Market Failure

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Lecture 23
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Market Failure

• In some situations market system of voluntary
  exchange may not lead to allocative efficiency
• lack of consumer information
• licensure and product quality regulation
• monopoly
• antitrust, price regulation
• externalities and public goods

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Externalities

• Definition
• externalities occur whenever an action taken by
  one person imposes costs or benefits on others
  (without their consent) that are not taken into
  account by the decision maker
• also called spillover costs or benefits
• examples

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Externalities

• Externalities can be positive or negative
• if action imposes costs on others, called a
  negative externality or said to have external
  costs
• if action creates benefits for others, it is
  called a positive externality or said to have
  external benefits

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External CostsFailure to register fully costs.

• Consider the market to the right. Under
  initial supply and demand conditions an
  output of Q1 and a price of P1 exist.

Price

• If, though, all costs are fully identified
  and measured . . .

then the new supply curve (S2 ) would
result in an output of Q2 ( lt Q1) and a price
P2 ( gt P1).
P2
P1

• The result of an externality with external
  costs (a negative externality) is that too
  many units are produced at a price below that
  which would prevail if all the costs of
  the production, provision, and consumption of
  the good were identified and factored into it.

D
Q1
Q2
Quantity /Time
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External BenefitFailure to register fully
benefits.

• Consider the market to the right. Under
  present supply and demand conditions an
  output of Q1 and a price of P1 exist.

Price

• If, though, all benefits are fully
  identified and measured . . .

then the new demand curve (D2 ) would
result in an output of Q2 ( gt Q1) and a price
P2 ( gt P1).
P2
P1

• The result of an externality with external
  benefits (a positive externality) is that too
  few units are produced at a price below that
  which would prevail if all the benefits
  of the good were identified and factored into
  it.

D1
Q1
Q2
Quantity /Time
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Externalities

• Sources
• producers
• factory spewing smoke or dumping effluent into
  river
• consumers
• drivers and air pollution, smokers, etc.

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Externalities

• Causes
• ill defined or un-enforced property rights
• property rights are the set of actions one can
  take with respect to the use of a resource
• right to use (and exclude others from using)
• right to transfer outright (i.e. sell)
• right to transfer partial use rights in exchange
  for income (i.e. rent or lease)
• when property rights are assigned and enforced,
  bribes or potential bribes will force decision
  maker to take into account effect on others
• does not matter who has rights, so long as they
  are assigned to someone
• Coase theorem

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Externalities

• Causes
• high transaction costs
• if costly to enforce and exchange property
  rights, mechanism by which one's preferences are
  transmitted to the decision-maker breaks down
• won't get prices or bribes that transmit
  information
• others are effected
• an action can only have external effects if there
  is someone in the vicinity to be effected

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Pollution and externalities

• There will exist some optimal level of pollution
• pollution has both costs and benefits
• benefit of pollution is related to value of the
  product that is jointly produced with pollution
• by polluting, a firm presumably is able to
  produce a product at lower cost which means lower
  prices and gains to both producers and consumers
• costs include impaired health, unsightliness, and
  perhaps higher costs to other firms

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Pollution and Externalities

• Individual driver will drive up to the point
  where his costs (MPC) equal his benefits
  (MPBMSB).
• This yields a quantity Q1.

Price
MSC

• The optimal amount of driving is where the
  costs to society (MSC)
• and benefits to society (MSB) are
• equal at the margin, Q.

MPC
P

• Excessive driving produces a net
• loss to society. This is the amount
• by which the MSCgtMSB for the
• amount of driving past Q.

P1
P1
MEC
MPBMSB
Q1
Q
Miles Driven
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Pollution and Externalities

• Solutions to the pollution problem.
• impose a fixed limit of Q driving per week for
  all.

Fixed Limit
Price
MSC
MPC

• problems
• need to know MSB and MSC to know where to set
  limit
• Q will be different for different people since
  MB and MC differ
• uniform limits are inefficient

P
P1
P1
MEC
MPBMSB
Q1
Q
Miles Driven
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Pollution and Externalities

• Solutions to the pollution problem
• pollution taxes
• optimal tax is equal to marginal external cost
  (difference between MSC and MPC)
• want decision maker to bear cost equivalent to
  MSC and produce Q

Price
MPC Tax
MSC
MPC
P
P1
P1
MEC
MPBMSB
Q1
Q
Miles Driven
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Pollution and Externalities

• "solutions" to the pollution problem
• pollution taxes
• problems
• need to know marginal external cost in order to
  determine tax
• advantages
• more efficient than across-the-board limits since
  those having lowest cost of pollution reduc- tion
  will reduce the most
• each firm will equate MC of pollution reduction
  with tax
• don't need to know relative costs of pollution
  reduction

Price
MPC Tax
MSC
MPC
P
P1
P1
MEC
MPBMSB
Q1
Q
Miles Driven
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Pollution and externalities

• Solutions to the pollution problem
• assign transferable pollution rights and allow
  trade
• examples
• bubble concept
• exchange of pollution control equip.
• outright sale of pollution rights
• problems
• transaction costs may be prohibitive
• advantages
• central authority doesn't have to know MB and MC
  for each firm
• more efficient than uniform limits

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Pollution and externalities

• Solutions" to the pollution problem
• separation
• takes two to have an externality
• could ban polluters from areas where external
  costs are the highest
• may not get "efficient" outcome, but relatively
  easy to carry out

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EndLecture 23