2.8 market failure & externalities of production

Question 1

define externalities and give example

Answer 1

External costs or benefits to third parties when
a good or service is produced or consumed. An
externality arises when an economic activity
imposes costs or creates benefits on third
parties for which they are not compensated or
do not pay for respectively
e.g vaccines, masks (positive spillover)
cigarettes, alcohol (negative)

Question 2

taking into account externalities, social efficient output is likely ___ to market equilibrium output

Answer 2

not equal

Question 3

3rd parties

Answer 3

are entities not involved in the actions of consumers and producers whose interests are not taken into consideration, hence no compensation made

Question 4

when market equilibrium output is socially inefficient,
(4 points)

Answer 4

• market not producing to what society desires
  -scarce resources are not optimally allocated,(allocative inefficient output)
• social surplus is not maximised(welfare loss will be present)
• marginal cost =/= marginal benefit

Question 5

market failure

Answer 5

The failure of markets to achieve allocative efficiency. Markets fail to produce the output at which marginal social benefits are equal to marginal social costs; social or community surplus (consumer surplus + producer surplus) is not maximized.

msb = msc

Question 6

2 types of externalities

Answer 6

production and consumption
prod:
honey-more bees
crude oil: more pollution
consumption:

cigarettes-second hand smoke

Question 7

marginal external costs (MEC)

Answer 7

refers to the spillover costs on third parties for producing one more unit of a good
MEC=MSB-MPC

Question 8

marginal social benefit (MSB)

Answer 8

e extra or additional benefit/utility to society
of consuming an additional unit of output,
including both the private benefit and the
external benefit.
3
MSB=MPB+MEC

Question 9

marginal social cost (MSC)

Answer 9

The extra or additional cost to society of
producing an additional unit of output,
including both the private cost and the external
costs.
MSC=MPC-MEB

Question 10

market success

Answer 10

In a self-interested, free and competitive market with no externalities, the price mechanism helps to allocate scarce resources to achieve a socially efficient output (allocative efficient output).
2. Socially efficient output implies achieving of allocative efficiency where
i. the right amount of the goods are produced and consumed from the society’s
point of view,
ii. scarce resources are optimally allocated (allocative efficiency),
iii. social surplus is maximized,
iv. MC = MB.

Question 11

Marginal private costs (MPC)

Answer 11

Marginal private costs (MPC) refer to costs to producers of producing one more unit of a good.
MPC=MSC+MEB

Question 12

Marginal social costs (MSC)

Answer 12

Marginal social costs (MSC) refer to costs to society of producing one more unit of a good.
MPC+MEC

Question 13

Marginal private benefits (MPB)

Answer 13

Marginal private benefits (MPB) refer to benefits to consumers from consuming one more unit of a good.
MPB=MSB-MEC

Question 14

Marginal social benefits (MSB)

Answer 14

Marginal social benefits (MSB) refer to benefits to society from consuming one more unit of a good.
MSB=MPB+MEC

Question 15

Marginal external benefits (MEB)

Answer 15

Marginal external benefits (MEB) refer to spillover benefits on 3rd parties for producing or consuming one more unit of a good.
MEB=MPC-MSC

Question 16

explain overproduction of a good due to external costs in production

Answer 16

Step 1 : Identify competitive mkt without external costs output, Q1 where MPB=MPC)
(Step 2 : Assumption of no external costs on either the SS or DD curve
(Step 3 : Identify type of externality, implications on the supply or demand curve and on the 3rd parties)
(Step 3 : Explanation of external costs on 3rd parties)
(Step 4 : Identify allocative efficient output, Q2 where MSB=MSC)
(Step 5 : Identify allocative inefficient output, Q1 where MSB>MSC or MSB<MSC)
(Step 6 : Identify and explain welfare loss area between Q1Q2)

Competitive mkt without external costs, Q1 is MPB =MPC
• Assuming MEB for consumption equals zero.
• Existence of MEC in producing electricity using coals
• External costs implies negative externalities on 3rd parties namely, stability of the global climate and the degradation of the eco-system (degradation of common pool resources) on neighbouring countries and the country’s future generations
• Due to MEC in production, MSC > MPC for all units produced
• At Q2, MSC = MSB implying allocative efficiency; Q2 is the social optimal output
• At Q1, MSC > MSB implying allocative inefficiency
• Between Q2Q1, welfare loss area E1E2A is seen as the sums of all MSC>MSB

Question 17

welfare loss

Answer 17

A loss of a part of social surplus (consumer plus
producer surplus) that occurs when there is market failure so that marginal social benefits
are not equal to marginal private benefits.

