Microeconomics MARKET FAILURES

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Microeconomics MARKET FAILURES
Mónika Kis-Orloczki Assistant lecturer
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Market failure

• The invisible hand of the marketplace and
  competition lead profit-seeking producers to
  offer consumers an efficient variety of goods and
  services, which are produced at least cost, and
  in efficient quantities. Efficiency is the
  markets great success, and is the reason market
  economies have been able to improve living
  standards over time. However, there are also
  instances of market failure, in which markets do
  not bring about economic efficiency.
• market failure Occurs when resources are
  misallocated or allocated inefficiently.
• Examples
• Monopoly
• Externalities,
• Public goods

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Externality

• externality arise when the production or
  consumption of private goods leads to cost or
  benefits to third parties, meaning people or
  businesses who are not party to the transaction.
• negative externality - an externality that harms
  someone.
• positive externality an externality that
  benefits other.

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Cost

• marginal social cost (MSC) The total cost to
  society of producing an additional unit of a good
  or service. MSC is equal to the sum of the
  marginal costs of producing the product and the
  correctly measured damage costs involved in the
  process of production (marginal social cost
  marginal private cost marginal external cost).
• Sample activities with external costs
• Allowing your cell phone to ring in class
• Driving a vehicle that emits exhaust gas
• Using river water to remove industrial waste
• Burning coal to generate electricity

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Benefit

• Marginal social benefit is equal to the private
  marginal benefit a good provides plus any
  external benefits it creates. In other words, MSB
  gives the total marginal benefit of the good to
  society as a whole. (Marginal social benefit
  Marginal private benefit Marginal external
  benefit)
• Sample activities with external benefits
• Looking your best
• Getting immunized against disease

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• AFree Market Equilibrium
• CEfficient equilibrium which occurs when all
  costs of production are included.
• Without intervention, the free market will
  produce too much at too low a price (the market
  does not allocate resources efficiently)
• To correct this, the government must tax the
  good, and use the money to correct the problem or
  pay those hurt by the negative externality

NEGATIVE EXTERNALITY
MSC
P
SMC
B
l
C
P
l
A
l
Pmkt
DMU
Qefficient
Qmarket
Q
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A free market equilibrium free maket.
produces less than the efficient equilibrium. If
all benefits are added in, should be at C
(efficient equilibrium). Need a subsidy to
correct (internalize) the externality.
Positive externality
P
Pmkt
Qefficient
Qmarket
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Internalizing externalities

• Policies to control pollution or preserve common
  property resources require a government. Five
  approaches have been taken to solving the problem
  of externalities
• government-imposed taxes and subsidies,
• private bargaining and negotiation,
• legal rules and procedures,
• sale or auctioning of rights to impose
  externalities, and
• direct government regulation.
• Taxes, subsidies, legal rules, and public
  auction are all methods of indirect regulation
  designed to induce firms and households to weigh
  the social costs of their actions against their
  benefits.

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Industrial CO2 Emissions, 2004
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The government

• might control pollution directly by restricting
  the amount of pollution that firms may produce
• emissions standard
• by taxing them for pollution they create. A
  governmental limit on the amount of air or water
  pollution
• emissions fee tax on air pollution
• effluent charge - tax on discharges into the air
• internalize the externality - to bear the cost of
  the harm that one inflicts on others (or to
  capture the benefit that one provides to others)

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Reducing Externalities - Kyoto protocol

• Oftentimes market failures go beyond the
  confines of any single country. In these
  situations, the best solutions often involve
  international cooperation. It is important to
  recognize that many countries governments have
  been responsible for the worlds pollution.
• Kyoto protocol Reached in Kyoto, Japan, in 1997
• required most industrialized nations to reduce
  CO2emissions by an average of 5.2 below 1990
  levels by 20082012. To achieve this goal, the
  United States, Europe, and Japan need to curb
  their CO2 emissions by 31, 22, and 35,
  respectively, from the levels that would have
  been attained in the absence of a reduction
  policy.
• The Bush administration rejected this agreement.
• The EU and its Member States ratified the
  Protocol in May 2002. Of the two conditions, the
  "55 parties" clause was reached on 23 May 2002
  when Iceland ratified the Protocol. The
  ratification by Russia on 18 November 2004
  satisfied the "55" clause and brought the treaty
  into force 16 February 2005.

