Market failure and externalities Flashcards
Market failure
A price mechanism leading to an inefficient allocation of scarce resources, and a deadweight/welfare loss
Factors impacting market failure
Merit goods being underconsumed
Information failures/gaps
Demerit goods
Immobility of factor inputs
Monopolies(productively and allocatively inefficient)
Goods giving off negative externalities(consequences)
Examples of merit goods
:Give off positive externalities(are under consumed):
Vegan goods
Public libraries with books
Gym-healthcare
Education
Water
Why should an economy not be left to market forces?
There are certain goods(merit goods) that may not be provided for without government intervention(e.g. public transport, healthcare and education), as no profits are made from this
Quasi-goods
Goods actually provided by the market and government(e.g. health in the UK)
Example of non-excludable public goods
Police- can’t exclude everyone from benefitting from the presence of the police
Causes of labour market failure
Markets fail when they fail to reach a socially efficient/equitable outcome: tends to be corrected with government intervention-
Labour immobility
Disincentives to find work
Discrimination by employers
Monopoly/monopoly power by employers
Labour immobility
Occupational immobility - barriers to moving easily between jobs
Geographical immobility - barriers to changing location to find a new job
Disincentives to find/take work
The unemployment trap - where economic incentives to take a job are poor
The poverty trap - disincentives to earn extra income e.g. Luton are closing down motor manufacturers, leaving many people redundant(without jobs)
Discrimination by employers
This is a part explanation of the gender gap in pay and women in senior roles.
Discrimination badly affects wages and employment for affected groups
Monopoly/monopoly power of employers
They can use their “buying power” in labour market to drive down wages
Why do public goods cause market failure?
Due to the problem of missing markets
Main characteristics of public goods
- Non-excludability
- Non-rival consumption
- Non-rejectable
Non-excludability in public goods
Benefits derived from pure public goods cannot be confined solely to those who have paid for it
Free rider problem
Non-payers can enjoy the benefits of consumption at no financial cost to themselves
Non-rival consumption in public goods
Each party’s enjoyment of a good or service doesn’t diminish others’ enjoyment - the marginal cost of supplying a public good to an extra person is zero
Non-rejectable public goods
The collective supply of a pure public good for all means it can’t be rejected by people e.g. a national nuclear defence system. We get the government to help us through either a petition or a general election(who we want in a position of power, on the basis of what they can do).
Private good characteristics
- Excludable(allows for the enforcement of property rights and collection of payment)
- Rival consumption
- Rejectable
Pure punlic goods
Non-excludable and non-rival in consumption(goods usually provided collectively by the state)
Examples of quesi public goods
NHS, education(either non-rival or non-excludable, not both)
Examples of pure public goods
Reduced risk of disease from vaccinations
Crime control for a community
National parks
Purely private goods
Groceries, supplied by firms, which are all in the private sector
Solution/government intervention towards market failure
Public sector provision - doesn’t constitute nature of public good
Private goods
Goods owned by private individuals/firms/households, for their own benefit
Pricing and Profit
Private goods are typically priced in markets based on supply and demand, and consumers pay for what they consume. Private firms are the primary providers of these goods
Examples of private goods
Private gyms
Tickets to an event
Meals in a restaurant
Why are public goods financed by government?
- Non-excludability
- Economies of scale
- Public interest and equity
Non excludability: why are public goods financed by government?
Taxation ensures everyone contributes to the funding of public goods, preventing free riding and ensuring the costs are distributed across the entire population
Economies of scale - why are public goods financed by government?
Producing public goods for a larger population can lead to lower per capita costs. Taxation allows governments to collect funds from a broad tax base, which can be more cost-effective in providing these goods compared to private firms or individual transactions
Why are public goods financed by government - public interest and equity
Taxation allows governments to allocate resources based on societal priorities, and ensure public goods are provided in a way to promote societal welfare and equity
Government should seek to achieve:
Equity(fairness)
Efficiency
The government gives benefits and housing to the bottom of the income scale, as well as free school meals and free education
Case for higher state spending on public goods
Economies of scale: It’s more efficient to provide public goods at state level, leading to a lower long run cost per user - cheaper for consumers: greater allocative efficiency
Access and affordability: The absence of profit motive makes public goods affordable - this is important for equity
Investment:Public goods can lead to higher private sector investment e.g. regeneration of economically deprived areas attracting entrepreneurs
Public goods and technological change
- Advances in technology are blurring the distinction between some public and private goods and services.
- In some cases, encryption allows suppliers to exclude non-payers - although the product remains non-rival.
