Topic 5: Market Failure Flashcards
1
Q
Define externality
A
def.: occur when economic activities affect third parties who are not involved in this activity. These externalities can have additional costs (a negative externality) or benefits (a positive externality)
2
Q
Describe the different types of costs and benefits
A
Supply side
private cost: the cost borne by the producer of a good or service
social cost: the total cost of producing a good, including both the private cost and any external cost
Demand side
- private benefit*: the benefit received by the consumer of a good or service
- social benefit*: the total benefit from consuming a good, including both the private benefit and any external benefit
3
Q
What causes externalities
A
- this source of market failure occurs largely due to an absence of private property rights
- private property rights*: the exclusive right of an owner to use, rent or sell property.
- with most goods and services, private property rights exist, and ownership is easy to ascertain. However, for some resources, private ownership is difficult, if not impossible I.E. air pollution and greenhouse gases
- because no one owns the resource, no one can demand restitution for damaging it.
- Therefore, the costs (or benefits) to these third parties is never reflected in the market price of these goods or services that contribute to the externality.
4
Q
Describe a negative production externality
A
- i.e. pollution of air/water
- in the absence of any intervention, the private market solution would occur where S1 = D (P0, Q0)
- if we can put a $ value on the costs to the local population, these external costs result in a supply curve of S2 (MSC)
- at Q0: there is a (social) deadweight loss, we are over-producing this resource because we are not taking into account ALL of the costs
socially efficient optimum = P1, Q1
5
Q
Describe a negative consumption externality
A
- i.e. excessive alcohol consumption, cigarette smoking
- the externality might include: higher health costs, drink driving dangers, domestic violence etc.
- if we can put a $ value on these, this results in a lower social benefit of D2 = MSB
- at Q0: there is a (social) deadweight loss, social benefit is lower than the private benefit
- we are over-producing this resource, so the social optimum = P1, Q1 (MC>MB)
6
Q
Describe a positive production externality
A
- i.e. research into new technology which adds to society’s pool of knowledge, hence the social cost is lower than the private cost
- case of under production as the social optimum is at P1, Q1 (MB>MC)
- DWL as full MB not being used
7
Q
Describe a positive consumption externality
A
- i.e. immunisation, restored historic buildings, education
- although there are private benefits to you improving your human capital (higher wages), there are also additional benefits that accrue to society overall (lower crime rates for example, better standard of government)
- in the absence of any intervention, the private market solution would occur at (P0, Q0).
- if we can put a $ value on the benefits to society, these external benefits result in a social benefit of D2=MSB
- at Q0: there is a (social) deadweight loss, we are under-producing this resource because we are not taking into account ALL of the benefits (MB>MC)
- social optimum = P1, Q1.
8
Q
Differentiate between rival and excludable
A
- rivalry*: occurs when one person’s consuming a unit of a good means no one else can consume it
- excludability*: anyone who does not pay for a good cannot consume it
9
Q
What are the different categories of goods?
A
private good: a good that is both rival and excludable.
public good: a good that is both non-rivalrous and non-excludable.
club good: a good that is excludable but not rival.
common resource: a good that is rival but not excludable
10
Q
Describe public goods
A
- Public goods are non-excludable, and non-rival.
- the combination of these two criteria leads to the essential market failure of these goods – the free-rider problem: “if I can consume this good without paying for it, then I won’t.” As everyone thinks this way, no one will pay for it and the good will never get produced.
- firms can’t find anyone to pay for the good. Society either has to do without this good, or the government has to provide it.
- i.e. national defence, immunisation programs, national parks, police, street lighting
- Q: if public goods need to be produced by the government, how do they know how much to produce?
A: Cost-benefit analysis, However, often difficult, because there is no price signal. Governments often have to rely on qualitative information, such as surveys
11
Q
Describe common resources and the tragedy of the commons
A
- rival but non-excludable
Tragedy of the commons
- def.: term comes from the Middle Ages, where a lot of pastoral farming (cows, sheep etc) was done on the commons of the village, which was free for all to use. Although it was available to all, the size of the common was finite
- this can cause market failure, because it is in no individual’s interest to withhold from using the resource common resources therefore tend to be over-exploited.
- examples:
- clean air and global climate: goes across borders (can’t ‘fence off’ the atmosphere)
- oil deposits: what happens when an oil reserve goes across many properties?
- congested roads: past some point, roads become rival i.e. in traffic jams, seen in increasing use of tolls
- fish, whales and other wildlife: no property rights in international waters
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12
Q
What are potential solutions to tragedy of the commons?
A
- private property rights
- if someone owned the common, then it would be in their interest to ensure its sustainability
- similar to Coase solution
- if the problem is specific to a small area, people generally can bargain and work out a solution themselves
- government
- if the problem is broad, governments can either tax, or set quotas, issue permits creating a market etc. i.e. rock lobster fishing in WA
- but sometimes, the problem is exceptionally difficult to co-ordinate (climate change and ocean fishing being two notable examples of this).
13
Q
What are private solutions to externalities
A
The Coase Theorem
- assuming transaction costs (the costs in time and resources parties incur in the process of carrying out an exchange (e.g. legal costs, negotiating time)) are low, bargaining can lead to an efficient outcome regardless of the initial allocation of property
- suggests property rights should be assigned to those negatively affected by the externality
- this is problematic when transaction costs>social costs, in reality transaction costs are seldom low and such ‘self-correction’ does not occur.
14
Q
What are government solutions to externalities
A
Regulation (command and control)
- this can include regulations that impose quantitative limits on the externality, or simply ban it outright
- sometimes when the externality cost is so great, the government sees the best case scenario is 0 production
- aim should be to balance the full costs of the externality with the solution (which is often not equivalent to 0 production)
- this is, however, quite a blunt approach, and doesn’t recognise that different people and firms have different capabilities (and therefore costs) to reduce the externality. This is why ‘market-based instruments’ are more commonly proposed today
15
Q
Describe a pigovian tax
A
- would be set that is equal to the marginal external cost at the socially efficient outcome (Q1)
- the tax internalises the externality, it is required to obtain the socially efficient outcome, because it specifically changes the behaviour of the private market participants
- potential problem: can be very difficult to know what these external costs are, and so therefore what level of tax needs to be set.
