Market failure: Externalities & Public goods

Price

Quantity

Demand = MB

QC

Supply = Sum of MC

PCPC

d = MR = MB

MC

qC quantityCompetitive Market Competitive firm in

Market• Competitive markets achieve Allocative efficiency (maximum satisfaction) when the highest price the consumer is willing to pay = the cost of producing the next unit of the good (P = MB = MC)...

…this means the market price reflects ALL benefits received benefits received and ALL costs of productioncosts of production.

• In many circumstances, there are costs or benefits from producing or consuming a good that go to others that are not involved in this market. This results in MARKET FAILURE.

MB = MCThe Competitive Situation

Market Failure• Competitive markets become Allocatively inefficient

because buyers and sellers do not take into accountdo not take into account all benefits and/or all costs from production of a good...

…because they have no incentiveno incentive to take into account EXTERNAL COSTSEXTERNAL COSTS and BENEFITS BENEFITS which accrue to someone besides themselves (buyers & sellers).

Why? Because they either don’t have to pay for them(costs) or don’t receive the benefit.

• Therefore, the market price of the good will not reflect will not reflect ALL costs or benefitsALL costs or benefits (ignore external costs or benefits)

• These external costs or benefits are called EXTERNALITIES or spillover effects...

…they represent the impact on third parties from market transactions.

Price

Quantity

Demand = MB

QC

Supply =MC

PCPC

d = MR = MB

MC

qC quantityCompetitive Market

Competitive firm in Market

Negative Externality

Negative Externality (external cost): a cost (beyond the firms cost) imposed on others in the production of a good or service......this cost is called the marginal external (or damage) cost (MEC or MDC)...

} MEC} MEC

...and is defined as the extra costextra cost imposed on third parties when a negative externality is present.

Examples: Dumping waste products into the air and water,secondhand smoke, traffic congestion, loud music played at

3:00 in the morning, airplane noise, etc

Price

Quantity

Demand = MB

QC

Supply =MC

PCPC

d = MR = MB

MC




} MEC} MEC

To find the cost to EVERYONE, we must add the MEC to the MC of the firm...…which gives us the total cost of production. This is called:

MARGINAL SOCIAL COST(MSC) = MC (from firms) + MEC (additional external cost imposed on others)

MSCMC+MEC =MSC

Price

Quantity

Demand = MB

QC

Supply =MC

PCPC

d = MR = MB

MC




} MEC} MEC

MSCMC+MEC =MSC

PE PE

QEqE

Allocative efficiency occurs when ALL cost and benefits are considered. This will now occur when MSC = MB.At Qc with price Pc , MSC > MB (because of the external costs)Competitive equilibrium is no longer efficientno longer efficient because of the negative externality.MSC > MB indicates that the competitive market overproduces the good at a price lower than the total (social) cost of production To reach efficiency, price must rise and quantity decline.

{

Price

Quantity

Demand = MB

QC

Supply = MC

PC PC d = MR = MB

MC

qC quantityCompetitive Market Competitive firm in Market

MEBMEB

Positive Externality

Positive Externality (external benefit): a benefit (beyond the consumers benefit) that is bestowed on others in the production or consumption of a good or service which we call...

...the marginal external benefit (MEB)......the extra benefitextra benefit bestowed on third parties when a positive externality is present.

Examples: Smoke detector in an apartment, vaccinations, college education, Christmas decorations on a house.

{

Price

Quantity

Demand = MB

QC

Supply = MC

PCPC d = MR = MB

MC


{ MEBMEB


{

To find the benefit to EVERYONE, we must add the MEB to the MB of the consumer...…which gives us the total benefit of production. This is called:

MARGINAL SOCIAL BENEFIT(MSB) =

MB (from consumers) + MEB (bestowed on others)

MSB = MB + MEB

MSB

Price

Quantity

Demand = MB

QC

Supply = MC

PC PC d = MR = MB

MC


{ MEBMEB


{

MSB = MB + MEB

MSB

At Qc with price Pc , MSB > MC (because of the external benefits)Competitive equilibrium is no longer efficient because of the positive externality. Allocative efficiency occurs when MSB = MC

QE

MSB > MC indicates that the competitive market underproduces the good at a higher price than is efficient.To reach efficiency, moremore of this good must be produced and sold.However, Consumers need a price lower than PC in order to buy more of this good.

PE

A firm would not produce more at a lower price

Correcting Externalities• Problem: Private individuals and firms have no

incentive to take into account external costs(MEC) or external benefits(MEB)...

...that is they don’t have to pay for the damage caused or receive the extra benefits of others.

