5b mkt failure - externalities

positive externalities

benefits of csption/pdtion on persons other than the crs/pds themselves. 3rd parties do not have to make payments to enjoy the benefits

EXPLAINING FRAMEWORK

1. define pos ext

2. identity MPB, MEB, 3rd party

3. since MSB = MPB + MEB, presence of pos ext will cause MSB > MPB

4. assume no neg ext, draw graph

5. in free mkt, eqm o/p lvl is at Qs, where MPB = MPC

• individuals consider priv cost & benefits

• do not take into account benefits enjoyed by 3rd parties

6. socially optimal o/p lvl is at Qs, where MSB = MSC, societal welfare maximised here

7. since Qm<Qs, underpdtion/csption of gd occurs, allocative inefficiency results

• deadweight loss to society as seen frm area ABC

• societal welfare can inc when csption/pdtion inc to Qs

solutions to inc dd

1. grants

• inc disposable income & purchasing power

• grant = MEB, MSB = MPB + grant

• Qm2 = Qs, external benefit is internalized (crs gain additional benefit)

LIMITATION

• difficult to estimate MEB, dont know how much subs/grants to give

  • too much: greater dwl, worsen societal welfare, gov fails

  • causes strain on gov budget; may need to raise tax/cut spending → has adverse effects on economy

2. legislation

• loss aversion: gov nudges crs to consume gd by removing privilege associated to not csming that gd

LIMITATION

• high monitoring costs; costs need to be < benefit, or else gov fails

• will have a grp of crs unable to abide top legislation

  • gov need to provide subs/grants for them → incurs a cost

3. moral suasion

• convince crs to consume via campaigns/advertising

LIMITATION

• completely voluntary, hard to monitor effectiveness, results not guaranteed

solutions to inc ss

1. indirect subsidies

• subs lowers COP, hence ss can inc

• subs = MEB, MPC dec to = MPC + subsidy = MPC2

• Qm2 = Qs

2. gov supplements pdtion

• gov directly provides gds

• ss inc, p of gd dec, lvl of csption inc

negative externalities

costs of csption/pdtion on persons other than csr/pdr themselves. 3rd parties are not compensated for external costs

EXPLAINING FRAMEWORK

1. define neg ext

2. identify MPC, MEC, 3rd parties

3. since MSC = MPC + MEC, presence of neg ext causes MSC > MPC

4. assume no pos ext, draw graph

5. in free mkt, eqm o/p lvl is at Qm, where MPC + MPB

• individuals consider only priv cost & benefit

• do not take into account external cost by 3rd parties

6. socially optimal o/p lvl is at Qs, where MSC = MSB, societal welfare maximised

7. since Qs<Qm, overpdtion/csption of gd occurs, allocative inefficiency results

• dwl loss of area ABC

• societal welfare inc when csption/pdtion dec to Qs

solutions to dec ss

1. indirect taxes

• inc COP, more expensive to pd gd, SS dec

  • tax = MEC, MPC inc to MPC + tax

  • new mkt o/p lvl is at Qm2, which is Qs

  • external cost is internalized

• advantages of indirect taxes

  • pay for ext damages from pdcing gd

  • prevents overpdtion from firms

  • encourgae firms to adopt more env-friendly pdtion methods

LIMITATION

• high administrative costs in collecting taxes

• difficult to estimate exact amt of taxes

  • too much: greater dwl, worsen societal welfare, gov failure

  • too little: problem not mitigated

• difficult & costly to charge each firm their own particular tax rate

• harder to implement when neg ext comes from across borders

2. cap and trade permits

• cap on amt of emissions each firm can emit

• firms can trade permits

  • those who need more emission permits buys from those who need less

• will only buy if px of permit < PC in reducing emissions

• will only sell if pc of permit > PC in reducing emissions

LIMITATION

• permits may become overpriced, making industry unprofitable

• difficult to determine optimal cap due to imperfect info

  • inadequate amt: no allocative efficiency, greater inefficiencies, gov failure

• high costs in administration & enforcement

3. legislation - output quota

• limit imposed on the amt of gd that can be pdced in mkt

• Qs fixed at Q, so even when dd inc, Qs is Q

• pc of good inc, MPC inc

LIMITATION

• sunk cost fallacy: individuals decisions are affected by fixed cost, not MC

  • as px of owning car is high with COE, drivers may drive more to spread out high fixed cost

  • counter productive, worsens societal welfare & mkt failure

4. legislation - banning

• least efficient, only implement is MSC > MSB for all o/p lvls

• MSC and MSB dont intersect, so thrs no Qs

LIMITATION

• greater welfare loss as banning removes all potential benefit that comes from pdcing/csming the gd → gov failure

• ban is only efficient if dwl due to overcsption is more than dwl due to undercsption from ban

5. nationalization

• firms with neg ext cld be taken into public ownership, gov can pd gd at socially optimal o/p lvl

LIMITATION

• no profit incentives, less concsious of reducing COP, unwilling to innovate

solutions to dec dd

moral suasion

• convince crs to voluntarily dec csption of gd

• salience bias cld nudge csr behaviour

  • focus on prominent/visible/emotionally-striking aspects to inc effectiveness

LIMITATION

• completely voluntary, effectiveness not guaranteed

gov intervention

1. shd gov intervene?

• cost benefit analysis

  • weigh magnitude of mkt failure + social benefits + social costs of gov intervention

  • if SB > SC will intervene

2. is gov intervention effective?

• depends if MEC/MEB is estimated accurately

  • quite difficult to estimate due to imperfect info

  • gov intervention will be ineffective if estimation is wrong