Chapter 16 Market Failure

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Chapter 16 Wong (2000 167) Market Failure? A
very brief introduction only! You have to read
the details suggested references yourself!
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6.2.1 Wong (2000 167)

• Private cost is the cost borne by the one who
  acts.
• External cost is the uncompensated cost borne by
  others.
• Social cost is the total cost borne by the whole
  society (including all economic agents) private
  cost external cost.

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Wong (2000 167)

• Divergence between private and social costs is
  the situation in which private cost is different
  from social cost due to the presence of external
  cost , i.e. SCgtPC.

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Equilibrium efficiency
Private optimum Qp (MPB MPC)
Social optimum QS (MSB MSC)
Fig. 16.1
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6.2.1c. Wong (2000 168)

• Private benefit is the benefit obtained by the
  one who acts.
• External benefit is the uncompensated benefit
  brought to others.
• Social benefit is the total benefit brought to
  the whole society private benefit external
  benefit.

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Wong (2000 168)

• Divergence between private and social benefits
  is the situation in which private benefit is
  different from social benefit due to the presence
  of external benefit, i.e. SBgtPB.

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Equilibrium efficiency
Wong (2000 169)
Private optimum Qp (MPB MPC)
Social optimum QS (MSB MSC)
Fig. 16.2
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6.2.2 Wong (2000 167)

• 6.2.2.1 Market failure refers to situations in
  which the the market price fails to allocate
  resources efficiently.
• 6.2.2.2 Externality is the situation in which
  ones action affects others without compensating
  them.

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Effect of externality
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Wong (2000 171)
6.2.2.3 Public good

• Private good is a commodity of which its
  consumption by any one person reduces the amount
  available for others, i.e., private good is
  exclusive in consumption.

• (Pure) Public good is a commodity of which its
  consumption by any one person does not reduce the
  amount available for others, i.e., public good is
  non-exclusive in consumption.

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• Impure public good is a commodity that can be
  consumed by many individuals at the same time.
  However, not all individuals can consume the
  whole amount of it because additional cost is
  involved in its consumption.

Examples
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For more details, please read Wong (2000 171)
Q16.3 Explain why the above are examples of pure
public goods impure public goods. Q16.4
Distinguish between public goods public
services.
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Private firms
e.g. Private carparks
e.g. Commercial Broadcasting
Private good
Public goods
e.g. Government carparks
e.g. Government Broadcasting
Government
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Wong (2000 171-2)
Demand for public good

• The market demand curve of a public good is its
  MSB curve. Why?

• MSB curve is equal to the vertical sum of MUV
  curves of all individuals in the market.

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For more details, please read Wong (2000 172)
Q16.5 Explain why the market demand curve for a
private good is equal to the horizontal sum of
MUV curves of all individuals but the market
demand curve for a public good is equal to the
vertical sum of MUV curves of all individuals.
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Optimal output MSB(åMUV) MSC(MC)
6.2.2.6 The social optimum
MUV1MUV2MSB

MSC
Optimal pricing scheme Perfect price
discrimination (i.e., P MUV) then åP MSC
MUV2
MUV1
0
Q
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Private optimum
Wong (2000 173)

• If uniform pricing is practiced
• High MUV users MUVgtP
• Low MUV users MUVltP and refuse to consume.
• So the marginal revenue collected (åPltåMUV) is
  much lower than MSB.
• In equating MRMC, the private optimum is much
  smaller than the social optimum.
• Underproduction is resulted and allocative
  efficiency cannot be attained. gt 6.2.2.7
• Moreover, as low MUV users are excluded from
  consumption, consumption efficiency cannot be
  attained.

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• If perfect price discrimination is practiced
• It is extremely costly for a producer to know
  the MUV curve of every individual.
• Individuals would pretend to be low MUV users.
  Then MR collected from perfect price
  discrimination would also be smaller than MSB.
• Underproduction is resulted and allocative
  efficiency cannot be attained.

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• 6.2.2.5 The free rider problem
• As public good is non-exclusive in consumption,
  it is difficult to prevent free-riders
  (non-payers) from consuming the good.
• As free riders appear in all kinds of pricing
  schemes, MR collected is lower than MSB.
• Underproduction is resulted.

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Any Remedy?

• Zero pricing
• Through financing the production of public good
  by tax revenue.
• Unfair to taxpayers who do not consume the
  public good.
• Inefficiency is passed to another sector of the
  economy.
• To estimate MSB, consumers may overstate their
  MUVs. Over-production may be resulted.

• Pricing
• The visible hand faces similar problems as the
  invisible hand.

Underproduction is resulted.
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For more details, please read Wong (2000 174)
Q16.7 Radio broadcast is a public good. What are
the problems in its pricing? What are the ways
to overcome the problems so that it can be
provided privately? Is the situation efficient?
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6.2.3 (Wong 2000 168, 170)
6.2.4 (Wong 2000 180)
Wong (2000 175)
Counter Argument the Market Works!
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17.1 6.3 Property rights, transaction costs
Coase Theorem

• (Wong 2000 195)
• 6.3.1.1 Private property rights defined
• (Wong 2000 196)
• 6.3.1.2 More well-defined private property rights
  gt lower transaction cost gt and greater gain
  from so more market exchange
• (Wong 2000 200)
• 6.3.1.4 Resource allocation (efficiency) under
  different (private or common) systems of property
  rights
• (Wong 2000 197)

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6.3.2 Zero transaction cost Coase theorem

• Coase Theorem states that regardless of the
  initial assignment of property rights, the market
  equilibrium is identical (allocation/output) and
  efficient provided that property rights are
  well-defined and transaction costs are
  negligible.

