Market Failure

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Market Failure

• EEP 255
• October 14, 2003

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Equilibrium Price and Quantity
Supply (MC)
Demand (MB)
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Efficiency of Markets
Marginal Benefit MB (D)
Marginal Cost MC (S)
gains
losses

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Market Equilibrium/ Efficient equilibrium
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Assumptions underlying the ideal market model

• Property Rights
• Use rights
• Exclusion rights
• Transfer rights
• Enforcement rights
• Characteristics of goods
• Private goods (rival and excludable)
• No Externalities
• Private costs/benefits social (true) resource
  costs/benefits
• Market competition
• Large number of sellers and buyers

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Overview

• Market Failure
• Definition
• Causes
• High Exclusion Cost Goods and Services
• Non-Rival Goods and Services
• Policy Implications
• Externalities
• External vs. Internal Effects of Markets
• Effect on Efficiency of Private Markets
• Examples

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Relationship Between the Economy and the
Environment
Sun
waste energy
energy
Economic System
waste matter
matter
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Markets for Abatement Fail to be Efficient
Sun
energy
Economic System
matter
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Markets for Natural Resource Conservation Fail to
Be Efficient
Sun
Economic System
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If government does not require efficient
abatement and resource conservation

• .. Markets for economic goods will fail to be
  efficient.

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Markets for Economic Goods Fail to Be Efficient
Sun
Economic System
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Definition of Market Failure
The inability of a market to provide an efficient
quantity of a good or service
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What types of markets fail to be efficient?

• Markets for high exclusion cost (non-excludable)
  goods
• Markets for non-rival goods
• Markets for low exclusion cost, rival goods which
  are produced using inputs which are high
  exclusion cost or non-rival goods (because this
  leads to market externalities)

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Definition of Exclusion Cost

• The costs that must be incurred to exclude people
  from using a good without paying.

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Examples of Exclusion Cost

• Locks on bikes, cars, and houses
• Metal detectors
• Burglar alarms
• Security guards
• Video surveillance
• Police patrol
• Packaging
• Firearms
• Military
• Fences
• Banks
• Environmental Regulations

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Examples of Goods that Have Different Exclusion
Costs
High Exclusion Cost
Low Exclusion Cost
Ocean Fish
National Defense
Prepared Food
Natures Services
Radio Broadcast
Police Protection
Clothing
Sound Waves
Parks
Streets
Shelter
Sidewalks
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Why High Exclusion Costs Cause Market Failure?

• Users of a non-excludable good or service can
  enjoy the benefits without paying the costs,
  (i.e., they can be free riders) since they cant
  be excluded. Property rights and prices can not
  be enforced. Hence market demand fails to form
  and none of the good is supplied.
• Exception some quantity might be supplied as a
  non-market charity.

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Market for Pollution Abatement (Clean air)
MB
MAC
Private Market Equilibrium
Efficient Equilibrium
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Market for Resource Conservation
MB
MC
Private Market Equilibrium
Efficient Equilibrium
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CAUTION!

• The fact that the market fails to organize the
  demand for a high exclusion cost good does NOT
  mean that there is no demand for the good. It
  just means that the demand remains unorganized if
  market institutions are used to allocate that
  good.

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Rivalry in consumption

• A good is said to be rival in consumption if
  the act of consumption by one consumer diminishes
  the quantity of the good available for
  consumption by other consumers (e.g. apples)
• A good is said to be non-rival in consumption
  if the act of consumption by one consumer does
  not reduce the quantity of the good available for
  consumption by other consumers (e.g. a painting,
  a lecture, road, view of Grand-Canyon)
• A good is said to be congestible, if it is
  non-rival when the number of consumers is not
  very large, but may become less available when
  number of consumers becomes very large (e.g.
  Roads, small parks)

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Opportunity cost of Non-rival vs. Rival Goods

• Nonrival good The marginal opportunity cost of
  serving an additional consumer of non-rival good
  is zero, since more than one person can obtain
  benefits from using that unit.
• Rival good The marginal cost of serving an
  additional consumer of a rival good is greater
  than zero, because additional units have to be
  produced to serve additional consumers.

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Examples of Non-rival vs. Rival Goods
Marginal cost of another user 0
Marginal cost of another user gt 0
Congestible Goods
Prepared Food
Natures Services
National Defense
Sound Waves
Information
Clothing
Libraries
Clean Air
Schools
Shelter
Police Protection
Streets
Parks
Ocean Fish
Sidewalks
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CAUTION!

• The fact that additional users of a single unit
  of a nonrival good can be added at no additional
  cost does NOT mean that there is no additional
  cost for supplying additional units of the good.
  It also does NOT mean that people do not want to
  consume more than one unit of the good. It also
  does not mean that every consumer derives the
  same marginal benefit from consuming that
  marginal single unit.

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Why Market Failure Occurs for Non-rival Goods

• If a market institution was used to allocate a
  non-rival good, each consumer would have to buy
  their own unit. Thus, the market demand curve
  would not truly represent the marginal benefits
  that society could obtain from each unit of the
  good. To obtain societys true demand (i.e.
  societys MB curve) for the good, individual
  demand curves should be added vertically rather
  than horizontally.