• Solution: Have individuals and firms incorporate (give them an incentive) or INTERNALIZE the external costs or benefits into their own cost-benefit calculations.

• If this occurs the firm will adjust their MC so it reflects the MEC and will equal the MSC…

...if this is done then the market price and quantity WILL reflect both private and external costs.

• Internalizing an externality can be done in numerous ways...

Correcting Externalities1. Persuasion(Can work at a personal level) If a roommate is playing a stereo at 3:00 am, you can

ask that person to stop so you and others can sleep. You can ask someone not to smoke by you. “Don’t Drink and Drive” is an attempt to get people to

consider the external costs of this action.2. Government intervention a) Direct regulation Government telling firms or individuals what to do

and exactly how to do it. Why? In some cases the externality is too

dangerous for any amount to occur, like plutonium or some chemicals

Examples: Specific equipment on cars, tailpipe emission tests, use of a “cleaner” gasoline

Correcting Externalities2. Government intervention, con’t b) Indirect intervention 1) Legal rules and procedures Various Product liability laws allow people to sue

manufacturers if their product is defective Firms have greater incentive to improve their

product so they don’t pay damages 2) Corrective taxes & Subsidies Firms ignore the MEC they impose on others The government can tax firms to simulate the

external costs to others(society).. By subsidizing a product that has a positive positive

externality externality, the government can simulate the MEB and encourage more production.

Price

Quantity of Dry cleaning

Demand = MB

QC

Supply =MC

PCPC

d = MR = MB

MC


Competitive firm in MarketCorrection of a negative externalityCorrection of a negative externality

New supply = MSC(MC + Tax) MC+ Tax = MSC = firms cost

PT

QTqT

A per unit tax adds to the cost of production for business firms that impose a negative externality

Tax = MEC (MDC)

The market supply curve will decrease (shift to the left) because the tax has increased the cost of production to business firms.This raises the market price and lowers market quantity.

Tax}Tax} dT = MRT = MBTPT

The per unit tax forces firms to take into account the external costs they impose on others…...the MSC to society becomes the internal or private MC to the firmBecause consumers pay a higher price, quantity does not go down the maximum amount

What have we learned from this?1)For efficient use of resources the Tax = MEC. It can be difficult to measure external costs and to get

the Tax rate = MEC In fact, it may only be possible by trial and error.2)The cost of reducing pollution is lower output

and/or higher prices (ceteris paribus) Of course, a firm has an incentive to choose the least costly

option. If paying the full amount of taxes and not reducing output is

the least costly, then the firm will do that.3) If Tax = MEC then tax revenue generated is large

enough to pay for all damages from the externality. • If the government could find people directly affected by the

negative externality it could transfer the revenue to them.....…since this is not likely, many would like to see reductions see reductions

beyond the efficient levelbeyond the efficient level, because they still have to bear the external costs (i.e. the pollution)

Price

Quantityof Students

Demand = MB

QC

Supply = MC

$4,000 $4,000d = MR

MC

qC

quantity of students

A well educated workforce tends to be more productive, which means more output for the economy and lower inflation….

…but students don’t take this positive externality in effect when deciding to go to college.

The government can make students (and colleges) take these external benefits into account by subsidizing production.

Correction of a positive externality

Competitive Market Competitive firm in Market

Price

Quantityof Students

Demand = MB

QC

Supply = MC

$4,000 $4,000d = MR

MC

qC

quantity of students

Correction of a positive externality

Competitive Market Competitive firm in Market

In this case the subsidy goes directly to the firm, which lowers cost..and causing the Supply curve to increase (shift to the right).

}d = MR

MC - Subsidy

MEB

Subsidy to firms = MEB

SupplyafterSubsidy$3,000 $3,000

QSqS

By lowering the price of education, more students will go to college.As long as the subsidy = MEB, efficiency will be achieved.This occurs whether the firm or the consumer receives the subsidy.

}

Correcting Externalities3. Market Solutions....

...Assigning property rights

If the government can assign property rights to resources where there were none before....

...and allowing owners of these property rights to bargain, negotiate, and sell them...

...the market itself will be able to internalize an externality and achieve efficiency....

An economist named Ronald Coase first developed this idea...

Coase Theorem

Rancher

Common Land

Who causes an externality is not always obvious. It takes at least two or more to cause externalities.

Example: The octagon above represents open common landSuppose a rancher sets up a few buildings and an area for his cows to graze on.

