Economics - Market failure: Externalities

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

evaluating tradable pollution permits

• difficult to calculate level of co2 emissions

• initial number of permits based on this calculation

• if calc is too high permits have no effect

• can be effective of decreasing quantity and thereby welfare loss

• larger firms can buy more permits, smaller ones struggle, can create monopolies

• if demand is inelastic will pass on cost as higher prices

• some firms switch to new technology

• some firms leave

• some switch country

• higher price for consumers

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.