities that are
2. What disadvantage does a market based approach
regulated ?
(ITQ’s) have over command and control (regulations) as try to think of 4 others and
a method of conserving NZ’s fishing resources
their regulations
1. Reliant on accurate information on MC,MB and
spillover costs if quota to be set accurately at social
optimum and the best resource use achieved
2. Cost of ensuring compliance may be high as it is
difficult to monitor a 200 km fishing zone to see if
fishers are exceeding their quotas
3. May be regressive as price of fish increase (since
restricted quantity and higher costs for firms shift S to
SITQ )  poor who spend proportionately more of their
income are hurt more
1.
Must wear seat belts
2.
Cant buy alcohol until 18
3.
Speed limits
4.
Must stay at school until 16
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p30
Case Study 2 : Treaty Issues
How has the Crown tried to honour its fisheries obligations to
Maori?

The Government has allocated 10 percent of the commercial quota to
Maori people through the Maori Fisheries Act 1989.

Taiapure, shoreline coastal fishing areas which are of special
significance to an iwi or hapu as a source of food, or for spiritual or
cultural reasons, can be established and run by a local community, once
approved

Mataitai reserves: fishing grounds of traditional importance to Maori,
where tangata whenua control non-commercial harvesting of seafood

Hui/Tangi management. This is a dispensation under amateur
regulations to take fish in differing quantities, sizes and methods
specifically for hui or tangi.

In 1992 the Crown honoured its commercial fisheries Treaty obligations
by assisting a Maori bid to buy Sealord Products, a large commercial
fishing company

In 1996 a revised Fisheries Act was passed. This Act supported the
Treaty of Waitangi Settlement Act of 1992. It required regulations to be
made that better defined customary fishing and the rights and
responsibilities of tangata whenua
What else do you think the Government could or should do to
honour its obligations under the Treaty of Waitangi?
- provide answers based on FACT not biased personal views
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p31
TREATY ISSUES ARE A PROPERTY RIGHTS ISSUE
While many people perceive the Maori fisheries rights issue as a racial
issue, the reality is that the strength of the Maori claims is based on the
strong legal claim they have developed for property rights which were
confirmed by the Treaty of Waitangi. The issue is not about race but
really about property rights where the claimants happen to be Maori.
The property rights issue came to the fore in 1986 when the Quota
Management System was introduced. This system is based on the
private ownership of quota, which is a right to harvest commercially a
certain quantity of a particular species of fish in a defined area. The initial
allocation of quota was based on the catch histories of all commercial
fishers.
Soon after the introduction of the QMS, Maori groups challenged the
legality of the system through the Waitangi Tribunal and in the courts.
The basis of their challenge was that in allocating private rights to harvest
fish commercially, the Crown had ignored Maori fisheries rights
guaranteed by the Treaty of Waitangi. The Waitangi Tribunal, the High
Court and the Court of Appeal all upheld the Maori claims. In November 1987 Maori successfully gained an
interim declaration from the Court of Appeal that prevented further development of the quota system.
Significantly, while finding that the allocation of rights was prejudicial to Maori, the Waitangi Tribunal found that the
purposes of the QMS and its mechanisms to restrict catches and conserve fisheries were not in conflict with the
Treaty. In the Tribunal's view, the management system was good but the allocation, by ignoring Maori rights
guaranteed by the Treaty, was wrong.
CUSTOMARY RIGHTS
In 1986 the courts found that
the taking of fish for customary
purposes by Maori was not
restricted by any fisheries law,
as section 88(2) of the Fisheries Act stated that nothing in the Act shall affect a Maori fishing right. However the
rights referred to were not
defined and this left the law open to interpretations which were inconsistent with both Maori customary lore and
the need for sustainable fisheries management.
The new Settlement Act seeks to resolve the sorts of problems associated with section 88(2) of the Fisheries Act
by clarifying how Maori customary rights will be applied and given legal effect. The new Act contains two separate
components dealing with Maori traditional, non-commercial fishing rights. One concerns Maori management of
customary gathering in all New Zealand fishing waters. The other concerns Maori management of discrete areas
called mataitai reserves.
In regard to the customary gathering, the Act provides for regulations to allow Maori to control the gathering of
seafood under customary practice by any person (Maori or non-Maori - it does not permit exclusion by race or
ethnicity). This would mean that if any person decides to go fishing anywhere along the coast, that person may
either elect to fish under the existing amateur fishing regulations or that person may choose to apply to local
kaitiaki (or guardians) to fish under the customary regulations which may provide benefits different from the
amateur regulations. These provisions are similar to the present 'hui/tangi' provisions of the Amateur Fishing
Regulations, but they will be more clearly defined. The customary rights and the procedures for using them are to
be clearly defined in regulations. This should lead to less confusion and minimise the potential for abuse of the
system. The rights will be strictly non-commercial in nature.
In regard to the mataitai reserve areas, the new Act provides for regulations, which will give local Maori
communities a degree of management responsibility over small, defined fishing grounds, which have been of
traditional importance to them. The Act requires that any controls on fishing within mataitai reserves must apply
equally to all people. There is only one exception; if a reserve is closed for general harvesting, the mataitai
management committee could still approve of the taking of seafood’s to meet the needs of events on the marae,
which manages the reserve.
Before any mataitai reserve can be established, the Act requires the Minister of Fisheries to consult with the local
community in the area and consider their views. Policing of the reserves is to be carried out by officers acting
under the authority of the Fisheries Act.
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p32
Read information on p27 + 28 and then complete the tasks
below
1. How has a lack of clear property rights affected
a. Maori
Loss of resources  future /current ability to earn
income reduced
ie. Maori over-represented in statistics of POOR
b. Resource allocation in areas customarily “owned” by Maori
ie. identify the market failure
and the deadweight loss that results from it
Non Maori (+Maori) overuse of resources since no
guarantee of future income flow so incentive is to use
it today as there is no guarantee of it being their OR
may be fear that will have to pay for its use in the
future so overcome the resources today
ie. SMC and SMB are to the left of PMB + SMB so the
socially desirable output level is less than the free
market output  overutilisation of resources
4. Identify and explain how
the policy you chose would
impact on equity
2. Illustrate the market failure using SMB / SMC analysis
Costs/
Benefits
$
SMC
S = PMC
PS
PFM
D = PMB
SMB
QS
QFM
Draw a reasoned conclusions
as to why the govt should /
should not use the policy
(based on equity or efficiency)
Output
3. Suggest a policy that could be used to address the market
failure you identified and explain how it would improve
efficiency.
Give clear property right (ownership) to Maori
 they have the incentive to preserve resources for the
future as they have a guaranteed income flow into the
future(  D to SMB)
 Maori can charge for resource use and so firms
forced to internalize cost of –ve externality of prodn so
S  to SMC
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p33
Case Study 3 : Pollution Permits
This is another market based attempt
to reduce pollution
It involves the Govt creating a market
for pollution rights. The government
determines the number of pollution
permits (based on scientific research
to establish a “safe” level of pollution.)
The intent of the market is to
encourage pollution reduction as
firms with pollution rights who use low
pollution methods can sell surplus
rights thus increasing their revenue
and profitability.
Firms not prepared (or that cant
afford)to pay to purchase pollution
rights must adopt new methods that
produce less pollution. Firms that are
prepared to pay are internalising the
social cost of their pollution.
in both cases the result is a more socially desirable
outcome
Note setting the baseline level of pollution firms must meet is
crucial
Too low = few pollution rights for sale as not many able to
reduce their pollution levels below this standard
Too high = few buyers because most firms will be able to meet
standard
CASE FOR AND AGAINST POLLUTION PERMITS
For