Up to 800 cows

Assume the grazing area has the capacity to fully feed up to 800 cows

Coase Theorem

RancherUp to 800 cows

Farmer Carrots

Common Land

Next, a farmer begins to plant his crop, carrots, on another part of this common landThere are no fences between these two, so if the rancher has more than 800 cows, some of those cows stray off the blue area in order to feed themselves (i.e. Rancher’s firm gets bigger)

Occasionally, some cows stray onto the land where the farmer planted his crops and they eat them! (This is the MEC)This lowers the amount of production for the farmer and will cost him revenue and profits.

Coase Theorem

1) Farmer can move; Rancher can move 2) Build a fence (either around rancher or farmer) 3) Rancher can keep cows to less than 800 (voluntarily

or through government regulation and/or taxes)Coase: By assigning property rights to the common land, these

two can solve the negative externality for themselves. It will be done in the same waysame way no matter who gets the

property rights

RancherUp to 800 cows

Farmer Carrots

Common Land

Farmer is upset about the damages, but, since rancher was there first, claims it is not his fault.This is a negative externality

Solutions for this negative externality:

Coase Theorem• Suppose we collect the following information from

the rancher and farmer:• The rancher will maximize his profit by raising 1000 cows.

But this leads to straying cattle and an external cost on the Farmer.

• Cost to the rancher to cut production back to 800 cows is $10,000 lost profit (200 x $50/cow)

• Cost to move cows or move the farm = $25,000• Cost to build a fence around ranch or farm

= $16,000• Maximum damage to farmers crops from

straying cows is $20,000 (200 x $100/cow)

Coase Theorem

• Which alternative will be chosen?• Suppose the rancher gets the property rights...…the rancher will keep only 800 cows!the rancher will keep only 800 cows! Why? Because the MEC > profit/cow, the farmer is willing to paywilling to pay

$10,000 to the rancher if he will limit his cows. (It is better to lose $10,000 than $20,000)

• What if the farmer gets the property rights? The rancher will keep only 800 cows! The rancher will keep only 800 cows! Why?• Because it is cheaper than paying $100/cow to the farmer for

each cow over 800.• Practical application: In some circumstances there is no

need for taxes and/or government regulation to correct externalities. If property rights can be assigned then the market system may be able to correct them.

Cost to cut production back to 800 cows is $10,000 ($50/cow) Cost to move cows or move the farm = $25,000Cost to build a fence around ranch or farm = $16,000Max damage to farmers crops from is $20,000 (MEC=$100/cow)

Summary: Externalities• An Externality is a cost or a benefit that affects others

not involved with a market transaction.• Negative Externality: a cost imposed on society• Positive Externality: A benefit bestowed on society• Correcting Externalities (Internalizing) Government solutions 1) Direct Regulation 2) Indirect intervention a) Legal Rules and Procedures b) Corrective taxes & Subsides Must be equal to MEC or MEB to achieve efficiency Market Solutions Assigning property rights Coase theorem: No matter who gets them, if the

conflicting parties can negotiate and trade, the efficient outcome is achieved.

An application: Pollution, a negative externality

Pollution: A negative externality Two questions must be answered:1)What is the optimal(MSC=MSB) reduction in pollution?

2)What is the lowest cost way to reach that reduction?• Government could directly lower pollution by telling

firms how much they must reduce it and exactly how it must be done...

…but some firms are in a better position (technology) to reduce pollution than others, direct regulation is not the most efficient(cheapest) way to reduce pollution...

...Pollutants that are not immediately hazardous to human health can be reduced cheaper by using more market based methods…for example...

…the polluter is given property rights to pollute... ...BUT THEY MUST PAY FOR THAT RIGHT

Market Solutions for reducing pollution1. Emission charges • Firms are charged for each unit of waste products they

dump into the air or water. • Need to measure the emissions or effluent of a firm.• These charges are similar to corrective taxes, but charge charge

directly for emitting pollutantsdirectly for emitting pollutants rather than producing the good...

…the difference is that emission charges give firms an incentive to reduce emissions (and not output)...

...so they don’t have to pay the emissions charges. • Moreover, firms have the responsibilityfirms have the responsibility to find ways to

reduce pollution. • Recently, the EPA has found that costs can be reduced

even more by auctioning off certificates to emit pollution...

...and allow firms to buy and sell these rights to pollute... Tradable emission permits

Interaction between the buyers for these permits establishes the price!

MB &Price

Tons of sulfur dioxide emissions per year

Tradable emission permits

Number of emission permits issued

Supply of Permits

150,000

Suppose the EPA decides thatemissions of sulfur dioxide should be limited to 150,000tons per year...The EPA could issue 150,000 emission permits and auction them off to firms...

...who will need one of these permits for each ton of sulfur dioxide they emit. What determines the price that is paid?The Demand for the permits!