Question 18

types of indirect Pigouvian taxes

Answer 18

fuel excise taxed (petrol, gasoline or gas taxes)- specific tax
carbon taxes(tax on carbon content of fuel used) - specific tax
sales tax (tax on just everything we buy - ad val orem tax

Question 19

carbon tax

Answer 19

incentivises firms to switch to less-pollutive sources of energy

Used to address the problem of global warming and climate change, caused by emissions of greenhouse gases—in particular, carbon dioxide

Carbon tax—tax per unit (specific tax) of carbon content of the fuels

      The carbon tax increases the cost of buying fossil fuels and hence firms’ costs of production

Different types of fossil fuels emit different amounts of carbon emissions when burned; the more carbon emitted,
the higher the tax

         ⊹ If firms switch to less or non-pollutive sources of energy ⊹ →Decrease in MEC ⊹ →Decrease in MSC ⊹ →Increase in socially-optimal quantity / level ⊹ Decrease in carbon tax per unit

Question 20

strengths and advantages of the use of indirect taxes (fuel and carbon taxes) (4points)

Answer 20

1. Assuming that external costs in production can be accurately measured, the imposition of indirect taxes equals to the MEC can internalize the external costs.
2. Due to higher COP, it incentives firms to develop and use cleaner methods of production if it is cheaper to do so to reduce the amount of tax firms have to pay.
3. Compared to Emissions Trading System (ETS) carbon tax is relatively easier to design, implement and to monitor.
4. Carbon taxes can be applied to all users of fossil fuels & do not offer opportunities for manipulation by the govts to offer preferential treatments to supporters.

Question 21

limitations/disadvantages of indirect taxes(3)

Answer 21

1. Since it difficult to quantify external costs in production, it is difficult to determine the actual amount of tax to be imposed to internalize the external costs in production. If the taxes are under-estimated, remnant welfare loss will still exist.
2. Carbon tax cannot target a particular desired level of carbon reduction unlike ETS. If it is cheaper for firms to continue to use their production methods and to pay the taxes, then it will lead to uncertain carbon- reducing outcome.
3. Carbon tax can be regressive since indirect taxes are paid partly by producers and partly by consumers. Hence, lower-income consumers would be affected proportionately more.

Question 22

tradeable permits

Answer 22

tradeable permits are rights to produce a certain amount of pollutants over a certain time period issued to firms by governments or international authorities, which can be bought and sold in markets

policies that involve the use of tradeable permits are also known as cap and trade schemes or Emissions Trading Systems(ETS)

Question 23

ETS

Answer 23

emissions trading systems:
policies that involve the use of tradeable permits are also known as cap and trade schemes or emissions trading systems

Question 24

price determinate of tradeable permits

Answer 24

Prices of tradeable permits are determined by the market demand for, and market supply of, the tradeable permits

Firms that can generate their output by emitting a lower amount of pollutants than allowed by their permits can sell their extra permits
Firms that need to emit more pollutants than the amount allowed by their permits need to buy more permits

Question 25

PES of tradable permits

Answer 25

0 as supply is limited(only certain amount of tradable permits available in market)

Question 26

what do tradeable permits incentivise?

Answer 26

Like carbon taxes, tradeable permits also incentivise firms to switch to less-pollutive sources of energy
 Decrease in MEC
 Decrease in MSC
 Increase in socially-optimal quantity / level
(Effects can be analysed via the same diagram used for carbon taxes)

move to cleaner tech -> reduce msc + additional profit from selling extra permits -> permits used to pay off clean tech

Question 27

strengths/advantages of ETS(3)

Answer 27

1. Assuming that external costs in production can be accurately measured, the imposition of trading permits equals to the MEC can internalize (absorb) the external costs.
2. Due to higher COP, it incentives high-polluting firms to develop and use cleaner methods of production if it is cheaper to do so to reduce the amount of trading permits firms have to buy.
3. ETS has the ability to target a particular desired level of carbon reduction through the limited number of trading permits given.