Total level of emissions known
 Internalises social cost of externality
of polluting firm (ie. polluters bear cost of
that decision)
 Flexible as firms able to choose own
(least cost) methods of reducing pollution
 Incentives to find non-polluting ways
of producing (ie. market signal is that
non-polluting rewarded with increased
revenue)
 Environmental groups can buy up
pollution permits and destroy them and
so reduce the overall level of pollution
Against
 Requires a lot of faith in scientists and
govt to set the environmentally safe level of
pollution
Note. If they get it wrong they may
irreversibly damage the environment
 Requires monitoring to ensure firms not
exceeding polluting rights
 With any market you get uneven impacts
eg. poor communities will find the air quality
in their area reduce as wealthy people buy
pollution rights for clean air
 As with any market if it is not perfect it
will be allocatively inefficient
eg monopoly firm polluter will respond to
higher costs by restricting output (so MR = 
MC pushing up prices to consumers)
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p34
Exam Practice
1. Use SMB / SMC analysis to show the
market for Christchurch Fires with a
negative externality of consumption
Costs/
Benefits
$
Market for Chch Fires
S = SMC
PS
PFM
DWL
D = PMB
SMB
QS
QFM
Output
2. Explain what causes the negative externality of consumtion
(and the market to fail)
Fire consumers don’t consider the spillover costs of fires on
third parties (like smog causing health problems) so PMB is to
the right of the SMB and they over consume fires (QFM) rather
than the socially desirable (Qs)
3. What legislative methods have the CCC and CRC used to
reduce these negative externalities ?
-
Ban the use of open fires
Set emission limits for fires (ie. they must be clean
burning)
4. What advantages does a legislative approach to reducing
pollution have over a market based approach (like pollution
permits)
1. Sets?a specific polln limit for fires so its short term effect on the environment is
more certain (than taxes which affect quantity indirectly through price changes)
2. Considerable debate over what causes smog in Chch so accuracy of information
questionable  in short-term (until good info available) legislation best means
guaranteeing a “better” level of polln
3. Regulations are the most common form of polln control so are more easily
understood and acceptable to the public (so may be more politically usable –[cost
less votes])
5. What disadvantages does a legislative approach to
reducing pollution have over a market based approach (like
pollution permits) ?
1. Firms will adopt unexpected /innovative approaches to get around regulations so in
the long run the environmental impact is less certain eg install fire with glass front to
meet regs but take it off when using it
2. Will result in a less efficient (in terms of resources used as money spent fighting
CCC controls rather than producing solns) result as it doesn’t give firms the freedom
to decide how to abate polln
3. No incentive to reduce polln below regulated amount
4. Monitoring and enforcing regs may be difficult – visit homes at nightr when fire lit
to check they following rules is very labour intensive  large wage bill;
Market Failure (3.3) Part 1- Introduction + causes of Market Failure p35
6. Explain how a market for tradeable pollution rights could be
set
up in
Chch
and how
it wouldthe
work
CRC
/CCC
could
determine
appropriate level of polln emissions (hopefully the
socially desirable level). Existing polluters (fireowners/firms) could then bid for
permits that allows them to pollute to a certain fixed level.
These permits could then be resold.
Overtime CRC could reduce # of permits to reduce overall level of polln (+ generate
XD)
Note. Would require monitoring to firms/homes NOT polluting without permit as
without this no incentive to pay for permit. To some extent permit holders would self
monitor this as the value of their permit falls if “free” polluting is permitted.
Demand for permits comes from those who wish to pollute (assuming emission Q is
set below current levels this should generate excess demand
Supply comes from permit holders who find ways to reduce polln and so allow them
7. Explain the advantages and disadvatages this has over
to sell permits for higher price than they bought them
legislation
Advantages
1. Allows firms/hholds to meet polln limit in their own least cost ways
 they have an incentive to be innovative and find least cost ways of reducing
emissions because they can sell permits if they are able to reduce their polln below
permit limit
2. Sets a limit on the amount of emissions (ie. amount of permits) which could be the
social desirable output (Qs) if appropriate information available)
3. System generates income for CCC/CRC (when original permits bought) so is a
possibility of a double dividend
4. Since incentive is to find innovative ways of reducing emissions R+D that is used
for this may discover new technology that has positive spillover benefits for the
environment
Disadvantages
1. Susceptible to normal market failure
ie.
- Not perfect information  if not accurate info on MC,MB +ext then the level of
permits will be incorrectly set and socially desirable output WONT be achieved
- Market power  incentive for large players to bulk buy permits (and so lower
costs) and so polln may be concentrated in certain geographic areas
8. If you were aiming to achieve the most socially desirable
outcome what approach would you use and why
Provided accurate information is available Polln permits because the market signal
(incentive) is to reduce polln as innovative polln reduction gives permit holders the
opportunity to sell them and consequently polluters acting in their own self interest
will reduce polln to a more acceptable long term level
With regulations on the other hand the incentive is to avoid the regulation (as this
lowers your costs) so innovative polluters will find unexpected ways of avoiding the
regulations and so in the long term they are less likely to achieve the socially
desirable level of emission
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p36
Case Study 4 : Kyoto Protocol
What is the Kyoto Protocol ?
The Kyoto Protocol is an United Nations funded agreement between nations whose aim is to
reduce damaging carbon emissions used by industries as part of their production process that
create the greenhouse effect that we suffer from now. The protocol is heavily supported by our
government who are concerned by the damaging effects on our tourism, farming and ecology
caused by the changes in environment caused by the Greenhouse effect. The protocol aims to set
up a market for carbon credits where industries that emit unacceptable levels of carbon
emissions are forced to pay for carbon credits which have been earned by industries that produce
oxygen instead, e.g. forestry.
Read the article “The Kyoto Protocol: How much benefit
and What cost “and use it plus your own economic skills to
complete the following tasks
1. Identify the type of market failure that the UN is trying to
correct by the Kyoto Protocol
Negative ext of prodn
2. Explain how the Kyoto Protocol is attempting to bring about
a more socially desirable world outcome
The protocol aims to set up a market for carbon
credits where industries that emit unacceptable levels
of carbon emissions are forced to pay for carbon
credits which have been earned by industries that
produce oxygen instead, e.g. forestry.
Definition
Greenhouse gases =
Greenhouse gases is a term a used for
gases (like carbon dioxide) which are
mainly generated as a result of burning
fossil fuels like coal, petrol and diesel.
While, the use of these fuels have
helped industrialisation enormously, it
has caused a steady increase in levels
of carbon rich gases and other
pollutants. Scientists predict that higher
 this will force polluters to internalise the cost of
their polln and consequently they will cut back prod to
a more socially acceptable level (ie. PMC shifts left to
SMC)
and it rewards socially desirable producers
