Market failure
Market failure: Occurs when markets are no longer allocatively efficient, and marginal social benefit does not equal marginal social cost.
Externality: An externality occurs when the production or consumption of a good or service has an effect on a third party. If the effect is harmful we call it a negative externality.
Merit goods: Goods that are beneficial to the individual and society as a whole, and are usually under-provided in a free market.
Demerit Goods that have negative effects when consumed and cause negative externalities of consumption.
Negative production externality: When the production of a good or service generates a negative effect on a third party or society, which has not been factored into the costs of producing the good. The amount produced is greater than what it should be, from the society's point of view.
Negative production externality example: Mining rare earth metals, Extracting oil and natural gas require lots of land causing to cut down forests
Possible government responses to negative production externalities: Imposing carbon tax on polluting firms, Tradable emission permits (Cap and Trade), Legislation
Positive production externality: When the production of a good or service generates a positive effect on a third party or society, which has not been factored into the costs of producing the good. The amount produced is smaller than what it should be, from the society's point of view.
Positive production externality example: Bee-keeping - Society will also benefit from bee-keeping, as bees are famous pollinators and they will pollinate agricultural plants that will later result in a more abundant harvest for farmers and more vegetables and fruits for consumers at farmers’ markets.
Possible government responses to positive production externalities: Subsidising firms, Direct government provision (government taking care of the market and providing good/service)
Negative consumption externality: When an individual's consumption of a good generates a negative effect on third parties who were not factored into the decision to consume that good. The amount produced is greater than what it should be, from the society's point of view.
Examples of Negative consumption externalities: Smoking cigarettes and drinking alcohol (demerit goods causing external health costs), driving vehicles (leading to pollution and global warming)
Possible responses to negative consumption externalities: Banning or regulating (age-restrictions, etc) a good, indirect taxes, minimum price controls, negative advertising
Pigovian tax: This term is used when an indirect tax is specifically used to correct market failure (negative externalities).
Positive consumption externality: When the consumption of a good or service generates a positive effect on a third party or society, which was factored into the costs. The amount consumed is smaller than what it should be, from the society's point of view.
Example of positive consumption externalities: Vaccines prevent the individual consumer from getting sick, but this has the secondary effect of preventing others from getting sick because vaccinations reduce the spread of illness.
Possible government responses of positive consumption externalities: Subsidising firms, Direct government provision (government taking care of the market and providing good/service), Positive advertisement, Legislation to make consumption compulsory
Problems with subsidies as a solution for positive externalities: It is very difficult for the government to estimate the level of subsidy deserved by every firm. Each subsidy uses government funds and therefore they have an opportunity cost; the government would have to cut back on other expenditures that might be important, such as health care.
Problems with direct government provision: The cost for the government might be high and create an opportunity cost, as in the case of subsidies. The government might lack the expertise found in firms, which are specialised in their area of knowledge.
Problems with imposing Indirect tax as a solution for negative consumption externality: When the good is addictive, such as cigarettes, its demand tends to be price inelastic and an increase in price will not reduce the quantity consumed very much. If taxes are raised too much, consumers might look for other illegal sources of supply, causing black markets to appear. Taxes make people pay for the external cost they create but do not stop the negative effect from taking place, as there will still be people using or consuming the good.
Problems with negative advertising as a solution for negative consumption externality: The costs of these solutions might be high and generate an opportunity cost for the government. There is always a level of doubt about how effective advertising is at reducing demand.
Problems with banning or regulating as a solution for negative consumption externality: This would have a large effect on the corresponding industry in terms of shareholders and employment. It might have a big effect on the government's revenue as it would receive fewer or no taxes from this market. Banning the good could have a negative effect on the government's future election prospects, as consumers are also voters, which makes it unlikely that governments will choose this option. Regulations will need to be enforced and this may impose an additional cost on the government.
Problem with positive advertisement as a solution for positive consumption externality: The costs might be high and generate an opportunity cost for the government, as with any other government expenditure.
Problems with legislation as a solution for positive consumption externality: This solution is less likely to be successful unless the government provides the goods and services free of charge. Some people might resent laws of this type if they see them as an infringement of their civil liberties. There is the additional cost of enforcing the law.
Common pool resources: Also known as common access resources which are rivalrous but non-excludable; for example, fish in the sea.
Rivalrous: The condition that occurs when someone consumes a good or service prevents someone else from consuming the good or service.
Non-excludable: The condition that occurs when someone cannot be prevented from consuming a good or service.
Why are common access resources a case of market failure: Because the individual benefits of consuming or using the resource are much greater than the private cost of doing so, and this gives the individual an incentive to keep consuming it. Therefore, there is an over-consumption with respect to what is optimal for society.
How to keep a common pool resource sustainable?: It must be consumed at the same rate of replenishment.
Government responses to threats to sustainability: Carbon taxes and cap and trade systems, Subsidies on renewable energy, Legislation and Collective self-governance
Carbon tax: Per unit tax paid on carbon emissions from burning fossil fuels. It is placed on firms that produce carbon dioxide through their production processes.
