Market Failure

Question 1

NOTE

Answer 1

• Ceteris paribus
• Describe why welfare loss happens

Question 2

Market

Answer 2

Any place, physical or virtual, where the buyers and sellers of goods and services meet with the purpose of exchange

Question 3

Market failure

Answer 3

Any situation where the allocation of resources by a free unregulated market is not efficient: either too much or too little is being made and consumed relative to what is most optimal for society.

We call this allocative inefficiency and recognize it when Marginal Social Benefit is not equal to Marginal Social Cost.

Types:
- Negative externalities (of production and consumption)
- Positive externalities (of production and consumption)
- Lack of public goods
- Common access to resources and a threat to sustainability
- Asymmetric information (HL)
- Abuse of market power (HL)

Question 4

Externality

Answer 4

Occurs when actions of consumers or producers result in negative or positive side-effects on others who are not part of the actions and whose interests are not considered.

Positive: External or spillover benefit

Negative: External or spillover cost

If production, relates to supply curve; if consumption, relates to demand curve.

Question 5

MPC, MSC, MPB, MSB

Answer 5

Marginal private costs (MPC) - costs to producers of the production of one more unit of a good or service

Marginal social costs (MSC) - costs to society of the production of one more unit of a good or service

Social Cost = Private costs + External costs

Marginal private benefits (MPB) - benefits to consumers of the consumption of one more unit of a good or service

Marginal social benefits (MSB) - benefits to society of the consumption of one more unit of a good or service

Social Benefits = Private benefits + External benefits

Question 6

Pareto optimal market

Answer 6

• Allocatively efficient
• Maximizes community surplus
• Can’t make anyone better off without making someone worse off

1. Label supply as MSC = marginal social cost, demand as MSB = marginal social benefit
2. Equilibrium MSC = MSB, P* and Q* are optimal (Cambridge calls these Qopt and Popt)
3. Highlight consumer surplus, producer surplus and community surplus

Question 7

Negative externalities of production

Answer 7

The production of a product creates a negative spillover/ external cost to others:

• Production ==> supply curve
• Negative = the marginal social cost will be greater than the marginal private cost (MSC > MPC) at Qm
• MSC > MSB
• Market over-allocates resources: Qm > Qopt
• Examples: pollution from factories (air, water, noise), depletion of resources

*MSC = MSB defines our optimum qty, welfare loss triangle always has base at Qm and points toward Qopt

Question 8

Correcting negative production externalities

Answer 8

General concept: shift the MPC curve upward to the MSC curve. To achieve allocative efficiency, quantity of good produced and consumed must fall to Qopt as price increases to Popt.

Market-based solutions:
- Indirect (or Pigouvian) taxes
- Carbon taxes
- Tradable permits
(?)
- Govt. legislation
- Intl. agreements
- Education and awareness
- Collective self-governance (Elinor Ostrom)

Question 9

Indirect taxes

Answer 9

Causes leftward shift in S, moving MPC + tax to be equal to MSC.

Advantage: Alignment
- Alignment of costs and incentives - “internalizing the externality”
- Taxes on emissions are directly at source, rather than on product output
- More direct incentive to impact the true issue—carbon emissions, rather than something one or two steps removed

Disadvantage: Valuation
- Hard to define exact emissions for every product/process
- Hard to align on relative importance of CO2, CH4, etc., and value of one ton CO2
- Options noted are all regressive—how to offset impacts to those on low income

Question 10

Carbon tax

Answer 10

Just like an indirect tax except after the shift to MSC1, the market reacts with a shift to substitutes, leading to MSC2 and a new optimum quantity at a lower price (producers shift to more efficient production methods, thereby lowering social costs).

Advantage: Alignment
- Alignment of costs and incentives - “internalizing the externality”
- Taxes on emissions are directly at source, rather than on product output
- More direct incentive to impact the true issue—carbon emissions, rather than something one or two steps removed

Disadvantage: Valuation
- Hard to define exact emissions for every product/process
- Hard to align on relative importance of CO2, CH4, etc., and value of one ton CO2
- Options noted are all regressive—how to offset impacts to those on low income

Question 11

Tradable permits

Answer 11

Government sets a fixed “supply” of carbon emissions and issues permits to firms, who can trade them with each other. Total permits at lower value than current emissions. Effectively this falls under the category of legislation, since government sets supply.

Tradable permits’ advantages and disadvantages similar to those of taxes (challenges with how to set the supply and then distribute the permits).