encouraging them to produce more again moving
them to a more socially desirable level (ie. PMC moves
right to SMC)
levels of greenhouse gases will cause a
significant warming of the earth by about
one to five degrees Celsius.
This could cause potentially disastrous
changes in the environment like violent
storms, expanding deserts and melting
ice caps, causing sea levels to rise and
engulf coastal regions.
3. Do you think it will be successful why / why not ?
- see discussionbelow on p 34/35
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p37
Insert Economic Tools for School Article
Vol 4 #1 term 2 2002
The Kyoto Protocol: How much benefit and
What cost
By Philip Bishop + Alex Sundakov
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p38
The Antarctic ozone hole is recorded at
approximately 10.5 million square miles on
September 19, 1998. This image shows
when chlorine and bromine from humanproduced compounds started to contribute
to large annual losses of ozone.
In September 2000, the Antarctic ozone
hole was the largest ever recorded -measuring at approximately 11 million
square miles, roughly three times the size
of the United States.
Source: NASA
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p39
END OF TOPIC REVISION
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p40
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p41
Important Definitions
TOPIC 1. PUBLIC GOODS
A. Why do markets fail to provide Public Goods ?
Public goods are that are demanded by consumers but are not
provided by at all by free markets (and so market failure
occurs). They are not provided because their characteristics
(which are the opposite of private goods) and these are:
1.NON EXCLUDABLE BY PRICE Free Rider Problem
You cannot limit the use of Public goods to those who have
paid for it because there is no (economically) feasible way to
exclude others (non payers) from using them
eg. If the city council decides to put security lighting in Hagley
Park there is no way they could charge people who used
them.
In a free market consumers would pay according to their
marginal benefit ie. the greater the MB the more they'd be
prepared to pay
But with Public Goods consumers know they receive benefits
even if they pay nothing because no one can stop them using
them even if they don’t pay.
 Private firms wont supply the lights
Tasks
1. Why can’t firms make a profit from
supplying lights in Hagley Park even
when there is clearly a demand for them ?
Because they have no way to
ensure those using the lights pay
for it
Market for Lights in Hagley
20 -15 --
DWL at QFM
10 -SMC
SMB
5 --0
QFM
0
Rivalry:
One person's consumption
of a product reduces the
amount available for other
people to consume because scarce economic
resources are used up in
producing and supplying
the good or service
Qs
Public Goods are
commodities whose
benefits are NOT
DEPLETED by another user
and which you CANT
EXCLUDE (by price) other
people from benefiting from
it
FREE RIDERS =
15 --
10 --5 --
Excludability:
Consumers can be
excluded from consuming
the product if they are not
willing to pay for it (for
example – if you don’t have
a ticket to the rugby you
cant get entry into Jade
Stadium)
PUBLIC GOODS =
2. On the graph below draw in the SMB (ie. market demand)
for lights in Hagley Park and identify QS QFM + DWL
20 --
A private good has three
main characteristics:
Rejectability:
Private goods and services
are rejectable - if you don't
like the look of the soup on
the college menu, you can
reject the chance to
consume it and use your
money to buy something
else.
because they have no way to make a
profit from supplying them
Costs/
Benefits
PRIVATE GOODS =
output
Person who consumes a
good without paying for it
Free riding with public
goods is possible because
once it is provided no one
can be excluded by price.
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p42
2. NON – DEPLETABLE (OR NON- RIVAL ) IN CONSUMPTION
MC = 0
Consumption by one consumer does not reduce the
availability of the good to others because once provided no
additional resources are needed.
Since the supply of public goods is not depleted by an
additional user, then the marginal cost of an additional user of
the lights in Hagley Park would be ZERO.
Tasks
1. What is the rule for allocative efficiency ?
(Hint. What happens at the output level where a perfectly
competitive firm allocatively efficient)
P = MC
2. If we follow this rule how much should consumers be
charged for Public Goods?
since MC = 0 for additional users of public goods
then the allocatively efficient price = 0
Public goods would be allocated efficiently if they
were supplied at no charge to anyone who wanted
them.
COLLECTIVE GOODS
(Must not be confused with
public goods) = goods that
are provided by free by
government but paid
collectively through taxes
Question
What is the difference
between a collective and
public good ?
Colllective goods is a
good provided by govt
out of general tax pool
Public goods is a good
that is non-excludable
by price and nonrival(or non-depletable)
Note public goods can
also be collective
goods but collective
goods are not
necessarily public
goods
3. On the Hagley Park graph on p
draw in the SMC and
- identify the DWL if lighting is not provided
- identify the DWL if the CCC provided it but charged $5
for each cyclist using the park at night
4. Try to think of 3 other Public Goods
Costs/
Benefits
20 --
*
*
National Defence
*
*
Public Roads
*
15 -10 -5 --
*
National Parks
DWL at $5 fee
SMB
0
Qs
QFM
SUMMARY
Not only is it impossible to charge for a Public Good
(since non-excludability means no one is prepared to
pay anything for it) but it is allocatively efficient not to
charge for it (because non - depletability means P =
MC at 0)
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p43
output
TOPIC 2. MERIT AND DEMERIT GOODS
Are goods that where govt intervention is NOT to correct for
market failure or to redistribute income instead for these goods
the intervention in to impose social values on individuals, to
force or encourage them to do more of some things (merit
goods) and less of others (demerit goods)
Governments try to discourage drug taking and encourage
education. These merit goods (and bads) need to be
distinguished from externalities:
eg. No one else may be harmed by someone taking
marijuana, yet many governments make it illegal. Moderate
drinking or smoking may have an adverse effect only on the
individuals partaking, yet government still tries to discourage
the consumption of alcohol and cigarettes through high taxes.
These are instances in which government interferes with the
general principle of consumer sovereignty, which holds that
individuals are the best judges of what is in their own interests
and promotes their own well-being. The government acts
paternalistically, that is, as if it were a father. Many economists
believe that government should limit itself to acting this way
with minors – few object to compulsory education
requirements for children but question whether government
should dictate what adults should or should not do, so long as
it does not cause harm to others.
Important Definitions
MERIT (BADS)GOODS =
Are goods that where govt
intervention is NOT to
correct for market failure
or to redistribute income
instead for these goods the
intervention in to
impose social values on
individuals, to force or
encourage them to do more
of some things (merit
goods) and less of others
(demerit goods)
A. Merit Goods
A Merit Good is a good govt
deems socially desirable so
acts to increase its
consumption.
One point often raised in association with merit / demerit
goods is that these are goods where consumer lack the
perfect information necessary to make sensible choices so the
govt intervenes its intervention on these grounds.
Perfect information allows them to make informed choices.
Imperfect or misunderstood information can result in ‘wrong’
choices. But are decisions “wrong” or simply different from
what govt feels is the appropriate decision.
Imperfect information can be caused by :

