Download Market failure, Externalities, the Enviroment, and Public

Price
MB = MC
PC
Supply =
Sum of MC
PC
The Competitive
Situation MC
d = MR = MB
Demand = MB
qC
quantity
Competitive firm in
Marketefficiency (maximum
achieve Allocative
QC
Quantity
Competitive Market
• Competitive markets
satisfaction) when the highest price the consumer is willing to
pay = the cost of producing the next unit of the good
(P = MB = MC)...
…this means the market price reflects ALL benefits received and
ALL costs of production.
• In many circumstances, there are costs or benefits from
producing or consuming a good that go to others that are not
involved in this market. This results in MARKET FAILURE.
Market Failure
• Competitive markets become Allocatively inefficient
because buyers and sellers do not take into account all
benefits and/or all costs from production of a good...
…because they have no incentive to take into account
EXTERNAL COSTS and BENEFITS which accrue to
someone besides themselves (buyers & sellers).
Why? Because they either don’t have to pay for
them(costs) or don’t receive the benefit.
• Therefore, the market price of the good will not reflect
ALL costs or benefits (ignore external costs or benefits)
• These external costs or benefits are called
EXTERNALITIES or spillover effects...
…they represent the impact on third parties from
market transactions.
Supply =MC
Price
Negative Externality
MC
PC
}
MEC
PC
}
MEC
d = MR = MB
Demand = MB
QC
Quantity
Competitive
Market
Negative
Externality (external
qC
Competitive firm in
aMarket
cost (beyond the
quantity
cost):
firms
cost) imposed on others in the production of a good or service...
...this cost is called the marginal external (or damage) cost
(MEC or MDC)... ...and is defined as the extra cost imposed on
third parties when a negative externality is present.
Examples: Dumping waste products into the air and water,
secondhand smoke, traffic congestion, loud music played at
3:00 in the morning, airplane noise, etc
Price
Supply =MC
MSC
Negative Externality
MC+MEC =MSC
PC
}
MEC
PC
}
MC
MEC
d = MR = MB
Demand = MB
QC
Competitive
findMarket
the cost to
Quantity
qC
Competitive firm in
Marketadd the MEC
must
quantity
To
EVERYONE, we
to the
MC of the firm...
…which gives us the total cost of production. This is called:
MARGINAL SOCIAL COST(MSC) =
MC (from firms) + MEC
(additional external cost imposed on others)
Price
MSC
Supply =MC
Negative Externality
MC+MEC =MSC
PE
PC
}
MEC
PE
PC
}
MC
MEC
d = MR = MB
Demand = MB
qE qC
Quantity
quantity
QE QC
Competitive
Competitive firm in
Allocative
efficiency occurs when ALL
cost and benefits are
Market
Market
considered. This will now occur when MSC = MB.
At Qc with price Pc , MSC > MB (because of the external costs)
Competitive equilibrium is no longer efficient because of the
negative externality.
MSC > MB indicates that the competitive market overproduces
the good at a price lower than the total (social) cost of
production
To reach efficiency, price must rise and quantity decline.
Positive Externality
Price
MEB
PC
{
Supply
= MC
MC
PC
Demand = MB
QC
Quantity
Competitive Market
{
MEB
d = MR = MB
qC
quantity
Competitive firm in Market
Positive Externality (external benefit): a benefit (beyond the
consumers benefit) that is bestowed on others in the production
or consumption of a good or service which we call...
...the marginal external benefit (MEB)...
...the extra benefit bestowed on third parties when a positive
externality is present.
Examples: Smoke detector in an apartment, vaccinations,
college education, Christmas decorations on a house.
Price
MEB
PC
Positive Externality
MSB = MB + MEB
{
Supply
= MC
MC
PC
Demand = MB
QC
Quantity
Competitive Market
{
MEB
MSB
d = MR = MB
qC
quantity
Competitive firm in Market
To find the benefit to EVERYONE, we must add the MEB to
the MB of the consumer...
