Economics chapter 2.7 market failure

Free market

price mechanism determines the most efficient allocation of scarce resources (factors of production: land labour capital entrepreneurship)

Market failure definition

An inefficient/ less than optimum allocation of resources, from societies point of view. There is a lack of allocative efficiency.

consumer surplus is not maximised, failure of market to produce at marginal social cost = marginal social benefit

Causes of market failure

externalities, public goods, common pool resources

marginal private benefit

Benefits received by those who produce or consume a product.

or: “The additional benefit received from the consumption or production (output) of one additional unit of output”

marginal social benefit

The total benefit to society from producing or consuming a good / service.
It includes all the private benefits plus any external benefits of production / consumption.

or “The benefit to society received from the consumption or production (output) of one additional unit of output. It is the sum of the private benefits plus the external benefits”

marginal private cost

Private cost of an activity to an individual economic unit

Marginal social cost

The total cost to society of the production or consumption of a product including private cost and negative externalities.

Socially optimum output

marginal social benefit (MSB) = marginal social cost (MSC)

no market failure

negative externalities of production

market is failing due to over-provision of goods/services as only the private costs are considered by the producers and not the external costs. harmful effects on third parties

social costs of producing a good are higher than private costs.

negative externalities of consumption

market is failing due to over-consumption of goods/services as only the private costs are considered by the consumers and not the external cost

social benefits are less than private benefits

demerit good

goods which have external costs in consumption deemed to be bad for the individual and society as a whole but would be over consumed if left to the free market

positive externalities of production

market is failing due to under-provision of these goods/services as only the private benefits are considered by the producers and not the external benefits

production would cause benefit to third party

positive externalities of consumption

market is failing due to under-consumption of these goods/services as only the private benefits are considered by the consumers and not the external benefits

merit good

goods and services which are deemed to be good for individuals and society as a whole but would be under consumed if left to the market

common pool resources

• non excludable, rivalrous

• add if needed

• tragedy of the commons

sustainability definition

meeting the needs of the present without compromising the ability of future generations to meet their needs.

unsustainability

resources used faster than they can be replenished

indirect tax

placed on a product with harmful side effects (demerit goods)

make the individual or firm causing the externality to pay for it

can be placed on negative externality of production or consumption (both shift the supply curve)

evaluation of indirect tax

• causing externalities pays

• reduce quantity of demerit goods (more efficient allocation of resources

• reduce external costs

• raises govt revenue

however

• depends on PED

• illegal markets

• output falls due to higher prices, may have to lay off workers

carbon taxes

• tax on producers who emit green house gases

• pay for each ton of carbon dioxide (CO2) emissions

• raises cost of production, decreases supply

evaluatating carbon tax

• increases cost of production for firms

• reduces external costs

• encourage firms to consider investing in pollution abatement technology

• raises government revenue

however

• effectiveness depends on ped

• firms unable to pay will leave market

• lay off workers due to high prices

subsidies

• grants paid by the government to producers to lower cost of production (Normally on Merit Goods)

• shifts supply curve to the right

• usually when there is positive externality of consumption

legislation and regulation

• Legislation aimed at the consumer side:

• shifts demand curve to the left (demand +legislation)

• such as limited drinking age

• aimed at producer: shifts supply to the left

evaluation of legislation

• can be targeted

• reduce external costs

• fines generate govt revenue

however

• hire more people for regulation

• difficult to determine whether law is being broken

• illegal markets

• unpopular with large companies and voters

education

• raising awareness of external benefits and costs

• shifts demand for merit or demerit good

evaluating education

• changes mpb

• amount spent on education is less than that spent on externalities

• positive cultural changes

• over time improves economic development

however

• takes long time to change behaviour

• opportunity cost

• demerit goods are usually addictive

• merit goods are usually expensive

evaluation method

1. challenges involved in measuring externalities

2. degree of effectiveness of the solution (big problems are hard to deal with, need multi-faceted approach

3. impacts on different stakeholders

tradable pollution permits

• cap and trade scheme

• governments allocate a suitable level of pollution

• each permit typically valid for the emission of one ton of pollutant

• firms that pollute more need to buy more

• additional cost of production therefore reduction in supply

• if costs of permits is higher than costs of investing in non polluting technology, creates incentive for firms to switch

international agreements

• adress negative externalities

• focus on: common pool resources, environmental challenges, global trade in demerit goods

evaluating international agreements

• reduction in welfare loss is greater when countries work together

• resources can be pooled

• interdependence

however

• more economically developed countries try and enforce agreements which reduce use of “dirty technology”

• no legal consequences from withdrawing from international agreements

• new political parties can tr and change agreements

collective self governance

when stakeholders in a community work together to combat negative externalities, usually associated with common pool resources

evaluating collective self governance

• creates common purpose

• community knows best how to manage resources

• create employment opportunities

• eco sustainable tourism

however

• disagreement

• taking back control from corporations can be violent and difficult

• works better when there are private property ownership rights

government provision

• merit goods and public goods are usually under-provided

• not provided by private firms due to free rider problem

• governments end up providing

evaluating government provision

• free at point of consumption

• accessible to everyone

• private and external benefits

however

• paid through taxation

• opportunity cost

• excess demand (waiting time at hospitals)

public good

non excludable and non rivalrous

under provision

government intervention: government provision, nothing, contract out (pay company to provide good/service)

policies for emissions from use of fossil fuels

legislation and regulation, indirect tax on output, carbon tax, tradable permits, education (taxes and tradable permits cause incentive, others do not)

policies to reduce demerit goods

legislation and regulation, education, indirect tax

policies for unsustainable use of common pool resources

collective self governance, etc

policies for positive production externalities

subsidies, government provision, education

policies for positive consumption externalities

legislation and regulation, advertising, education, direct government provision, subsidies.

Evaluating tradable pollution permits - Challenges

Difficult to accurately calculate the total level of CO2 emissions produced by firms, leading to a potentially misleading allocation of permits. The initial number of permits issued is based on these calculations, and if the calculation is too high, it results in an oversupply of permits, rendering them ineffective in reducing pollution.

Evaluating tradable pollution permits - Effectiveness

While these permits can be an effective method for decreasing the overall quantity of emissions, thus helping mitigate welfare loss, their effectiveness heavily relies on proper initial calculations and government oversight to ensure compliance.

Evaluating tradable pollution permits - Market impact

Larger firms often have greater financial resources to buy more permits than smaller firms, which may struggle to acquire sufficient permits for their emissions. This disparity can lead to market imbalances and potentially create monopolies where larger companies dominate the market.

Evaluating tradable pollution permits - Price impact

If the demand for permits remains inelastic (meaning that supply changes do not significantly affect demand), firms are likely to pass on the increased costs of permit acquisition to consumers in the form of higher prices for goods and services.

Evaluating tradable pollution permits - Technology shift

In response to the costs associated with purchasing permits, some firms may opt to invest in new technologies that reduce emissions, thereby decreasing their need for permits and potentially leading to lower overall pollution levels.

Evaluating tradable pollution permits - Market dynamics

While some firms might strategically leave the market due to the financial burden of purchasing permits, others may relocate their operations to countries with less stringent environmental regulations, leading to potential 'pollution havens'.

Evaluating tradable pollution permits - Consumer effect

The increased costs incurred by firms from purchasing permits can result in higher prices for consumers, which may lead to reduced consumer spending or changes in consumption patterns as people seek more affordable alternatives.