- Technological progress reduces the cost of smart-metering(a private good) used in road pricing - making roads more of a private(excludable) good
- The open source/Creative Commons movement has made much digital information a public good in nature(this information is non-rival and non-excludable).
Externalities
The unintended side effects or consequences of an economic activity or transaction that affect third parties who are not directly involved in that activity or transaction
Externalities
Spill-over effects from production and/or consumption for which no appropriate compensation is paid to one or more third parties affected e.g. Thames Water have been putting sewage in the waterworks in the country, but don’t pay to clean the sewage up
Key exam point
Externalities lie outside the initial market transaction, and without state intervention, they’re not reflected in the market price
Why are externalities inevitable?
- Inter-connectedness of Economic Agents
- Property rights and transaction costs
- Public goods
Inter-connectedness of Economic Agents
In a modern economy, individuals, firms and governments engage in a wide range of economic activities. These interactions often have ripple effects that extend beyond the immediate parties involved e.g. when a factory produces goods, it may emit pollutants into the environment, affecting neighbouring communities
Transaction costs
How much you pay when buying property
Property rights and transaction costs
Property rights are not always well-defined, and transaction costs can be high, making it difficult to negotiate and enforce agreements that internalize externalities e.g. people in flats may have free hold(owning the house plus the land built on), or lease hold(having ownership of the house, but not the land, meaning a tax must be paid to the freehold owner).
Public goods
Public goods, such as clean air, often cause positive externalities because they benefit everyone,whether they contribute to their provision or not. Individuals may underinvest in such goods, assuming others will bear the costs.
Examples of negative production externalities
Factory pollution emissions
Examples of negative consumption externalities
Household waste, and air pollution
Examples of positive production externalities
Reforestation projects, the free-sharing of academic research
Examples of positive consumption externalities
Vaccinations to protect public jealth during a pandemic
How do externalities cause market failure?
Externalities can cause market failure, because they disrupt the efficient functioning of markets.
Market failure occurs when the allocation of goods and services in a free market economy is not efficient or equitable - leading to outcomes that are not in the best interests of society.
This means externalities lead to a net loss of social welfare.
Externalities can lead to market failures, because the prices and quantities determined by supply and demand in the market do not account for these external costs or benefits.
Equity
Social cost= private cost
Private cost
The internal costs faced by the producer or consumer directly involved in a transaction
External cost
Occurs when the activity of one agent has a negative effect on the wellbeing of a third party. They impose costs on other agents, causing market failure(social cost> private cost).
Total social cost=
Private cost + external cost
External benefits
Social benefits, which include private benefits, but also add in the external benefits(which involve the rest of society) that might occur from production and/or consumption
Marginal private cost
The internal cost to a producer or consumer from supplying or consuming one extra unit of a good or service
Private benefit
The benefit, satisfaction or utility an individual agent derives from producing or consuming something
Marginal external cost
Cost to third parties from the production/consumption of an extra unit of output
Marginal social cost
Total cost to society arising from producing/consuming an extra unit of output
Marginal social cost=
Marginal private cost + marginal external cost
Net private benefit=
Private benefits - private costs
Net social benefit
Private benefits - private costs + positive externalities - negative externalities
Why are private costs greater than the private benefits of a motorway?
Pollution
Accidents on the motorway
Significance of property rights
Property rights define and allocate ownership, control and responsibilities over resources and assets.
When property rights are well-defined, it’s easier to determine who should bear the costs or enjoy the benefits of that activity
Well defined property rights facilitate bargaining and negotiation between parties involved in an economic activity(when it’s not clear who’s responsible for a property, there may be problems).
Positive impacts of property rights
Property rights can incentivise investment in technologies and practices that mitigate negative externalities or create positive ones.
Property rights can help prevent or mitigate the tragedy of the commons(no clearly defined property rights), where shared resources are depleted or overused due to a lack of ownership
Example of tragedy of commons
Thames Water have been putting sewage in the waterworks, but nobody cleans up(Thames Water know nobody will take responsibility due to no defined property rights for the waterworks)
Where are property rights absolutely fundamental?
In a free market economy - with the government imposing lots of regulations to protect private property
Example of private costs
Cost of land and planning permission
Labour costs
Examples of external costs
Visual pollution
Falling property prices in area(people who own land lose money)
Examples of external benefits
Lower taxpayer subsidies required in long run, falling property prices in area(for first time buyers), employment created(multiplier effects)
Example of negative production externalities
Farming - UK farming causes over a quarter of cities’ particle pollution, discharges into rivers
Air pollution from factories
Noise pollution
Waste from manufacturing processes
Chemical factories - toxins in the water close to 3M’s Antwerp factory found to have caused serious long-term health problems
Examples of negative consumption externalities
Impact of gambling addiction on families
Passive smoking - inhalation of second hand smoke associated with respiratory infections
Air pollution from smokers
Household waste
Noise
Negative externalities - welfare effects
External costs from air pollution
External costs from urban road congestion
External costs from air pollution
Outdoor pollution is linked to around 40,000 deaths each year in the UK.
