17-1Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Chapter 17

Market failure and resource allocation

17-2Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

17-3Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

17-4Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Sources of market failureTwo 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

17-5Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

17-6Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

17-7Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Spillover costs

Q0DD

P

Qe Qo

SS11 SS

17-8Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

17-9Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Spillover benefits

Q0

P SS

QoQe

DD DD11

17-10Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

17-11Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

17-12Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

P

Q

D

When verticallyadded equals

collectivewillingness

to pay

D2

D1

Demand for a public goodSS

3

5

8

17-13Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

17-14Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Over-allocationcorrected

P

Q

D

0

St

S

Spillovercosts

Tax

Q0 Qe

Correcting for spillover costs

17-15Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

17-16Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Correcting for spillover benefits (cont.)P

Q

D

S

0

Dt

SubsidySubsidyto consumerto consumer

Under-allocationUnder-allocationcorrectedcorrected

17-17Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

P

Q

D

0

St

S′t

Subsidy toproducersincreases

supply

Under-allocationcorrected

Qe Q0

Correcting for spillover benefits (cont.)

17-18Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

17-19Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

17-20Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

17-21Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

17-22Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

17-23Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Market for pollution rights (cont.)

500 750 1000Quantity of pollution rights (units)

Pri

ce p

er p

oll

uti

on

rig

ht

$100

$500

D2000

D2008S

17-24Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Next chapter:

Inequality and poverty