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Illustration of the theorem
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Initial situation

• Factory pours sewage to the river

• Reduce the output of the farm

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Case I The farm does not have the right of
enjoying clean water.
(Wong 2000 176)

• Suppose there is no law restricting pollution

• The farm owner Mr. B negotiate with Ms. A and
  pay her to cut her output and pollution.

• Max. amount that Mr. B is willing to offer to
  Ms. A is the external cost he borne MSC - MPC

• Min. amount that Ms. A is willing to accept is
  the her net receipt in producing that unit of
  output MPB MPC MSB - MPC

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In equilibrium,
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Case II The farm has the right of enjoying clean
water

• Suppose there is a law restricting pollution

• The factory owner Ms. A negotiate with Mr. B and
  pay him to allow her production.

• Max. amount that Ms. A is willing to offer to
  Mr. B is is the her net receipt MPB MPC
  MSB - MPC

• Min. amount that Mr. B is willing to accept is
  the external cost he borne MSC - MPC

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(Wong 2000 177)
In equilibrium,
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Conclusion

• If transaction cost is zero, by Coase Theorem,
  private contracting would change the private
  optimum to the social optimum.
• Efficiency is achieved and no deadweight loss is
  resulted.
• Notice that the assignment of property rights
  has no influence on the allocation of resources.

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Remarks 1. Optimal level of pollution

• If pollution cannot be avoided in production
  (cost of preventing or eliminating pollution is
  too high), it is efficient to allow pollution
  whenever the marginal gain of pollution can cover
  its marginal cost. So there exists an optimal
  level of pollution (which may not be 0).

2. Reciprocal nature of the problem

• There exists no reason why someone should have
  the right of a resource (e.g., clean water).
  Whoever has the right will gain and whoever has
  to buy the right will lose. So who is the victim
  is reciprocal, depending on the assignment of
  right.

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Prohibitively high transaction cost
(Wong 2000 178)
Achieving efficiency without reallocating
resources

• If the transaction cost in eliminating the
  deadweight loss is larger than the loss, no
  private contracting occurs.
• Although the private optimum is different from
  the ideal social optimum (that there exists
  deadweight loss), the resource allocation is
  still efficient (as no improvement is worth to be
  made).

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(Wong 2000 179)
Assignment of property rights affects the
allocation of resources (TC is prohibitively high)

• If the farm does not have the right and the
  transaction cost is prohibitively high

• Factory will produced at QP1

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• If the farm has the right and the transaction
  cost is prohibitively high

• The factory will be banned from production,
  i.e., 0QP2

0QP2
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(Wong 2000 180)
Government intervention is unnecessary and
inappropriate

• As resource allocation by the invisible hand
  must be efficient (agents are maximizers), there
  is no market failure.
• No government intervention is needed.
• Moreover, the use of visible hand may be of
  ill-motive, involve high administrative and
  information cost, and restrict individual
  freedom.
• So even if there were market failure, the use
  of visible hand might not be appropriate.

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(Wong 2000 185)

• Q16.2 The construction of a rubbish collection
  point causes the value of nearly properties to
  fall. To attain economic efficiency, which of
  the following options should be adopted?
• The rubbish collection point should compensate
  the nearby property owners.
• The rubbish collection point should install
  pollution reduction device.
• The rubbish collection point should be relocated.
• The nearby properties should be relocated.

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EIL 16.4 (Wong 2000 182)
B
C
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Road B
Road C
Time (hrs)
Time (hrs)
MC
AC
2
ACMC
1
Users
0
0
Q1
Q2
Q3
Users
(a)
(b)
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Toll
Toll
S
S
D
D
Capacity
0
Capacity
0
(a)
(b)
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Toll
S
S
D
Capacity
0
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Toll
S
D (Trips out and back)
D (Trips out)
P2
P1
Capacity
0
Figure 10
One-way pricing
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Toll
S
D
D
Capacity
0
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W
6.3.3.3 (Wong 2000 197)
W
MRP
ARP
Q2
Fishing effort
0
Q1
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Make notes

• Hand in to me on 22/8 by group
• Make a copy of the notes for the other 3 groups
• Test on Social Cost on 22/8
• Marks will be given to Ms Seto
• Next lesson 20/8/03, 830am
• Suggested fieldtrip route Tsim Bei Tsui, Luk
  Keung near Sha Tau Kwok, Hoi Ha
• Please read file news about these current
  topics football gambling, SARS transmission,
  ecotourism, HKSAR conservation policy, wetland
  conservation e.g., Long Valley, fishing
  stoppage/holiday, keeping pets in public housing,
  marine park such as Hoi Ha.