Air pollution worsens many chronic conditions such as cancer, asthma and heart disease.
External costs from urban road congestion
Direct and indirect costs of congestion for all drivers totaled £31 billion in 2016, an average of £968 per driver.
The UK is ranked as 3rd most congested in Europe, with drivers spending an average of 32 hours a year in congestion during peak hours.
Government regulations for cars
To put catalytic converters - to reduce pollution
Why do negative externalities lead to market failure:
Output Q1 only considers private costs and benefits. If we ignore the externalities, output is too high for a social optimum.
Impact of negative production externalities
They create external costs, which lead to marginal social cost being above marginal private cost, with negative production externalities creating a divergence between social and private costs
Social optimum level of output when there are negative externalities
When there are negative externalities that are higher than private costs. Social optimum takes externalities into account(MSC= MPB)
Private optimum level of output
Where MPB= MPC
Negative consumption externalities
If consumption of a product reduces benefits enjoyed by third parties, the benefits to society are less than benefits obtained by individuals consuming the product. Negative externalities lead to overconsumption and hence overproduction
How the government responds to positive externalities being under-consumed/produced?
The government might subside products e.g. education for students in public schools, the NHS receive government sunsidies, the police receive government subsidies
Subsidies-
Incentives by the government to increase production/consumption, and to encourage positive externalities
Positive externalities
When third parties benefit from the spill-over effects of production/consumption. When there are positive externalities, social benefits exceed private benefits
Social benefit=
Private benefit + external benefit
Total marginal social benefit=
Marginal private benefit + marginal external benefit
Examples of positive consumption externalities
- Apple orchards that allow bee populations to grow
- Health care services(e.g. vaccinations to protect public health during a pandemic)
- Free school meals/improved nutritional advice
Government interventions with positive externalities
- Government provision(e.g. providing vaccines for free) and funding e.g. the Bus Services Bill - every town in England and Wales with a population of more than 1000 people has a regular service operating seven days a week.
- Government subsidy to consumer(reduces private cost/increases real income)
- Government subsidy to producer
Do the government want people to stop smoking?
Not really - they make lots of tax revenue out of people smoking
Choice architecture
Influencing consumers to make a certain decision by placing things strategically in certain places so consumers can buy them
Positive externalities from production
Open-Source Software made freely available to other users.(spillovers from research and development projects in areas like materials science and vaccine platforms)- free sharing of academic research
Spending on infrastructure - reduces delays, lowers costs for logistics/transportation
Growing trees(reforestation projects)
Because there are positive externalities in production…
The marginal social cost of production is less than the marginal private cost of production. The socially optimum level of output in this example is therefore higher than the free market equilibrium
Subsidies for Tesco to fill up shelves
Tax breaks
Low interest rates
The government can give Tesco’s some free money
Long run
This period lasts approximately 10 years(the amount of time it takes to educate people for a workforce) - but we don’t have time for this, because in that time, economies need to be funded
Net social benefit:
Social benefit - social cost
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Mixed externalities
Mixed externalities occur when production/consumption leads to both external costs and external benefits. The socially optimum level of output will depend on the extent and value
of these negative and positive externalities
Mixed externality examples
HS2:
Positive externalities - Getting into Birmingham faster, creating lots of jobs
Negative externalities - Costs too much, less spending on other infrastructure(healthcare), destroying view of countryside(lots of homes and villages destroyed)
What are mixed externalities also known as?
Partially internalised externalities
Other mixed externality examples
Motorways-
Positives of M25: Less traffic congestion in London
Negatives of M25:
Costs money to build, accidents could happen
Low traffic neighbourhoods:
Positives - Protects neighbourhood, less chance of accidents
Negatives - Congestion will occur somewhere else
Agricultural Pesticide Usage(to protect crops from pests and diseases)
Why are mixed externalities more complex to address than cases with purely positive or negative externalities:
Policymakers need to consider both types of effects and find ways to encourage the positive aspects, while mitigating the negative ones
Positive externalities of pesticides
Can lead to increased agricultural productivity and higher crop yields- meaning food security, lower food prices, and supports the livelihood of farmers and agricultural workers
Negative externalities of pesticides
- Risk of environmental pollution
- Pesticides can leach into the soil, contaminating groundwater and nearby water bodies.