Misunderstanding over the true costs or benefits of a
product. e.g. drugs and higher education

Uncertainty about costs and benefits
e.g. should young workers buy into pension schemes when
we can only guess at economic conditions in 40 years time?

Complex information
e.g. choosing between makes of computers requires
specialist knowledge of hardware.
-Do I buy an Apple or PC computer?

Inaccurate or misleading information e.g. some advertising
may ‘oversell’ the benefits of a product

Addiction e.g. drug addicts may be unable to stop
consumption of harmful substances
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p44
Task
In the space below draw an SMB / SMC graph to show why
market failure would occur in the Market for Measles
Inoculations where a lack of perfect information causes
socially undesirable decisions
ie. under-consumption of inoculations
MC/
MB
CONSUMER SOVEREIGNTY =
The principle that each
individual is the best judge
of what makes him better
off.
Market failure through information failure
- Merit Goods
PMC = SMC
PFM
“Correct” valuation
SMB
PS
PMB
QFM
QS
Consumers
incomplete valuation
Output
i. Government Policies for Merit Goods
The government considers we should have merit goods and
services because they are thought to be good for us. Merit
goods are not necessarily the same as goods with positive
externalities, because government is not merely correcting for
market failure, but encouraging the consumption of something
considered to be good for us
The economic concern is that the government paternalism is
over-riding consumer sovereignty and so if market failure does
not exist then the govt intervention will itself cause market
failure.
There are a wide range of policies the government can use to
encourage the production / consumption of merit goods
Task
In the space provided below each heading below give
examples of policies currently being used for NZ merit goods
1. SUBSIDIES
- Prescription drugs from pharmacies are subsidised
- Doctors visits for adults are subsidised, but means
tested
- Tertiary education is subsidised
- Local authorities provide subsidies for public
transport
2. FREE PROVISION
3. COMPULSION
- Wearing cycle helmets
- Wearing seat belts
- Attending school (until
16)
4. EDUCATION
- TV adverts on benefits
of wearing seat belts
- Pamphlets distributed
to relevant institutions
about safety in
workplace, public
health issues like
immunisation
- Primary and secondary school education is provided
free of charge, although schools may ask for a
donation
- All Nzers have free access to hospitals
- Dentist visits for children are free
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p45
II. CASE STUDY PROVISION OF HEALTH CARE
Market for Health
Costs
Costs/ /
Benefits
Benefits
S = SMC
SMB
Ps
D = PMB
QFM Qs
Quantity
Tasks
1. ldentify the DWL at freemarket equilm and Qs Ps on the
Market for Health graph above
2. Explain why market failure occurs in the market for health
Consumers don’t appreciate the future benefits that will accrue to
them from being healthy so they under-come
OR.consumers don’t internalise benefits to others of them being
healthy (like increased productivity) so underconsume health
This market failure means the government must intervene if a
socially desirable level of output (allocatively efficient) is to be
achieved
 Current Govt Policy = Free Provision of Hospital Care
Costs /
Benefits
Market for Free Public
Hospital Care
S
S
SMB
0
Quantity
Tasks
1. What market situation exists on the Market for Free Public
Hospital Care:
Excess Demand
- is there any evidence of this market situation in NZ ? What
Waiting List
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p46
2. How have people who can afford Health Insurance
responded to this market situation ?
Taken out Health Insurance Policies to avoid having to
wait on waiting lists
3. How does Health Insurance affect Public Health Provision ?
Should reduce waiting lists as some patients are now
treated in Private Hospitals (funded by insurance) so
demand should fall
BUT
Health insurance increases demand for healthcare
as policy holders MC is zero for each hospital /
doctor visit (once they’ve paid premium)
MORAL HAZARD =
This is an inefficiency that
may result from insurance.
Once the premium is paid
the risk is removed from
the insured and so they act
in a less so socially
desirable way
Eg. Once you got fire
insurance you are less
careful and so the number
of fires increases
 as resources in health care are scarce  D pushes
up costs of providing it (as producers needing more
resources must pay higher prices to attract the
scarce resources to them)
The PPC diagram highlights the problem for government faced
with rising health costs
Other goods
Provision of Healthcare
Healthcare
Task
Use the PPC diagram to explain why the govt, faced with
rising health costs, is failing to provide an allocatively efficient
level of public health
If govt revenue remains constant but costs of
providing health rise then more govt funds must be
allocated to health and the opportunity cost of this is
less govt spending in other areas
 govt must balance increase health with other votewinning policies so govt may be prepared to
intervene but not to the extent necessary to achieve
Qs
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p47
B. De-merit Goods
A De-merit good is one that the govt decides is not socially
desirable so acts to reduce its consumption
eg. drinking alcohol..
Task
In the space below draw an SMB / SMC graph to show why
market failure could occur in the Market for Alcohol
MC/
MB
Market failure through information failure
- De- Merit Goods
PMC = SMC
PFM
PMB
PS
SMB
QS
QFM
Output
i. Government Policies for De-merit Goods
The government considers we should have merit goods and
services because they are thought to be good for us. De-merit
goods are not necessarily the same as goods with negative
externalities, because government is not merely correcting for
market failure, but encouraging less consumption of something
considered to be bad for us
The economic concern again is that the government
paternalism is over-riding consumer sovereignty.
There are a wide range of policies the government can use to
encourage the production / consumption of merit goods
Task
In the space provided below each heading below give
examples of policies currently being used for NZ de-merit
goods
1. TAXES
The following products attract excise duty in NZ:

alcohol and alcohol products (such as wine, spirits, beer, alcoholic ice cream and
popsicles

