Download Market Failure - WordPress.com

Market Failure
Definitions & Terminology
• Allocative efficiency (Pareto Optimality) is where
• MARGINAL SOCIAL BENEFIT
= MARGINAL SOCIAL COST
(draw on a diagram)
• If there is allocative inefficiency, too much or too
little of goods or services are produced and
consumed from the point of view of what is
socially most desirable. Overprovision of a good
means too many resources are allocated to its
production (overallocation); underprovision
means that too few resources are allocated to its
production (underallocation)
Market Failure
In the real world, free markets often “fail” to achieve allocative efficiency
• The causes of “market failure”
1.
2.
3.
4.
5.
Imperfect competition
Externalities
Collectively consumed (“public” )goods
Common access resources
Asymmetric/Imperfect information e.g.
case of insurance and/or Irrational buyers:
case of financial crisis
6.
Inequitable distribution of income?
• When a market fails, it justifies
• government intervention
• e.g. taxes, subsidies, regulation, price controls,
government provision of the good
Introducing Externalities
• the state or quality of being external
(outward, outside); often unforeseen or
unintended (dictionary.com)
More formally..
• An externality occurs when the actions of
consumers or producers give rise to negative or
positive side-effects on other people (thirdparties) who are not part of these actions, and
whose interests are not taken into consideration
• When a consumer buys a good, she or he derives
some benefits and when a firm produces and sells a
good, it incurs costs. But sometimes the benefits or
costs spillover onto other consumers or producers
who have nothing to do with consuming or
producing the good.
• When this happens, there is an externality
Types of Externality:
• If the side effects on third parties involve
benefits, there is a positive externality also
known as an
external benefit
• If the side effects on third parties involve
costs, there is a negative externality also
known as an
external cost
Examples of goods with externalities
MERIT
GOODS
have
EXTERNAL
BENEFITS
Positive Externality of Positive Externality of
Consumption
Production
DEMERIT
GOODS
have
EXTERNAL
COSTS
Negative Externality of
Consumption
Negative Externality of
Production
Real Life Examples
• Negative production externalities
– Environmental pollution
• Negative consumption externalities
– Due to smoking in public places, cars
• Positive production externalities
– If there is research and development e.g. hybrid technology, IPS
cells and Stem cell research; spin-offs from NASA
– From orchards and bee farms
• Positive consumption externalities
– Arising from education and health care, leading to increase in
productivity, learning from each other, less crimes ..
• If a Negative Externality : (due to Demerit
Goods)
 SOCIAL COST = Private Cost + External Cost =
TOTAL Cost
•
• If a Positive Externality: (due to Merit Goods)
 SOCIAL BENEFIT = Private Benefit + External
Benefit
•
= TOTAL Benefit (or utility)
Modeling and Analysis of Externalities
• To model and analyze externalities, consider the
definition of demand and supply
– Demand curve is also the consumer’s marginal benefit of
consumption
– Supply curve is also the firm’s marginal cost of production.
(The cost to producers for producing one more unit of the good,
the minimum revenue needed to stay in business)
• Since the benefits received by consumers go to the
private individuals, we can refer to the demand curve
as the marginal private benefits (MPB)
• Similarly, since the costs incurred by producers go to
the private firms, we can refer to the supply curve as
the marginal private costs (MPC)
Modelling Externalities
• 1) Model the existence
of a
Positive Externality of
Consumption
• 3) Model the existence
of a
Positive Externality of
Production
• 2) Model the existence
of a
Negative Externality of
Consumption
• 4) Model the existence
of a
Negative Externality of
Production
REVIEW
• If there are externalities (benefits or costs) on the rest of
the society full benefits or costs to society differ from
private ones
•  the concepts of marginal social benefits (MSB) and
marginal social cost (MSC)
– Marginal social benefit = benefits to society from
consuming one more unit of a good
– Marginal social cost = costs to society of producing one
more unit of a good
– (Both equal the PRIVATE cost/benefit + / − EXTERNAL
cost/benefit)
• When this occurs, the equilibrium price and quantity
determined by the intersection of MPB and MPC
(demand and supply in the private market) are not
equal to the ones determined by the MSB and MSC
(social optimum or efficient outcome)
• From the societal perspective (the entire society),
the social optimum or the “best” allocatively
efficient outcome is where all benefits and costs
are recognized
– (Remember: Adam Smith assumed that when there
are no externalities then the private equilibrium is the
optimal allocative outcome… in other words, he
assumed that MPB = MSB and MPC = MSC)
• Thus, when externalities are present, the market
equilibrium P and Q determined by MPB and
MPC is NOT allocatively efficient… because social
benefits or costs differ from private ones
WELFARE LOSSES
Redefining Allocative Efficiency
• Allocative efficiency is achieved when
• MSC = MSB.