Example of market failure
Externalities - both positive and negative externalities
Missing markets
Where provision of goods/services is purely determined by the authorities
What government interventions can help reduce negative externalities and therefore correct market failure
Carbon taxes
Taxing demerit goods - to discourage over consumption
Carbon tax
A tax on the consumption or production of goods and services which can cause carbon emissions. It’s a policy designed to make the polluter pay for externalities created(internalising externalities). e.g. Keir Starmer’s government aren’t taxing people polluting water, because they’re weak and corrupt.
Impact of carbon taxes
A tax on carbon increases the private cost of emitting carbon - causing output to contract towards the social optimum.
A carbon tax will raise tax revenues that might be used by the government to fund clean energy products or use as a rebate to those affected(such as consumers and businesses)
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Aim of carbon border tax
A carbon border tax aims to reduce emissions by placing a tariff on imports from countries with less stringent(more relaxed) climate policies(e.g. big polluters like America or China)
Key features of a carbon border tax
- The idea is to level the playing field)between richer and poorer countries) for domestic companies that are subject to carbon pricing or other climate regulations by preventing foreign companies from gaining a competitive advantage through lower costs.
- Requires importers to pay a fee for the carbon emissions embedded in the products they’re exporting.
- The European Union is developing a carbon border tax mechanism, which is set to be introduced in 2023. The EU are still Britain’s neighbours who trade with them
Examples of poorer countries
Ethopia
Zimbabwe
Sierra Leone
How rich countries become wealthy
By burning fossil fuels and causing pollution, whereas poorer countries are told not to industrialise(they should clean up and electrify instead)
When did Britain leave the EU
31 January 2020
Advantages/justifications to Europe introducing a carbon border tax
- Encourages countries with weaker climate policies to take action to reduce their carbon emissions
- Protects domestic industries: Helps to prevent carbon leakage, which occurs when companies move production to countries with weaker climate policies
- Green tariffs generate revenue for climate action: used to fund climate action, such as investment in renewable energy and energy efficiency
Disadvantages/drawbacks to Europe using a carbon border tax
- Could lead to trade disputes if seen as a protectionist measure- will hamper exports from poorer countries(arguments between Trump and China - Trump is threatening to impose tariffs on Chinese vehicles going to America).
- A carbon border tax would increase the cost of imported goods, which could lead to higher consumer prices. This will have a regressive impact on low income households.
- Simpler to have a global carbon price, which would be levied on all companies per tonne of CO2 produced as a result of their operations. But agreement on this is a long way off.
Number of countries in EU
27
Consequences if burning carbon without a permit:
Could get fined. You can buy carbon permits as a country, to exchange with other countries
How carbon trading is designed to reduce emissions
Carbon trading creates a market for carbon permits. Firms that emit more CO2 than they’re allowed to can buy credits from companies that emit less. The supply of permits is capped and gradually reduced which leads to a higher price. Consequently, a higher marginal private cost from production might create an incentive for businesses to invest money in low-carbon technologies.
Downsides/limitations of using carbon trading as a policy to reduce smissions
1) Carbon price volatility - this is a barrier to investment, due to higher risk, with a carbon tax providing more certainty to businesses affected.
2) Risk of carbon leakage-occurs when companies move production to countries with lower carbon prices, to avoid paying for carbon credits
Regulary interventions with externalities(attempting to correct market failure)
Smoking bans in public places
Recycling directives for household appliances
Fishing quotas to protect stocks from over-fishing
Case for regulating activities causing negative externalities
1) Regulations act as a spur for business innovation to cut the level of carbon emissions.
2) Regulations may be more effective if demand is unresponsive to price changes.
3) Regulations can be gradually toughened each year - this will help stimulate investment.
Costs/disadvantages from adding extra regulation of industries
- High cost of enforcement/administration of strict laws
- Regulations can lead to unintended consequences/this causes government failure
- The cost of meeting regulations can discourage small businesses and lead to less competition in markets
Example of negative externalities
Externalities of river pollution:
Agriculture:Pollution from intensive farming(such as chicken farms) is a common way rivers are being contaminated.
Water companies regularly discharge raw sewage into rivers and fail to inform the public when this occurs.
Examples of effective interventions to stop negative externalities
To curb the dumping of raw sewage into UK rivers:
Investing in new sewage infrastructure(building new sewage treatment plants and upgrading storm management capacity)
Unlimited fines/risk of prosecution for companies and executives for exceeding limits
Pollution tax- internalizes externality
Net social benefit=
(Private benefit + external benefit)-(private cost + external cost)
Example of an indirect tax
VAT
