Topic 7: Market failure: externalities, public goods and the commons

Market failure

A market outcome is Pareto inefficient because key competitive assumptions fail

Pareto efficiency

No feasible change can make someone better off without making someone worse off

Deadweight loss

Loss of total surplus relative to the Pareto efficient allocation

Efficiency condition

The efficient quantity satisfies MSB equals MSC

Externality

One agent’s action affects another’s utility or production outside the price mechanism

Negative externality

Private decisions ignore external damage leading to overproduction or overuse

Marginal social cost

MSC equals MPC plus MEC

Marginal social benefit

MSB equals MPB plus MEB

Pigouvian tax

A per unit tax set equal to marginal external damage at the efficient level

Pigouvian tax formula

Set t equal to MEC evaluated at the efficient level

Firm objective with pollution tax

Maximise pb times b minus Cf of b and r minus t times r

How Pigouvian tax works

The tax makes private marginal incentives match social marginal incentives

Cap and trade

Government sets a total emissions cap and issues tradable permits

Why permits are efficient

Trading equalises marginal abatement costs across firms

Coase theorem

With well defined tradable rights and zero transaction costs bargaining yields an efficient outcome

Coase limitation

Transaction costs or many parties can prevent bargaining from achieving efficiency

Public good

Non rival and non excludable

Common good

Rival but non excludable shared resource

Tragedy of the commons

Overuse of a common good because individuals ignore congestion or depletion imposed on others

Samuelson condition

Efficient public good provision satisfies the sum of individual MRS equals marginal cost

Free riding

Individuals undercontribute to a public good because they can benefit without paying

Private provision rule

An individual contributes until their own MRS equals marginal cost if they contribute at all

Why public goods are underprovided

Individuals ignore benefits to others so their MRS is below the summed social willingness to pay

Open access equilibrium

Users enter until average product equals cost

Social optimum in commons

The planner chooses use where marginal product equals cost

Why commons are overused

With diminishing returns average product exceeds marginal product so average based entry continues beyond the efficient point

Adverse selection

Hidden attributes before trade distort participation and can drive high quality goods out of the market

Akerlof lemons mechanism

Buyers pay based on expected quality causing good sellers to exit and quality to unravel

Moral hazard

Hidden actions after contracting distort incentives leading to inefficiently low effort or excessive risk