tobacco, tobacco products and tobacco substitutes

fuels such as motor spirit, compressed natural gas (CNG), and liquified petroleum
gas (LPG).
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p48
2. BANNED – PUNISHABLE BY FINES AND / OR IMPRISONMENT
- Class A drugs
- Unlawful use of firearms
- Open fire in Chch
3. REGULATION
- Noise
- Firearms
- Importation of wildlife into and out of NZ
4. EDUCATION
- TV adverts on drink – driving + Auahi Kore (ie. smokefree)
II. CASE STUDY AUAHI KORE (SMOKE FREE)
Put in article from p223 Geoff Evans
Senior economics
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p49
Tasks
1. Why is tobacco smoking considered to be a demerit good ?
Because govt considers it to be harmful and actively
discourages its consumption
2. What harmful effect of smoking is mentioned in the article
Tobacco consumption leads to 4500 smoking related
deaths each year
3. What action has already been taken to reduce the harmful
effects of smokiing
Taxes have been imposed and public warnings issued
4. Which “tougher measures“ is the government seeking to
implement in order to reduce the number of people who smoke
Further price rises and possible legal action against
tobacco companies
5. Assume the price of a packet of cigarettes was $7.00 before
the latest rise. Calculate the PED using the data in the article
Approx 1.4
6. Name a lobby group on each side of the smoking debate
and briefly summarise their concerns
ASH – Action on Smoking + Health
Group ___________________
Explanation:
Lobbying to decrease tobacco consumption because
of the negative effects it has on health, including
passive smokers- those who inhale other peoples
smoke
Group ___________________
Personal rights groups
Explanation:
Lobbying on peoples right to make their own choices
ie. fighting for consumer sovereignty
What action would you suggest in order to reduce the harmful
effects of smoking, justify your view (by equity or efficiency)
Complete BAN + imprisonment if caught smoking
If smoke you ever smoke you are NOT eligible for free
health care
BECAUSE will result in allocatively efficient level of
smoking which is Q = 0
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
p50
END OF TOPIC REVISION
Market Failure (3.3) Part 1- Introduction + causes of Market Failure
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Market Failure (3.3) Part 1- Introduction + causes of Market Failure
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PART 3
MARKETS, EQUITY AND EFFICIENCY
In this section we consider whether the free market solution is
equitable, or fair.
Important definition
The problem with arguing points of equity is that it is a very
subjective concept. It is based on values and is very much a
case of “equity lies in the eye of the beholder” It is different
from person to person, society to society.
Equity can be divided into two simple types:
1. Horizontal Equity: People in similar situations are
treated similarly.
eg, those will similar incomes pay similar taxes.
Note.in NZ this is NOT the case if you earn money by capital
gains you may not pay tax
eg. Selling home at higher price – you don’t pay income tax on
the capital gain
2. Vertical Equity: People in different situations should be
treated differently according to what society sees as fair.
eg. our progressive tax system means that those with high
incomes pay more tax than those with low incomes.
Note The Current Tax Rates are:
Taxable income
up to $38,000
Tax rate for every
$1 of taxable income
(excluding earner levy)
19.5 cents
$38,001 to $60,000
inclusive
33 cents
$60,001 and over
39 cents
Capital gains = the income
gained from selling an asset
ie. Selling price minus
buying price (less expenses
involved in buying /selling)
Horizontal tax equity: =
occurs when those under
the same circumstance
(income) pay the same
amount of tax.
eg. most people think it is
unfair if people in the same
circumstance are treated
differently
Vertical tax equity: =
occurs when people
different circumstances
(income) are treated
differently
eg. most people would think
it is unfair if an unemployed
person should pay the
same amount of tax as a
millionaire
Equity =
idea of fairness or social
justice.
Note equity cannot be
measured directly by
statistics so involves a
value judgement
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Example 1
Important Definitions:
John's total taxable income for the year was $65,238.
Here is how to work out the amount of tax due on the
income:
$0 to $38,000 @ 19.5%
=
$7,410.00
$38,001 to $60,000 @ 33%
=
$7,260.00
$60,001 to $65,238 @ 39%
=
$2,042.82
$16,712.82
Therefore the tax due on John's income of $65,238 was
$16,712.82.
Example 2
Sarah's total taxable income for the year was $45,000. Here is
how to work out the amount of tax due on the income:
$0 to $38,000 @ 19.5%
=
$7,410.00
$38,001 to $45,000 @ 33%
=
$2,310.00
$9,720.00
Therefore the tax due on Sarah's income of $45,000 was
$9,720.00.
Task
1. Calculate the tax that has to be paid by the following income
earners :
Income level
Tax to pay
Av Tax (%) Marg Tax (%)
(8000X.195)
$1560 ________
19.5% ________
19.5%
________
(7410 + 3333)
10743 ________
22.4% ________
33%
$48000
________
(7410+7260
$98000 +14820) ________
29490 ________
30.1% ________
39%
2. GST is 12.5%
Suppose two people earn, 1 = $400 disposable income all of
which is spent on g+s, 2 = $800 disposable income of which
$600 is spent on g+s and the rest is saved
$8000
ProgressiveTax =
Where the tax rate becomes
proportionately higher the
greater somebodies
income.
e.g. PAYE.
Proportional Tax: =
Where the rate of tax
remains the same no matter
what your level of income.
e.g. GST ???
Regressive tax =
is a structure where low
income earners pay a
higher proportion of their
income in tax than do high
income earners.
e.g. the tax on alcohol and
cigarettes.
Average tax rate: =
total tax to pay divided by
before tax income.
Marginal tax rate:=
Is the amount of tax that
must be paid on the next (or
last) dollar of income
earned.
Disposable income =
income available to spend
so is gross income minus
tax
Calculate
Person 1
$ GST paid
$50
________
Av tax (%)
12.5%
________
Person 2
________
________
$75
9.4%
Is GST proportional or regressive ? – explain why
Regressive since average % income paid in GST falls as
income (+ propensity to consume decreases) increases
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A. Unequal income (INEQUALITY) is fundamental
to a free market system
Equality means the same.
eg. If a primary school teacher and a secondary school
teacher earn the same amount of money, then they have
equality of income
The market system (where prices / incomes are set by
demand and supply) provides the best explanation for income
inequality
Because different items have different prices and are sold in