280,000

Marginal Benefit of emitting

$150

A

B

Once a firm purchases a permit it may use it to emit pollution or to Re-sell it to another firm for profit if it does not need it.Those firms that find it cheapest to reduce emissions will do so and sell their unused permits to firms who find it too expensive.

MB &Price

Tons of sulfur dioxide emissions per yearNumber of emission permits issued

150,000 280,000

$150

If demand for the product rises, firms may find it more beneficial to emit more pollutants, the MB of emitting shifts to the right...

MB emitting 2

...then the price of permits is driven up

$250

$50

Supply of Permits

C

A

MB emitting 3

D MB emitting


If firms can find better(improvement in technology) ways to reduce emissions of pollutants then Marginal benefit of emitting goes down... …and so will the price!

B

MB &Price

Tons of sulfur dioxide emissions per yearNumber of emission permits issued

150,000 280,000

$150

B

Supply of Permits

A

MB emitting


If the government ever want to further reduce emissions then they simply buy up permits and retire them…

…shift the supply curve to the left.

$220

100,000

This allows the government to have control over the total amount of pollution.

Moreover, any environmental groups who wish to lower emissions may buy up permits and hold them

(this lowers total emissions)

Characteristics of goods • Many goods have the following characteristics:1. If one person consumes a unit of a good (such as an

apple) then no one else can consume that unit of the good (no one can eat that apple)

This is called rivalry in consumption…...consumption of a good by one person reducesreduces the

consumption by others. 2. If you don’t pay for it, you don’t get the good or

service. This is called excludability… it is easy to prevent

someone from consuming a good once it has been produced if they don’t pay for it.

Goods with these two characteristics are called Private goodsPrivate goods

Public Goods • Some very necessary goods DO NOT HAVE these

characteristics……instead they have the opposite...1) Non-rival in consumption: The consumption of a good by one person does NOT

reduce the consumption by others......these goods are COLLECTIVLEY consumed......everyone can consume the good or service at the

same time and not detract from anyone else’s consumption.

Examples: National defense, Air, TV, Movies(up to a point), Education, Fireworks display, Air traffic control, Police and Fire protection

Public Goods1) Non-rival in consumption2) Non-excludable: it IS NOT possible or at least extremely expensive to

exclude someone from consuming the good once it has been produced...

...whether you pay for the good or not you will be able to consume the good.

Examples: National defense, Air, Fireworks display, Air traffic control, Police and Fire protection

• Goods that have the characteristics of collective consumption and non-excludability are called PUBLIC GOODSPUBLIC GOODS

• Market Failure: Private firms will not producewill not produce public goods because there is no profit to be made...

...because no one will willingly pay for the good.

Public Goods and their provision• Since Public goods are consumed collectively, there is

usually only one level of production for that good...Problem is getting people to voluntarily contribute(pay)

for production of a public good. Why? Two reasons:a) Free-rider problem...people can benefit from a public

good even if they do not help pay for it......because a public good is non-excludable......therefore people have an incentive to enjoy the

benefits without paying for them...a FREE RIDER!b) A drop in the bucket problem...since public goods

tend to be expensive their provision does not depend on any single individual...

…the more people needed to contribute, the greater the incentive to free ride because you believe someone else will pay for the good.

Public Goods and their provision• Solution: Since most people believe this good is

necessary the government can provide for the production of the good...

…either by producing it themselves...

...or hiring a private firm to produce the good.• The government pays for the good by taxing (charging)

people in order to pay for it.• How much of the good to produce and what to charge

for it is determined by the system of government in place.

• The reason many people are unhappy with these taxes is that they may pay more in taxes than their marginal marginal benefitbenefit from the public good.

Public or Private goods?• In the real world there is not a clear distinction

between public public and privateprivate goods Example: Education is supported by government

although it is excludable. Television programs are a mix of collective viewing

and excludability. There are private security firms in addition to police.• Some goods are non-rival only up to a certain point,

then adding another consumer WILL REDUCE enjoyment of other consumers:

• A public park or swimming pool, exercise club, etc......or even an expressway...

Public or Private goods?• Goods that are non-rival for some levels of

consumption tend to be overused... because the marginal cost of using these goods is close to (if not) zero.

• Example: In the case of an expressway there tends to be congestion at certain peak use times…

…but at other times there is no congestion.• Economic solution: Charging for use of an

expressway when you use it would prevent congestion…

...for example, efficient use of an expressway would be to charge a higher price at rush hour than normal times.

Traffic Choice:

An Experiment was conducted with 400 drivers that were given $600 to $3,000 and were allowed to keep whatever was left over as they “paid” for the use of roads over an 8-month period.

Results:The participants did use freeways less often and undertook other actions to “save” money.