• An externality creates a divergence between MPC
and MSC or between MPB and MSB
• Where there is an externality, the free market
leads to an outcome where MPB = MPC, but
where MSB is not equal to MSC, indicating
allocative inefficiency
• NEGATIVE EXTERNALITIES ………………. at too
…………………. a price
• POSITIVE EXTERNALITIES ………………. at too
…………………. a price
Graphically
Negative Production Externality
• For each level of output , the social costs of producing the good
are greater than the firm’s private costs
• The vertical distance between MSC and MPC represents the
(marginal) external cost
•
The free market outcome is determined by the intersection of MPB and MPC
and is indicated with “m”. The social optimum (allocatively efficient) outcome
is given by the intersection of MSB and MSC which is indicated with “opt”
Welfare Analysis
• The welfare loss occurs where MSC > MSB for the
output that is overproduced (Qm – Qopt)
• It is the loss to society due to overproduction of the
good caused by the externality. Society would be
better of if less of the (harmful) good is produced.
• There would be a WELFARE GAIN if less of the good
was produced
2. Positive production externalities
• Positive externalities of production refer to
external benefits (or “negative costs”) created
by producers
• Examples
– Research and development and development of
new technology that spreads throughout the
economy (eg lasers)
– Firms training workers who later switch jobs
– Pharmaceutical firms or NASA developing new
medication that can be used for other purposes
– Fruit orchards and bee (honey) farms
(continued)
• In the production, there are external benefits as
the firm not only benefits but also the third party
and society as a whole
• This implies that the social costs of the
production (with positive external benefits) are
lower than the private costs incurred by the firm
(the external benefits can be thought of as “negative
costs”- production is more beneficial than expected)
• The MSC curve lies below the MPC curve and the
vertical difference between the two is the
(marginal ) external benefit
• Comparing the market outcome and the social outcome, it is
evident that the market underallocates resources for the
production of this good or underproduces it.
• Society would have been better off if more of the good was
produced (ie a WELFARE GAIN if more of the good)
• For the shortage of quantity below Qopt, MSB > MSC. WL is the
total loss calculated as the difference in the MSB and MSC
More specifically, theWL (DWL) due to the
allocative inefficiency is…
3. Negative Consumption Externalities
• Negative externalities of consumption refer to
external costs created by consumers
• Examples
– Consumers of cigarettes smoking in public places
spilling over second hand smoke to other people
– Heating homes and driving cars utilizing fossil
fuels and gas that emit pollution to the
atmosphere/cause noise pollution, congestion and
accidents
– Partying with loud music, construction work,
alcohol etc.
(continued)
• Perspective now is the consumer  expect the MB
curve to change and not the MC curve
• When there is a negative consumption externality, the
marginal private benefit (MPB or demand curve) no
longer reflects the social benefits (MSB)
• The external costs to third parties (non-smokers)
creates “negative benefits” to society and cause the
MSB curve to lie below the MPB curve
• The vertical distance between the MSB and MPB
represents the (marginal) external cost
• This is shown as follows…
Graphical Illustration
• Note: since the externality involves consumption, the demand
curve is unreliable but the MC curve is unaltered (assume no
exterrnalities in production or MPC = MSC)
• The market outcome is determined by the intersection of MPB and
MPC but the social optimum is determined by the intersection of
MSB and MSC
• NOTE- MISTAKE in diagram. Popt should be HIGHER in order to
reduce quantity demanded to Qopt
•
•
•
•
The welfare loss (due to the overproduction of the good in the market) is
equal to the vertical difference between MSC and MSB curves (the external
cost where MSB < MSC.) for the amount of output that is overproduced
relative to the social optimum (Qm – Qopt)
For the excess amount of output produced beyond Qopt, the WL is the total
difference of MSB and MSC for the extra output being produced
There would be a WELFARE GAIN if output was reduced to Qopt
NOTE- same MISTAKE in diagram Popt should be HIGHER
4. Positive Consumption Externalities
• Positive consumption externalities refer to
external benefits created by consumers
• Examples
– Consumption of education benefits the person
who receives it but also give rise to external
benefits
– Consumption of health care, immunization, HIV
tests, etc., also benefits the society at large as
healthier economy
(continued)
• When there is a positive consumption externality,
the marginal private benefit (MPB or demand
curve) no longer reflects the social benefits
(MSB)
• The external benefits to third parties and society
cause the MSB curve to lie above the MPB curve
• The vertical distance between the MSB and MPB
represents the (marginal) external benefit
• This is shown as follows…
Graphical Illustration
• Note: the MC curve is unaltered (MPC = MSC or NO
production externalities)
• The market outcome is determined by the intersection of
MPB and MPC but the social optimum is determined by the
intersection of MSB and MSC
• NOTE- MISTAKE in diagram. Popt should be LOWER in
order to reduce quantity demanded to Qopt
• Welfare loss (due to the underproduction of the good) is equal to the
vertical difference between MSC and MSB curves (the external benefit) for
the amount of output that is underproduced relative to the social
optimum (Qopt – Qm)
• For the shortage of the output below the Qopt, MSB > MSC. WL is the
sum of difference between MSB and MSC for the shortage of output
• NOTE- MISTAKE in diagram. Popt should be HIGHER in order to reduce
quantity demanded to Qopt