Limitations of carbon taxes: Encourages the production of alternative energy such as nuclear power which has issues and impacts of its own such as radioactive waste. Fossil fuels are generally very price inelastic. They are regressive. Fossil fuels used to produce electricity and petrol/gasoline are often necessities for families.
Why are indirect taxes regressive in nature?: Although everyone pays the same price for the same product, every income is different and, therefore, lower income households end up paying more as a percentage of income than a higher income household.
Strengths of carbon taxes: Most effective when the size of the tax is exactly equal to the externality (or the social costs associated with climate change). A tax can incentivise firms to produce at the social optimum.
Cap and Trade system: When the government sets emission reduction targets and encourages firms to meet them by creating economic incentives.
Tradable emission permit: Permit for firms to pollute. Firms may purchase permits to give them the right to pollute one tonne of CO2 emissions.
Strengths of cap and trade: The cost of the permits encourages firms to buy or develop technology to reduce their emissions. In this way, market forces create incentives to firms to act in a more sustainable manner. Governments earn revenue from the sale of the permits.
Limitations of cap and trade: It may be difficult to monitor and enforce carbon emissions. As it is difficult to measure the cost of excess carbon emissions on society, it is also difficult to place a socially optimal price on the permits. If the permits can be sold on the open market, then traders can drive up the prices of permits.
Difference between carbon tax and cap and trade system: If the government uses a carbon tax, it can set the price for carbon, but cannot set a quota for carbon emissions. However, with a cap and trade system, the government sets the quota for carbon emissions, but cannot set the price for carbon.
Legislation: Laws enacted by governments to limit, prohibit, or require certain behaviours.
Strengths of legislation: Legislation is most effective when laws are passed that are very specific and easy to enforce. For example, airport noise is relatively easy to monitor. There is only one airport, and many householders nearby are ready to complain if the noise exceeds a certain level.
Problems with legislation: The ban or restriction may lead to unemployment in the corresponding industry, as jobs would be lost if firms are closed or the market reduced. The cost of setting and then enforcing the policy standards may be very difficult to implement, and/or have a greater cost than the pollution itself.
Collective self-governance: Refers to voluntary actions done by local communities in order to reduce their negative externalities of consumption
Strengths of collective self-governance: Stakeholders (the users of the common pool resource) have expert knowledge on the state of the forest or ocean floor etc. Works best when all stakeholders communicate with each other clearly, and have strong agreements on monitoring and enforcement.
Limitations of collective self-governance: Some stakeholders will always have more power than others. Stakeholders may also have conflicting objectives.
Public goods: Goods that are both non-rivalrous and non-excludable; for example, street lights, natural security, lighthouses.
Private goods: Goods and services that are simultaneously rivalrous and excludable.
Excludable: The condition that occurs when someone can be prevented from consuming a good or service.
Non-Rivalrous: The condition that occurs when someone consumes a good or service does not prevent someone else from consuming the good or service at the same time.
Club goods: Goods that are excludable but non-rivalrous. An example is a movie theatre or toll highway.
Free-rider problem: When a non-excludable good will not be produced by the free market because no one is willing to pay for it, when they think someone else will pay for it.
What are public goods also an example of?: Merit goods with positive externalities. All public goods are merit goods, but not all merit goods are public goods.
Economies of scale: A firm’s ability to produce with lower average costs when they grow in size.
Pressure groups: Organisations that exist with a specific desire to make a change. For example, Greenpeace is a pressure group that aims to highlight environmental concerns and reduce environmental problems.
Strengths of direct government provision: Improves social welfare as consumption is increased. Eliminates the free-rider problem. Can be more efficiently provided because the government, as the sole provider, can achieve economies of scale.
Government response to public goods: Direct government provision (government supplying the goods and services themselves)
Allocative efficiency: Producing the optimal combination of goods from a society's point of view; When the market is at equilibrium
Asymmetric information: When one party in a transaction has more information than the other party.
Moral hazard: Type of asymmetric information where there is a situation in which one participant takes on more risk because they know they will not pay the consequences of that risk. There is asymmetric information after the transaction has taken place.
Adverse Selection: Type of asymmetric information when there is a situation in which one participant has more information before the transaction occurs.
Examples of adverse selection: all-you-can-eat buffet, insurance, used car market
Principal agent problem: Refers to the conflict of interest when the objectives of the owners of a firm and objectives of the firm's managers are different.
Difference between adverse selection and moral hazard: In the case of adverse selection, the participant has more information before the transaction takes place; in moral hazard, the asymmetric information changes their behaviour after the transaction has occurred.
Regulation: when governments monitor firms and industries to confirm that they are abiding by relevant legislation.
Legislation in asymmetric information: Governments can force consumers and producers to disclose all relevant information without hiding or forging it.
Government responses to asymmetric information: Legislation, Regulation and Provision of information (directly provide all the information of a good/service to consumers)
Signalling: A private response to the problem of asymmetric information in which participants with more information communicate this information to the other party.
Screening: A private response to the problem of asymmetric information in which participants with less information force those with more information to reveal their information.
Private responses to asymmetric information: Signalling and Screening