Locally provided public goods• Tiebout hypothesisConsider two identical towns except for police protection... One town spends a lot of money on police and is

likely to have lower crime rates……Households that do not want to take a risk of being a

victim of crime will move into this town and will pay higher taxes to avoid crime...or…

...if a town finds a way to reduce crime without higher taxes so many households will try to move in they bid up housing prices…

...these higher housing prices are the “price” of lower crime.

• Those households that willing to bear greater risk would choose the lower tax/ higher crime risk town.

Locally provided public goods• Tiebout hypothesis:

The efficient mix of public goods (police, fire, schools, roads, etc) is produced when local housing prices and/or taxes reflect consumer preferences...

…this means local taxes and housing prices act like market prices...

…and equilibrium is reached by consumers “voting with their feet”

Summary of Public Goods• Public goods have two characteristics:

1) Non-rival in consumption

2) Non-excludable when produced

• Problem: Firms won’t produce them because there is no way to make a profit.

• Why?

Free-rider problem

Drop in the bucket problem

• Solution: Government raises funds through taxation so they can provide for public goods

Market Failure: Imperfect InformationA lack of symmetrical information between buyers and sellers can cause markets to be inefficient or not work at all: This leads to the problem of Adverse SelectionAdverse Selection.Example: Used Car market and the “Lemons” problemSuppose half of used cars are lemons(bad cars) and half are cherries(good cars)Buyers are willing to pay $7,000 for a cherry, but only $1,000 for a lemon.Since you have a 50/50 chance of buying a lemon or a cherry and don’t know ahead of time what you are going to get the price of used cars is the average of the price of a lemon and a cherry ($7,000 + $1,000) / 2 = $4,000Owners of used cars know the type of car they have. Lemon owners would love to get $4,000 for their car and will enter the used car market.Cherry owners will not get “fair” value for their car and not enter the market.Therefore, with asymmetrical info there tends to be more lemons Therefore, with asymmetrical info there tends to be more lemons than cherries and the market function barely if at all.than cherries and the market function barely if at all.

Market Failure: Imperfect Information

Adverse SelectionAdverse Selection is a problem in insurance markets:

Those who tend to have more accidents or bad health are more likely to demand insurance than those less accident prone or with good health if rates are the same for everyone.

To counter this insurance companies are very nosy and charge different rates to customers with differing characteristics.

This also explains why health insurance companies need to charge different rates depending on health, or only those with bad health will want insurance.

Market Failure: Imperfect InformationAnother asymmetrical info problem comes afterafter the two parties agree to a contract:

Moral HazardMoral Hazard: One party to a contract passes the cost of it’s behavior onto the other party.

Why a problem: Can’t tell the future behavior of the party you have entered into a contract with.

Another problem in the insurance markets.

The very fact that you are covered by insurance may lead you to increase risky behavior that causes the insurance company to have to pay up.

Insurance companies write into contacts behaviors they will not pay out for, such as suicide for Life Insurance or the need to have smoke detectors before agreeing to fire insurance.

Market Failure: Imperfect InformationMarket Solutions to imperfect and asymmetric information:

1. Provide more information.

• Companies sell information about products, etc to consumers.

• The internet has increased the ability to gather information tremendously.

• In labor markets, recruiters or “Headhunter” are hired by business firms to avoid going through a job search.

2. Government solutions:

•Create laws, rules, and regulations that require companies to make information available to consumers.

•Food labeling, and especially financial reports in equities markets are subject to these government dictates.

Arrow’s Impossibility Theorem

Suppose society has 3 individuals, Amy ,Bob, CharlieThree proposals are put before them. Their preferences are ranked for each proposal. Which one will they agree on?

ProposalX Y ZIndividual

Amy 1 2 3

Bob 3 1 2

Charlie 2 3 1

Results of Voting on ProposalsVotes of:

Amy Bob CharlieVote Results

X vs. Y X Y X X beats Y

Y vs. Z Y Y Z Y beats Z

X vs. Z X Z Z Z beats X

The outcome is inconsistent, no proposal dominates the other

Impossibility TheoremKenneth Arrow: no system of aggregating individual preferences into social decisions will always yield consistent, non-arbitrary results.

Voting Paradox: An example of the impossibility theorem.

Importance: Who sets the agenda has power to determine the outcomes of votes.

Logrolling: occurs when congressional representatives trade votes, agreeing to help each other get their pieces of legislation passed.

A person only has the incentive to gather info up to the point where their marginal benefit = marginal cost.

Since the cost of government is spread over everyone, the marginal cost of government policy is very small for an individual, giving little incentive to keep up on issues facing society.

Market failure: Externalities & Public goods

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