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Example A Market With 2 Consumers
Individual 2s Demand
Individual 1s Demand
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For A Rival Good, Add Quantity Values
Horizontally to Get Market Demand for the Good
The numerical labels on the data points are
quantity values
Market Demand
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For A Non-Rival Good, Add P Values Vertically to
Get Societys Demand for the Good
Societys Demand
The numerical labels on the data points are price
values
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A Market Does Not Represent Societys True Demand
for the Nonrival Good
Societys Marginal Benefit curve
Market Demand
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When A Market is Used to Allocate a Non-rival
Good, The Quantity Supplied is Inefficient
Supply
Societys Demand
Market Demand
Market Quantity
Efficient Quantity
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Additional questions

• Suppose the government provides the socially
  efficient quantity, how much should it charge to
  the consumers?
• Zero? since opportunity cost0
• Equal? divide cost by of consumers?
• Equal to their MB? Revelation problem
• Does the socially efficient quantity at these
  prices, be the individual consumers quantity
  choice (individuals quantity demanded)?

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High Exclusion Cost vs. Non-rival Goods

• When exclusion costs are high, exclusion is not
  feasible. Therefore, a market institution will
  fail to produce an efficient quantity of the
  good.
• When a good is nonrival, exclusion is not
  desirable. Therefore, a market institution will
  fail to produce an efficient quantity of the good.

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Public Goods

• When a good has high exclusion costs and is
  nonrival, it is referred to as a public good.
• When a good has low exclusion costs and is rival,
  it is referred to as a private good.

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Abatement and resource conservation are high
exclusion cost, non-rival goods, so they are
public goods.
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Policy Implications

• Markets fail to produce an efficient quantity of
  abatement and resource conservation.
• If the quantity of abatement and resource
  conservation is inefficient, then markets for
  private goods which directly or indirectly use
  natural resource inputs or which affect the
  quantity of abatement will also be inefficient.

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The Effect of Market Failures for Public Goods on
the Efficiency of Markets for Private Goods

• If a public good is an input to the production of
  a private good, the input price will not reflect
  its true marginal cost. Therefore, the price of
  the producers output will not reflect its true
  marginal cost either.

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Example Effect of Market Failure for Abatement
on Markets for Private Goods

• If the government does not determine the quantity
  of abatement, none will be produced.
• If abatement is not required, firms are free to
  discharge untreated wastes into the air, water,
  or land.
• This changes the firms profit functions because
  the cost of waste disposal, C(W), is zero.
• Because production costs are lower, the supply
  curve for the firms outputs will shift to the
  right. This is shown in the next slide.

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Inefficient vs. Efficient Pollution Abatement
MB
MAC
Private Property or Open Access Equilibrium
Efficient Equilibrium
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Private Good Example Market for Electricity
MC with abatement
MC without abatement
MB
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Private, Social, and External Costs Without
Abatement
Marginal Social Cost without abatement
Marginal Private Cost without abatement
MB
Marginal External Cost without abatement
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Market Failure in the Private Goods Market
Marginal Social Cost (MSC)
Marginal Private Cost (MPC)
MB
Marginal External Cost (MEC)
Efficient Equilibrium
Inefficient Equilibrium
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Externalities

• Costs or benefits that result from market
  activities, but are not reflected in the market
  supply or demand curves.
• Externalities can be positive (e.g. private
  flower gardens) or negative (e.g. pollution)

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Terminology of Externalities

• Marginal Social Benefits (MSB)
• Benefits to market consumers plus benefits
  enjoyed by individuals external to the market
• Marginal Private Benefits (MPB)
• Benefits enjoyed by market consumers only
• Marginal Social Costs (MSC)
• Costs to market suppliers plus costs borne by
  individuals external to the market
• Marginal Private Costs (MPC)
• Marginal costs borne by market suppliers only

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Negative and Positive Externalities

• MSB MPB MEB (Marginal External Benefit)
• Negative externality occurs when MEB is negative
• Positive externality occurs when MEB is positive
• MSC MPC MEC (Marginal External Cost)
• Negative externality occurs when MEC is positive
• Positive externality occurs when MEC is negative

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Market for Resource Conservation Example of
Stock Size in a Ocean Fishery
MB
MC
Open Access Equilibrium
Efficient Equilibrium
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Effect on the Market for Harvested Ocean Fish
MSC
MSB
MPC
Efficient Equilibrium
Private Market Equilibrium
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Marginal User Cost in the Market for Harvested
Ocean Fish
MSC
MSB
MPC (also Marginal extraction cost)
Marginal User Cost (MUC)
Efficient Equilibrium
Private Market Equilibrium
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User Cost

• The cost of using an asset today rather than
  saving it for a future use.
• Its an inter-temporal externality
• MSC-MPC MUC (marginal user cost)

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Summary
Failure in this market causes failure in this
market
Failure in this market causes failure in this
market