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Public (social) goods

• A private good is a good or service that can be
  consumed by only one person at a time and only by
  those people who have bought it or own it. A
  private good is both rival and excludable.
• A public good is a good or service that can be
  consumed simultaneously by everyone and no one
  can be excluded from enjoying its benefits. It is
  both nonrival and nonexcludable.
• In an unregulated market economy with no
  government, public goods would at best be
  produced in insufficient quantity and at worst
  not produced at all.

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The characteristics of public goods

• nonrival in consumption A characteristic of
  public goods One persons enjoyment of the
  benefits of a public good does not interfere with
  anothers consumption of it.
• nonexcludable A characteristic of most public
  goods Once a good is produced, no one can be
  excluded from enjoying its benefits.

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The characteristics of public goods
Excludable Non-excludable
Rival Private good (pencil, coke) Merit goods Common property (fish in the sea, space on a public beach)
Nonrival Club goods (concert, tennis club, cable television) Pure public goods (national defence, clean air

• mixed goods Goods that have characteristics that
  are part public and part private.
• Common property
• Club goods
• merit goods are those goods and services that the
  government feels that people left to themselves
  will under-consume and which therefore ought to
  be subsidised or provided free at the point of
  use. Consumption of merit goods is thought to
  generate positive externality effects  where the
  social benefit from consumption exceeds the
  private benefit. (health services - vaccination,
  education)

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• Common property resources are non-excludable, so
  consumers cannot prevented from using them and
  are rival, so one persons use reduces another
  persons ability to benefit from the good.
• These two characteristics lead to an important
  economic implication Consumers will have an
  incentive to overuse the good. Because its
  rival, if a consumer doesnt use the good, they
  will lose the opportunity to use it.
• Club goods a subtype of public goods that are
  excludable but non-rival, at least until reaching
  a point where congestion occurs.

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• free-rider problem Because people can enjoy the
  benefits of public goods whether they pay for
  them or not, they are usually unwilling to pay
  for them. A free rider is a person who enjoys the
  benefits of a good or service without paying for
  it. Because of the free-rider problem, the market
  would provide too small quantity of a public
  good. To produce the efficient quantity,
  government action is required.
• Methods reducing free riding
• social pressure,
• mergers,
• compulsion,
• privatization.
• drop-in-the-bucket problem The good or service
  is usually so costly that its provision generally
  does not depend on whether or not any single
  person pays.

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Optimal level of provision for public goods

• Government has no choice but to produce pure
  public goods itself. For impure public goods, it
  is possible for government to use regulation, or
  price incentives to guide the marketplace towards
  efficiency. Government policy alternatives are of
  three general sorts
• Government can price the good.
• Government can produce the good.
• Government can regulate the good.
• Governments can impose taxes and licensing fees
  to require those who benefit from public goods to
  pay for them.

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Optimal provision of public goods

• The price mechanism forces people to reveal what
  they want, and it forces firms to produce only
  what people are willing to pay for, but it works
  this way only because exclusion is possible.
• For private goods, market demand is the
  horizontal sum of individual demand curveswe add
  the different quantities that households consume
  (as measured on the horizontal axis).
• For public goods, market demand is the vertical
  sum of individual demand curveswe add the
  different amounts that households are willing to
  pay to obtain each level of output (as measured
  on the vertical axis).

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The aggregate demand curve for the public goods
At the optimal level, societys total willingness
to pay per unit is equal to the marginal cost of
producing the good.