Question 28

limitations/disadvantages of ETS

Answer 28

1. Administratively costly to design, implement & monitor. ETS are difficult to design & implement as they involve complicated decisions such as setting the cap at the right level. Overestimation of MEC → fewer permits issued → pushes price of permits up & ↑ installation of abatement equipment if it is cheaper to do so than to buy permits →↑ COP → reducing S(MPC) beyond MSC. ETS can be seen to be ineffective due to the possibility of firms cheating if enforcement and monitoring is not strict.
2. ETS can only target one particular industry or small group of industries due to its complexities in designing and implementation & can be easily manipulated by govts to offer preferential treatments to supporters resulting in unfair allocation.
3. Carbon leakage happens when there is an absence of uniform carbon pricing across nations where polluting firms are likely to relocate to nations with lower or no carbon pricing thus, making ETS ineffective in reducing the threats of pollution and sustainability posed by the use of fossil fuels globally

Question 29

reducing the output of goods that generate external costs in production (4)

Answer 29

• market based solutions
  
  1. indirect taxes
  2. permits
• legislation/regulations
• self-governance
• international agreements

Question 30

how legislation and regulation reduces output of goods that generate external costs in production

Answer 30

associated with the command method

can be designed and implemented in a variety of forms, including the following
- emission standards
- licenses
- outright restrictions

causes marginal social cost to decrease

Question 31

strengths and advantages of using legislation and regulation

Answer 31

Strengths / advantages
Easier to implement than market-based policies as they avoid the technical difficulties that arise in the use of market-based policies

More certainty in achieving their objectives (if it can be enacted quickly) than market-based policies where firms may choose to continue polluting; polluting firms are forced to close down or to install emissions equipment or to use less polluting or harmful production inputs mandatorily.

Question 32

limitations/disadvantages of using legislation and regulation

Answer 32

Limitations / disadvantages
Monitoring and supervision required otherwise, they will be ineffective.

Legislation (laws & regulations) are time-consuming due to bureaucratic procedures, which may take a while before it could be implemented, worsening environmental conditions.

Insufficient legislation and regulation as economic growth remains a top priority. Overall efforts of legislation and regulation by the Chinese government in reducing the threats of pollution and sustainability posed by the used of fossil fuels is seen to be insufficient globally and thus, ineffective as economic growth remains a top priority in China.

Question 33

what is collective self-governance

Answer 33

a solution to the overuse of common pool resources where communities of resource users take control of the resources and use them in a sustainable way
• Not a policy imposed by governments, but an approach undertaken by communities of resource users—the resource users realise that it is in their own best interests to work collectively to preserve resources that are vital to their livelihoods
• Runs counter to the concept of the “tragedy of the commons”

Question 34

conditions required for collective self-governance

Answer 34

The ability of resource users in the community to communicate with each other to design i) rules concerning the use of the resources, ii) monitoring and conflict-resolution mechanism and iii) sanctions for violating the rules
• The costs of self-organization are not too high (e.g., not too many resource users)
• The common pool resources must be bounded by a clear boundary (e.g., a defined pasture, wood, or lake)

Question 35

advantages (2) and disadvantages of collective self-governance

Answer 35

advantages:
- No government intervention and, hence, government resources are not required
- Ability to reduce supply curve to MSC position in the production of any goods and services with MEC in depleting common pool resources

Disadvantages of Collective Self-Governance:
- Limited to only small groups
- Not applicable to many common pool resources (e.g., the oceans) due to the strict conditions required

Question 36

what are international agreements

Answer 36

• Policies are mainly made by national governments
  ⊹ However, the problems of negative production externalities and the overuse of common pool resources often have regional or global repercussions so international agreements are required

Some notable examples:
• Montreal Protocol
• European Union Emissions Trading System (EU
ETS)
• Kyoto Protocol
• Paris Agreement
(Refer to pages 160 and 161 of Tragakes)

Question 37

advantages and disadvantages of international agreements (2+2)

Answer 37

Advantages of International Agreements
⊹ Fewer Carbon leakages due to a more uniform carbon pricing across nationals
⊹ More effective in reducing overall
emissions globally as each country reduces their SS curves towards MSC position due to international agreements & effort

Disadvantages of International Agreements
⊹ Not all nations will leave up to its commitments due to political difficulties, economic growth prioritization & corruption
⊹ Likely to disadvantaged developing countries who have no financial ability and will power to engage R&D for cheaper green production processes hence, likely to abandon agreements
74

Question 38

positive externalities

Answer 38

the beneficial effects that are enjoyed by third parties whose interests are not accounted for when a good or service is consumed/produced, therefore they do not pay for the benefits they receive.

Question 39

negative externalities

Answer 39

Negative effects suffered by a third party whose interests are not considered when a good or service is consumed/produced so the third party are therefore not compensated.