different quantities, the various people who supply them earn
different (unequal) incomes.
To illustrate that unequal rewards form the basis of the market
system, consider the ss/dd for the following occupations:
Market Gardener
Professional League
Player (Stacy Jones)
Dentist
SL
S
L
w
w
SL
w
DL
q
DL
DL
q
q=1
Briefly explain why market forces cause different incomes for
the different occupations above:
1. Market Gardiner
Many people are capable of being market gardeners,
the training is shorter and cheaper than a dentist so
the supply curve is flat (small wages  big Qs) so
even if demand is large income relatively low
2. Dentist
Training for dentists is very expensive so people will
only do it if wages(income) is high  S curve is steep
 because demand is large they earn high income
3. RL Player
Because there is only one Stacy Jones the S curve is
vertical  Stacy’s income is determined by demand for
him. If the Warriors play well and are popular he’ll be
able to negotiate a high salary
Discussion
1. Is it fair that a doctor earns
more
a stop
– go be
man ?
Yes than
– no one
would
prepared to do training if
no reward
2. Resource ownership is not
equally accessible so is it
“fair” that govt intervenes to
help lower income earners ?
Yes – resource owners
have the means to earn
income but those without
dont
3. Discrimination occurs in NZ
– should govt intervene ?
Yes –inefficient not to, not
best use of resources if
best person not appointed
 lower productivity
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B. Measuring Income Inequality
The Lorenz curve, named after an American economist, Max
O Lorenz, is a useful quick glance guide to income inequality.
The curve shows the relationship between the cumulative
percentages of households and the cumulative percentages of
income (or some other measure of wealth / inequality) they
earn.
NZ Disposable Income
Lorenz Curve
NZ Disposable Income Lorenz
Curve after GST
Key point
All economies have lines to the right of the line of complete
equality BUT the further you are from this line the more
unequal is the distribution of income
The RED line above shows NZ’s Lorenz curve for disposable
income
The BLACK line shows the effect on NZ’s Lorenz curve of GST
Task
Explain the positioning of the Lorenz curves
a. Disposable income
Not every body earns the same income (even after income taxes are paid) so the red
Lorenz curve must be to the right of the line of equality
b. Disposable income + GST
NZ disposable income after GST is paid is more uneven than the NZ disposable
income Lorenz curve (and so to the positioned further to the right) because poor
people spend a higher proportion of their income meaning more of it is exposed to the
tax and so after GST they have a smaller proportion of income and so the gap
between rich and poor will widen shifting the Lorenz curve right.
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Skill Constructing
Lorenz Curves
Step 1: Draw a square. Use at least 1/3 of the page when drawing the model.
There is nothing worse than small, hard to read graphs and models. (Done for you)
Step 2: Label the axis. Both the vertical and the horizontal axis on the square represent 100%, go
up the scales in blocks of 20%. The vertical (left hand) axis shows Percentage of Income
Received. The horizontal axis (the base) shows Percentage of Households.
Step 3: Draw the equal distribution line. This line shows 100% equality, i.e. that 20% of the
households earn 20% of the income; and 40% of the households earn 40% of the income, etc. The
line is drawn from the bottom left corner straight up to the top right corner.
Your Lorenz curve should now look like this:
Percentage of
Income
100
0
0
100
Percentage of
Households
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Step 4: Work out the cumulative percentage of income. Use the table below to work out the
cumulative percentage of income. The first two have been done for you.
Income Distribution for (……..)
Percentage of Households
Share of total Income (%)
Cumulative Percentage (%)
Lowest 20%
5
5
2nd 20%
10
(5+10 =) 15
3rd 20%
15
(15+15=) 30
4th 20%
25
(30 + 25 =) 55
5th 20%
45
(55 + 45 =) 100
Step 5: Plot the Lorenz curve for the country. Plot the Lorenz curve using the cumulative
percentage of income.
Your Lorenz curve should now look like this:
Title
% of
income
100
0
0
100
% of households
Step 6: Give the Lorenz curve a title. “Income Distribution by Household for (country)”
Key Points.
☺ The curve always begins at the origin and ends at 100% as 100% of households income is
distributed to 100% of the households.
☺ If the income distribution was totally equal, the Lorenz curve would line on the straight line.
The further away from the straight line, the more unequal the distribution of income.
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The following table shows the share of income each
household in New Zealand receives.
New Zealand Income Distribution by Household 2003
Percentage of
Households
Lowest 20%
Second 20%
Third 20%
Fourth 20%
Fifth 20%
Share of Total
Income
Cumulative
Percentage
5.4
10.6
15.2
22.7
46.1
5.4
16
31.2
53.9
100
Task
Use the skillsheet on p
to construct NZs Lorenz curve.
Plot New Zealand’s Income Distribution on the Lorenz curve
below.
New Zealand Lorenz Curve
% of
Household
Income
Complete the following:
Income Distribution by
Household in Mordor.
H/H
(%)
Low
20%
2nd
20%
3rd
20%
4th
20%
5th
20%
Share Cum
of
ulativ
Inco
e
me
%
4
4
12
16
22
38
30
68
3232
100
% of
Household Plot the figures on the Lorenz
curve for NZ.
s
Based on the table, is there economic inequality in New
Does it show a more or less
Zealand?
even distribution?
YesYes
Why/Why Not?
Because there is not an even distribution of income i.e. 2
Because there is not an even distribution of income i.e.
20%=20%, 40%-40% etc0%
Why/Why Not?
More even at top end
(top 60% closer to line of
equality)
Less even at bottom
(bottom 20% further from
line of equality)
=20%, 40%-40% etc
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Analysing the Lorenz Curve
Examine the Lorenz curve below and then complete the
exercises and questions below it.
B
Cumulative % of
income
100%
Lorenz curve A
A
Cumulative % of
households
0%
C
100%
1. What does line AB show?
Line of equality
2. Using 2 different coloured pens draw a BLUE line that
shows a more equal distribution than the one shown + a RED
line to show a less equal income distribution than Lorenz
curve A
3. What does line ACB show ?
Line of complete inequality
4. For each of the situations below
i. Draw a new Lorenz curve B to it
ii. Give an explanation for the shift you make
a.. 2004 Budget introduces Working for Families package
Cumulative % of
income
Lorenz curve A
Cumulative % of
households

