Chapter 17
Market failure and
resource allocation
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-1
Learning objectives
• Discuss the nature, and provide examples
of, spillovers (externalities)
• Examine the implications of spillovers for
the efficient allocation of resources
• Briefly discuss the problem of the commons
and its implications
• Describe the characteristics of public goods
— indivisibility and the inability to apply the
exclusion principle — and the potential role
of government in ensuring the adequate
provisions of these goods
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-2
Learning objectives (cont.)
• Show how we can evaluate government
activity through cost–benefit analysis
• Determine the economic considerations
that underlie environmental problems and
examine some suggested solutions to the
pollution problem
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-3
Sources of market failure
Two major sources of market failure. The
market either
• Produces the wrong amounts of goods or
services, resulting in externalities or ‘spillover’
effects, or
• Fails to allocate sufficient resources to
the production of certain goods, called
‘public’ or ‘social’ goods
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-4
Spillovers or externalities
• These are costs or benefits associated with
the production or consumption of a good or
service that flow on to parties that are external
to the market transaction
• Spillovers
– Costs or benefits associated with production
or consumption that flow on to parties external
to the market transaction
– The market over-allocates resources
– Also called externalities because these are costs or
benefits that are external to the market transactions
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-5
Spillovers or externalities (cont.)
Spillover costs
• Production or consumption of a commodity
that inflicts cost on some third party without
compensation
• Example: environmental pollution
• Spillover costs arise in some cases due
to the problem of the commons
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-6
Spillover costs
S1 S
P
0
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
D
Qo Qe
Q
17-7
Spillovers or externalities (cont.)
Spillover benefits
• Production or consumption of goods and
services which confer external benefits for
which payment or compensation is not
required
• The market under-allocates resources
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-8
Spillover benefits
S
P
D
0
Qe Qo
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
D1
Q
17-9
Public goods and services
• Private goods are produced through
the market system
– They are divisible
– Subject to the exclusion principle
• Public goods not provided by the market
and are:
– Indivisible
– Not subjected to the exclusion principle
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-10
Public goods and services (cont.)
• Public goods are goods and services that
are not provided by the market system
• Pure public goods are goods and services
that are both indivisible and not subjected
to the exclusion principle
• A common problem of public good is
the free-rider problem
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-11
Demand for a public good
S
P
8
When vertically
added equals
collective
willingness
to pay
5
3
D2
D1
D
Q
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-12
Solutions to market failure
•
•
•
•
Correcting for spillover costs
Legislation
Specific taxes
Property rights and individual bargaining
– Coase theorem
 Property ownership is clearly defined
 The number of people involved is small
 Bargaining costs are negligible
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-13
Correcting for spillover costs
St
Spillover
costs
P
S
Tax
Over-allocation
corrected
0
Q0
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
Qe
D
Q
17-14
Correcting for spillover benefits
• Subsidise buyers
– This would reduce the private cost to consumers
and increase the consumption of the good
• Subsidise producers
– Government can encourage the production by
subsidising producers of the good or service
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-15
Correcting for spillover benefits (cont.)
P
S
Subsidy
to consumer
Dt
Under-allocation
corrected
0
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
D
Q
17-16
Correcting for spillover benefits (cont.)
St
Subsidy to
P
producers
increases
supply
S′t
Under-allocation D
corrected
0
Qe
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
Q0
Q
17-17
Allocating resources to
public goods
Cost–benefit analysis
• Method used to allocate resources to public
goods that maximises society’s welfare
• Problems associated with cost–benefit analysis
include the difficulties in measuring the value
of certain costs and benefits in practice
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-18
The pollution problem
• The law of conservation of matter and energy
• Four important causes of pollution
1. Population density
2. Rising incomes
3. Technology
4. Incentives
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-19
Anti-pollution policies
• Individual bargaining and liability rules
and lawsuits
– The allocation of property rights to individuals
may allow them to negotiate with polluters so
that they are compensated for the damage
caused by pollution — Coase theorem
• Government intervention: direct control and taxes
– Direct controls: legislated standards
– Specific taxes: emission fees
• Establishment of a market for pollution rights
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-20
Market for pollution rights
• Involves the establishment of an allowable
amount of pollution — in line with the ability
of the environment to recycle — by a pollution
control agency, and the development of a set
of ‘rights’ to create units of pollution which
would be sold or auctioned in the market
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-21
Market for pollution rights (cont.)
• Rights to pollute would be sold or auctioned
off to polluting firms, providing a market for
pollution rights
• Polluters would bid for the pollution rights up
to the point at which the cost of the pollution
rights exceeds the private cost of pollution
abatement
• A market for pollution rights ensures an
efficient allocation of resources
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-22
Market for pollution rights (cont.)
Price per pollution right
D2008
S
D2000
$500
$100
500
750
1000
Quantity of pollution rights (units)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-23
Next chapter:
Inequality and poverty
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
17-24