Topic 9 & 10: Market Failure Flashcards
‘Invisible hand’
Although people act selfishly when producing, selling or buying G and S, they are led by an ‘invisible hand’ to maximise benefits to society as whole
Requirements for efficient markets
Clearly defined good
Accurate and transparent info
Clearly defined, transferrable property rights (at any point in time, it is is clear who owns the good)
A system for sharing price info and for making transactions
Many buyers and sellers
Role of gov
If we meet of requirements for efficient market: economists argue for limited gov role.
Don’t fix prices (reduces ability of producers and consumers to adapt to circumstances)
Don’t impose quotas or min production levels (let people decide)
If market is efficient, gov actions can only make things worse (even if well-designed)
What do we mean by efficient market?
Markets that are Pareto Efficient
Suppose that a particular policy is proposed, proponents need to make the case..
a) that free market would fail to deliver best outcomes
and b) that the proposed policy would deliver better outcomes
Market failure
Related to whether the market works well to generate benefits for community
Examples of distribution policies
Progressive income tax
Welfare payments for unemployed
Decisions to share environmental funding evenly amongst regions
Increasing block tariffs for water
Causes of market failure (poor performing markets)
Good is nor clearly defined (e.g. biodiversity)
Lack of info (e.g. buyers can’t determine quality of good)
Absence of clear transferrable property rights (e.g. open access fishery)
Absence of mechanisms for a market (connecting up buyers and sellers, price discovery, standard contracts)
Too few buyers or sellers
Informational problem
Ignorance (policy response: R and D)
Information asymmetry (policy response: reverse auction, run extension program )
Externality
Economic activity -> impact on somebody other than producer or consumer of good
Impact of third party not reflected in market price of good
-ve externalities
Economic action causes cost to 3rd party
Pollution from factories, nutrients or sediments from farms into rivers, clearing native vegetation for housing, airport noise, emissions of CO2 from vehicles
One action can have multiple external costs
Rising sea level-> loss of land, increased drought -> loss of agricultural production, higher temp -> damage to coral reefs, more severe storms-> loss of life
+ve externality
Economic action causes benefit to 3rd party
Reducing fertiliser rates, reducing fishing intensity, install scrubbers in factory chimney , create beautiful gardens, planting trees
One action can have multiple external benefits
Plant trees on ex-cropland: reduce soil salinity, carbon sequestration , habitat for wildlife, aesthetic benefits
Optimal abatement
MB=MC
Policy for externality: command-and-control regulation
Specify level of pollution that cannot be exceeded
Penalise any firm that exceeds limit
Firm tries to choose as little abatement as it can (to save costs). The min it can choose is the regulatory limit
Information requirement: MB abatement, MC abatement
Advantage: simple, well accepted approach
Disadvantage: inflexible
Policy for externalities: Pigouvian tax
Tax on each unit of pollution, equal to marginal cost of pollution (or the marginal benefit of abatement) at social optimum
Internalising externality (people generating the externality are made to experience the marginal costs or benefits themselves
Set tax= MB of abatement at social optimum
From firm’s perspective, tax is their MB of abatement
Information requirement: MEC of pollution
Advantage and disadvantage of Pigouvian tax
Advantage: generates revenue for gov
Can substitute for other taxes
Creates incentive for innovation
Disadvantage: people don’t like idea of taxes
Requires lot of money to change hands. Polluters pay for all emissions, not just those above accepted amount
Policy for externalities: incentive payments -> encourage abatement
Set payment= MB of abatement at social optimum
From firm’s perspective, payment is their MB of abatement
Info requirement: MEC of pollution
Advantage: creates incentive for innovation
Disadvantage: high cost to taxpayers
Coase Theorem
Recognises importance of negotiation
Two parties can agree on allocation of benefits and costs (Pareto optimal), regardless of which party is assigned rights
Requires: transferrable property rights, 0 transaction costs
Coase and property rights
Externality problem can be viewed as an absence of property rights
If either side has clear property rights (and transaction costs of negotiating not too high) the problem can be solved by negotiation
Policy option for Coase and property rights
Define and enforce property rights
Example: tradeable pollution permits (emissions trading scheme, creates right to CO2, can be bought by people who place a high value on abatement)
Negotiation may be too costly
Even with well-defined property rights negotiation itself could be too costly (costs of identifying other pollution victims, communication, coordination, info and legal and admin costs)
Implication of high transaction costs
Look for ways to reduce transaction costs
If successful-> define property rights
If not successful -> revert to more traditional policy approach (tax, payments, regulation)
Transaction costs apply to those too
Not necessarily worth it: do a BCA
Evidence that Coase was right
Lighthouse often used as archetype public good
High risks of free riding faced by any shipping company that builds them
Coase found that prior to mid 19th century in England, lighthouses were privately owned, operated and funded
Negotiations between shipping companies were effective
Why do we need many sellers?
Competition helps to keep P=MC
Means consumption is as high as it can be without costing more than its worth
Monopoly
Has incentive to cut back on supply in order to raise price and make more profit
Only one seller
-> deadweight loss
Policy response to monopoly
Regulate to prevent monopoly behaviour
Example: Australian Competition and Consumer Commissions (ACCC)
Natural monopoly
Businesses that have very fixed costs
Isn’t practical or realistic to have competition
Example: water supply
Monopoly: natural resource example
OPEC (Organisation of Petroleum Exporting Countries)
Exist to agree on reductions in oil supply in order to increase prices — members act in unison to try to create a monopoly
Natural monopoly: policy responses
Gov takes over supply or
Gov allows monopoly to exist but regulated them tightly to prevent then exploiting consumers