Chapter 7: Market failure

Market failure

When price mechanism causes an inefficient allocation of resources resulting in net welfare loss in society

Externalities

Spillover effects of production or consumption on the third part

Private costs

Costs internal to the firm such as wages or rent

Social costs

Private costs + external costs

Example of external benefit of consumption

Vaccination

Social benefits

Private benefits + external benefits

Social optimum equilibrium

When marginal social costs equals marginal social benefit

What happens to the supply curve when there are external costs

Supply curve shifts to the left and becomes marginal social cost

What happens when external costs are ignored

There is under-pricing as the firm doesn’t take into account external costs and overproduction as there is high demand due to lower price

What happens to the demand curve when there is external benefit

The demand curve shifts to the right and becoming marginal social benefit

What happens when external benefits are ignored

There is underpricing as firms do not realise the full social worth

Pollution permits

Grants firms permission to emit a certain amount of pollution

Advantages of pollution permits

Incentive to reduce pollution to buy less permits

They are tradable

Generates revenue for the government through sale of permits

Disadvantages of pollution permits

Difficult to know how many to allocate

Diffuser to measure how much pollution is actually getting emitted

Takes a long time to show effect

If permits are introduced in one country and not the other, production may shift to countries without permits leading to overpollution

Polluters may choose to pay fines instead of reducing pollution

Cap-and-trade scheme

When the government sets a decreasing cap for emissions on companies and trades emissions allowances

Carbon price floor

When the government sets a decreasing cap for emissions on companies and trades emissions allowances

Advantages of carbon price floor

Reduces costs of investing in low carbon projects

Helps reduce carbon price volatility

Makes low carbon electricity more competitive

Disadvantages of carbon price floor

Restricts supply of pollution permits to increase the market price

Doesn’t generate revenue

Price set high may damage international competitiveness

Advantages of pollution taxes

Internalised the externality by making the polluter pay

Creates incentive to reduce pollution

Raises tax revenue

Disadvantages of pollution tax

Low PED may cause tax to have no effect

May affect low income families more

Risk of tax evasion

Why can pollution taxes lead to government failure

The wrong level of taxation may be assigned

Demand may be inelastic so will have a small effect on demand

May have a bigger impact on low income families causing larger income inequality

A high tax may cause production to shift to other countries leading to unemployment

De-merit goods

Products that are harmful to society

Government failure

When government intervention leads to a less efficient allocation of resources

Disadvantages of adding extra regulation of industries

High cost of enforcement

Can cause unintended outcomes

Can discourage small businesses and lower competition

What are the features of public goods

Non-excludability

Non-rivalry

Non-excludability

It is impossible to stop others from benefitting from a good

Non-rivalry

When more people benefit from a good, it does not reduce the amount available for others

Why are public goods underprovided

Due to the free rider problem and valuation problem

The free rider problem

When a consumer benefits from a good that he has not paid for causing the good to be underprovided

The valuation problem

The consumers and producers cannot agree on the value of good causing firms to not provide it