Explanation
Poor families
- receive benefit
 gives the
a. more income

b. greater opportunity to
succeed at school because
1. heathier / better fed
2. don’t need to miss /
leave school to support
family

100%
0%
One of the key aims of Budget
2004 was to recast the income
support system for low to middle
income working families with a
package of measures entitled
"Working for Families".
Working for Families has three key
aims:
100%
 current / future income of
poor increases moving them
closer to line of equality
To make work pay by
ensuring that people are better off
by being in work and are
rewarded for their work effort;
To ensure income adequacy,
with a focus on low to middle
income families with dependent
children, to address issues of
poverty, especially child poverty;
and
To support people into work
by ensuring people get the
assistance they should to support
them into, and to remain in, work.
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b. Welfare benefits are increased in an attempt to close the
gap between rich and poor
Explanation
Poor families - receive benefit  gives the
a. more income
b. greater opportunity to succeed at school
because
1. heathier / better fed
2. don’t need to miss /
leave school to
support
family
Cumulative % of
income
100%
Lorenz curve A
 current / future income of poor increases
0%
Cumulative % of
households
100%
moving them closer to line of equality
c. User – pays (non-means tested) charges are introduced by
the government to reduce spending on health
Explanation
Poor families are more likely to be sick as they
are in poorer quality housing / worse nuitrition
 they go to doctor more often or if cant
afford to miss work (+ earn less)
 distribution of disposable income after
effects of user pays will less even since poor
will be affected to a proportionately larger
degree
Cumulative % of
income
100%
Lorenz curve A
0%
Cumulative % of
households
100%
d. Holidays Act makes time and a half compulsory for workers
working on Public Holidays
Explanation
2 possible effects
1. Poor better off (Lorenz curve moves
towards line of equality) as pay
increases
2. Poor worse off (Lorenz curve moves
away from line of equality) as shops +
restaurants close on Public Holidays
 workers who used to work now don’t
reducing their income
Cumulative % of
income
100%
Lorenz curve A
0%
Cumulative % of
households
100%
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Appendix 2–
GINI COEFFICIENT
Changes in income inequality are measured by the ginicoefficient
The gini-coefficient is defined as the ration of :
area A to area A+B
 complete equality occurs when A = 0
complete inequality occurs when B = 0
In NZ the gini coefficients in 1983/84 = 0.353
1995/96 = 0.404
 Does this indicate a worsening or an improvement in
NZs distribution of income ?
Ans.
International Comparisons
Gini –coefficients for selected OECD countries 1970s -1990s
gini coefficient
Gini-coeffificents for selected OECD Countries
0.36
0.34
0.32
0.3
0.28
0.26
0.24
0.22
0.2
NZ
1970s
1980s
1970s
1980s
1990s
NZ
0.269
0.264
0.331
Aussie
0.291
0.312
0.306
UK
US
0.313
0.34
0.344
France
UK
0.28
0.33
0.33
Sweden
France
0.296
0.298
0.291
Sweden
0.232
0.216
0.23
Aussie
US
1990s
Years
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Appendix 3- THE ROLE OF FINANCIAL INCENTIVES
a. Improves Resource Allocation.
Important Definitions
Sunrise industry = newly
developing growth
industries
 try to think of 3 NZ egs
1.
2.
Sunset Industries
eg. Cinema Market
 D emand for cinema
THE PRICE
SYSTEM AT
WORK
3.
Sunrise Industries
eg. DVD Hire Market
 Demand forDVD hires
tickets
Sunset industry =
declining industries
 try to think of 3 NZ egs
1.
 Price and quantity
 Price and quantity
2.
3.
 Profits so MANAGEMENT tries to
cut costs
 cut workers hours
 cut production (eg. less
screenings
)
 cut capital purchases (eg. use old
machines)
 some inefficient firms shut down
 Profits so MANAGEMENT has
incentive to expand
 Ex isting firms expand (possibly by
opening new branches)
- increasesD for factors
- increase in borrowing
 New firms enter this market
(as entrepreneursseek higherprofits)
- further ing D for factors
 some inefficient firms shut down
 I ncomes earned by
resource owners incinema
industry
 I ncomes earned by
resource owners inDVD
industry
Resourcesmoved out of
Resourcesattracted to
declining cinema industry
DVD industry (possibly
from declining Cinema
market
Summary
People whose skills are in high demand (eg. those who
produce products for sunrise industries) earn higher incomes
demonstrating that these markets need more of these people.
People whose skills are outdated (eg. those working producing
products for sunset industries) receive lower wages indicating
less of these resources are needed and thus sending a
SIGNAL to these people that they need to retrain
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CASE STUDY: THE PRICE SYSTEM IN ACTION
Task
NZ has a competitive advantage in the production of racing yachts with
