Topic 9 & 10: Market Failure

Question 1

‘Invisible hand’

Answer 1

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

Question 2

Requirements for efficient markets

Answer 2

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

Question 3

Role of gov

Answer 3

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)

Question 4

What do we mean by efficient market?

Answer 4

Markets that are Pareto Efficient

Question 5

Suppose that a particular policy is proposed, proponents need to make the case..

Answer 5

a) that free market would fail to deliver best outcomes

and b) that the proposed policy would deliver better outcomes

Question 6

Market failure

Answer 6

Related to whether the market works well to generate benefits for community

Question 7

Examples of distribution policies

Answer 7

Progressive income tax

Welfare payments for unemployed

Decisions to share environmental funding evenly amongst regions

Increasing block tariffs for water

Question 8

Causes of market failure (poor performing markets)

Answer 8

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

Question 9

Informational problem

Answer 9

Ignorance (policy response: R and D)

Information asymmetry (policy response: reverse auction, run extension program )

Question 10

Externality

Answer 10

Economic activity -> impact on somebody other than producer or consumer of good

Impact of third party not reflected in market price of good

Question 11

-ve externalities

Answer 11

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

Question 12

+ve externality

Answer 12

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

Question 13

Optimal abatement

Answer 13

MB=MC

Question 14

Policy for externality: command-and-control regulation

Answer 14

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

Question 15

Policy for externalities: Pigouvian tax

Answer 15

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

Question 16

Advantage and disadvantage of Pigouvian tax

Answer 16

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

Question 17

Policy for externalities: incentive payments -> encourage abatement

Answer 17

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

Question 18

Coase Theorem

Answer 18

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

Question 19

Coase and property rights

Answer 19

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

Question 20

Policy option for Coase and property rights

Answer 20

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)

Question 21

Negotiation may be too costly

Answer 21

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)

Question 22

Implication of high transaction costs

Answer 22

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

Question 23

Evidence that Coase was right

Answer 23

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

Question 24

Why do we need many sellers?

Answer 24

Competition helps to keep P=MC

Means consumption is as high as it can be without costing more than its worth

Question 25

Monopoly

Answer 25

Has incentive to cut back on supply in order to raise price and make more profit

Only one seller

-> deadweight loss

Question 26

Policy response to monopoly

Answer 26

Regulate to prevent monopoly behaviour

Example: Australian Competition and Consumer Commissions (ACCC)

Question 27

Natural monopoly

Answer 27

Businesses that have very fixed costs

Isn’t practical or realistic to have competition

Example: water supply

Question 28

Monopoly: natural resource example

Answer 28

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

Question 29

Natural monopoly: policy responses

Answer 29

Gov takes over supply or

Gov allows monopoly to exist but regulated them tightly to prevent then exploiting consumers