Question 12

Govt. legislation

Answer 12

• Restrictions or limitations on pollutants
• Bans on the use of harmful substances
• Requirements for licenses to limit access

Question 13

Intl. agreements

Answer 13

Broader scale version of government legislation for transnational or global issues (such as climate change)

Question 14

Education and awareness

Answer 14

• Typically an important part of a solution but does not work on its own (also, often just a short term reaction)
• General education
• “Name and shame” (Greenpeace)

Question 15

Collective self-governance (Elinor Ostrom)

Answer 15

• With common pool resources, the idea that the users can work together to manage the resource for the long term good
• Critical conditions: good methods of communication and clear boundaries

Question 16

Common pool resources

Answer 16

• Resources not owned by any individual or company
• Do not have a price
• Available for anyone to use without restriction
• Clean air, lakes, rivers, fishery stocks, wildlife, hunting ground, forests, soil fertility, grazing land, stable global climate,…
• Rivalrous: use by one person reduces amount available for others
• Non-excludable: people can’t be prevented from accessing it

Question 17

Tragedy of the commons

Answer 17

Cattle herders in the pasture (classic ex.): how does this example display key features of the idea of common pool resources?

• Critical aspects of the resource
• Changes in yields—unsustainable production

Question 18

Sustainable resource use

Answer 18

The level of use that allows the resource to regenerate itself, avoiding degradation or depletion (non-renewable resources have no level of sustainable use [oil and gas, minerals])

Question 19

Negative externalities of consumption

Answer 19

The consumption of a product creates spillover/external cost to others:
- Consumption ==> demand curve
- Negative = the marginal social cost will be greater than the marginal social benefit at Qm (MSC > MSB)
- MPB > MSB, market overallocates resources
- Examples: smoking, alcohol, gambling, unhealthy foods
- Demerit goods: harmful when consumed and create negative externalities. The consumer is either unaware of or ignores the risks leading to overconsumption of consumption.

Question 20

Correcting negative consumption externalities

Answer 20

Market-based policies:
- Impact supply
- Internalize the externality
- Indirect tax to raise Pc and reduce consumption (less effective if PED<1)
- Hard to measure external costs

Government regulation, advertising/education, nudges:
- Impact demand
- Effectiveness sometimes limited and not durable

Question 21

Positive externalities of production

Answer 21

The production of a product creates a positive spillover/external benefit to others:

• Production ==> supply curve
• Positive = the marginal social benefit (MSB) will be greater than the marginal social cost (MSC) at Qm
• MSC < MPC, market underallocates resources
• Examples: R&D which leads to benefits across industries, employee training that benefits an employee even after switching to a new firm

Question 22

Correcting positive production externalities

Answer 22

Direct govt. provision:
Impact supply by shifting MPC to the right toward MSC, increasing quantity supplied and lowering P

Subsidies:
- Intro into a perfect market creates allocative inefficiency
- Intro with market failure eliminates it
Same impact as above

Question 23

Positive externality of consumption

Answer 23

The consumption of a product creates spillover benefit to others:
- Consumption ==> demand curve
- Positive = the marginal social benefit (MSB) will be greater than the marginal social cost (MSC) at Qm
- MSB > MPB, market underallocates resources
- Examples include: Immunisations, preventative healthcare, healthy foods, organic foods, exercise programs, education
merit goods—when consumed, provide external benefits, although these may not be fully recognised, hence the good is under-consumed

Question 24

Correcting positive consumption externalities

Answer 24

Legislation/Education/Nudges:
All shift MPB curve toward MSB curve by increasing demand

Direct Government Provision/Subsidies:
- These shift MPC
- Intro with market failure eliminates it
- Same impact as above

Question 25

Do direct provision and subsidies and legislation, education and nudges work?

Answer 25

Direct provision and subsidies:
- Generally quite effective
- Challenge is with opportunity costs of government spending
- Generally not efficient—governments are not known for being low cost providers

Legislation, education and nudges:
- Can narrow the gap but generally not complete solutions
- Can sometimes be more effective short term than long term

Question 26

Public goods [and market failure]

Answer 26

Public goods are:
Non-rivalrous — the consumption of the product by one person does not reduce the ability of someone else to consume it
Non-excludable — not possible to exclude someone who hasn’t paid for this good from using it (‘free riders’)

A free market will supply private goods, although not necessarily in the right quantities.

A free market will not, however, supply public goods. This is because the ‘free rider’ issue means that the producer will not receive sufficient compensation. Therefore the government must provide them.

Question 27

Solving the market failure with public goods

Answer 27

Direct Government Provision:
- Government can do this effectively if well managed, but that is sometimes a challenge
- All the same points about opportunity costs we discuss every time the government intervenes apply in this case as well

Contracting out to the private sector:
- Risks with corruption, favouritism/cronyism
- Requires effort for transparency
- Profit motive of private sector can create a conflict
- Government needs to monitor execution to ensure standards, which increases costs

Question 28

Goods (rivalrous, non-rivalrous, excludable, non-excludable)

Answer 28

“Typical” goods, merit or demerit.
Rivalrous, excludable
The exclusion mechanism is price. Readily provided by the market.
Computers, cars, etc
.
Quasi-public goods (the rest)
Non-rivalrous, excludable
Often positive externalities but supplied with some price.
Pools, museums

Common pool resources
Rivalrous and
Non-excludable.
At risk without action.
Common fields, fisheries, clean air.

Public goods
Non-rivalrous and non-excludable.
Not provided by market due to free rider issue.
Military, police / fire /ambulance services