the result that NZ boat builders make faster boats. Use the concepts of
sunrise/sunset industries to help you complete the exercises below.
1. Give a reason to explain why NZ has a competitive
edge in racing yacht prodn.
2. Show the effect of NZ’s competitive edge on an
appropriately labelled S/D graph
1. Identify an industry that may contract ( sunset?) as
yacht building expands
Fishing boat building industry
2. Show the effect of the racing yachts success on an
appropriately labelled S/D graph for the industry you
identify in 1.
S1
D1
Explain any curve shifts
D1 results from o’seas buyers wanting more NZ
boats because ours are faster
Explain any curve shifts
3a. What effect will this competitive edge have on
resource use in NZ.
MORE NEEDED to produce luxury boats to meet D
b. Show the effect of the competitive edge on an
appropriately labelled labour market S/D graph
wages
Workers from fishing industry attracted by higher
wages in luxury boat building industry. The
shortage of workers pushes up wages and these
firms facing higher costs reduce supply
3 Explain the effect of the change you have shown in 2.
on resource in the contracting industry
The  S  less resources needed in fishing boat
building industry removing the XD for workers in
this part of the economy
DL1
Explain any curve shifts
D for labour as more needed to produce the extra
luxury yachts demanded
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4. Use evidence from your analysis above to explain:
i.
How the price system improves resource allocation
The price system has raised wages in high demand areas increasing the number of workers /
resources working in this area.
ii.
Why free market systems result in income inequality
Those workers in high demand receive relatively higher wages than those in low demand areas
b. Encourages innovation and risk-taking
The key idea that differentiates entrepreneurs from other
human resources is the willingness to take risks.
Many people have great ideas, but do not take that extra step
to put those ideas into practice.
It is the ENTREPRENEURS that create growth and job
opportunities for the rest of the country.
Financial incentives, such as high wages and profits are the
reward for effort and enterprise, a return for taking risks. They
motivate people to increase productivity.
Financial incentives not only encourage people to work harder,
but also to work smarter. These incentives mean that
producers will strive for better production techniques to
increase productivity, and new products to increase sales or
gain market dominance.
1st Suppose an innovation in aircraft technology involves
the implementation of uptilted wing tips, which greatly
improves fuel economy and raises the cruising speed of
all 747’s.
Cargo
Air tonnes
PPC for Jumbo Jets (747’s)
Jumbo jets (Boeing 747s)
can be adapted for cargo
handling or for transport.
The PPC demonstrates the
potential output of each
given that airlines cannot
use the aircraft for both
purposes at the same time.
Passenger
Kilometres
Tasks
1. Clearly demonstrate the effect of the technological
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development on the PPC diagram.
2. Explain any change you have made to the PPC.
Since technology improves output of BOTH production areas the PPC shifts to the
right
3. Explain the role financial incentives would have had in
encouraging Boeing engineers to develop this new technology.
Boeing may pay engineers an share of the increased
profits they generate for the company and so they
will try to find ways of improving profit so they get
higher pay.
4. Identify examples of unequal income distribution that would
result from this innovation.
Boeing workers get higher pay BUT other airlines are now less
competitive so less sales for them and so less profit
2nd suppose there is a further development in aviation
technology which gives cargo aircraft a front opening
hatch, which enables the jumbo jet to taxi up to the freight
bay, raise the “nose of the aircraft and load and unload
full cargoes more efficiently.
Tasks
Cargo
PPC for Jumbo Jets (747’s)
Air tonnes
Passenger
Kilometres
1. Clearly demonstrate the effect of this new technological
development on the PPC diagram above.
2. Explain any change you have made to the PPC
New technology decreases the time taken to load and unload cargo so more cargo
flights possible so “maximum possible” output increases but new tech does affect
passenger transport so “maximum possible” output remains unchanged.
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3. What impact will the new innovation have on incomes within
different airline divisions and between airline companies
Those working in cargo will get increased income, eg, have to work overtime so
the airline can handle the increased number of flights.
Note workers may want to shift from passenger to cargo as incomes have
increased
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End of Topic Revision
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