…which gives us the total benefit of production. This is called:
MARGINAL SOCIAL BENEFIT(MSB) =
MB (from consumers) + MEB (bestowed on others)
Price
MEB
PC
PE
Positive Externality
MSB = MB + MEB
{
Supply
= MC
MC
PC
{
MEB
MSB
d = MR = MB
A firm would not
produce more at
a lower price
Demand = MB
QC QE Quantity
Competitive Market
qC
quantity
Competitive firm in Market
At Qc with price Pc , MSB > MC (because of the external benefits)
Competitive equilibrium is no longer efficient because of the
positive externality. Allocative efficiency occurs when MSB = MC
MSB > MC indicates that the competitive market
underproduces the good at a higher price than is efficient.
To reach efficiency, more of this good must be produced and sold.
However, Consumers need a price lower than PC in order to buy
more of this good.
Correcting Externalities
• Problem: Private individuals and firms have no
incentive to take into account external costs(MEC) or
external benefits(MEB)...
...that is they don’t have to pay for the damage caused or
receive the extra benefits of others.
• Solution: Have individuals and firms incorporate
(give them an incentive) or INTERNALIZE the
external costs or benefits into their own cost-benefit
calculations.
• If this occurs the firm will adjust their MC so it
reflects the MEC and will equal the MSC…
...if this is done then the market price and quantity
WILL reflect both private and external costs.
• Internalizing an externality can be done in numerous
ways...
Correcting Externalities
1. Persuasion(Can work at a personal level)
If a roommate is playing a stereo at 3:00 am, you can
ask that person to stop so you and others can sleep.
You can ask someone not to smoke by you.
“Don’t Drink and Drive” is an attempt to get people to
consider the external costs of this action.
2. Government intervention
a) Direct regulation
Government telling firms or individuals what to do
and exactly how to do it.
Why? In some cases the externality is too
dangerous for any amount to occur, like
plutonium or some chemicals
Examples: Specific equipment on cars, tailpipe
emission tests, use of a “cleaner” gasoline
Correcting Externalities
2. Government intervention, con’t
b) Indirect intervention
1) Legal rules and procedures
Various Product liability laws allow people to sue
manufacturers if their product is defective
Firms have greater incentive to improve their
product so they don’t pay damages
2) Corrective taxes & Subsidies
Firms ignore the MEC they impose on others
The government can tax firms to simulate the
external costs to others(society).
By subsidizing a product that has a positive
externality, the government can simulate the
MEB and encourage more production.
Price
New supply = Supply =MC
MSC(MC + Tax)
MC+ Tax = MSC = firms cost
MC
PT
PC
}
Tax
PT
PC
Demand = MB
dT = MRT = MBT
}
Tax
d = MR = MB
Tax = MEC
(MDC)
qT qC
QT QC Quantity of Dry cleaning
Competitive
Competitive firm in
externality
Market Correction of a negativeMarket
quantity
A per unit tax adds to the cost of production for business firms that
impose a negative externality
The market supply curve will decrease (shift to the left) because the tax
has increased the cost of production to business firms.
This raises the market price and lowers market quantity.
The per unit tax forces firms to take into account the external costs they
impose on others…
...the MSC to society becomes the internal or private MC to the firm
Because consumers pay a higher price, quantity does not go down
the maximum amount
What have we learned from this?
1)For efficient use of resources the Tax = MEC.
It can be difficult to measure external costs and to get the
Tax rate = MEC
In fact, it may only be possible by trial and error.
2)The cost of reducing pollution is lower output and/or
higher prices (ceteris paribus)
Of course, a firm has an incentive to choose the least costly
option.
If paying the full amount of taxes and not reducing output is
the least costly, then the firm will do that.
3) If Tax = MEC then tax revenue generated is large
enough to pay for all damages from the externality.
• If the government could find people directly affected by the
negative externality it could transfer the revenue to them.....
…since this is not likely, many would like to see reductions
beyond the efficient level, because they still have to bear the
external costs (i.e. the pollution)
Pric
e
Competitive Market
Supply
= MC
Competitive firm in Market
MC
$4,000
$4,000
QC
Demand = MB
Quantity
of Students
d = MR
qC
quantity
of students
Correction of a positive externality
A well educated workforce tends to be more productive, which
means more output for the economy and lower inflation….
…but students don’t take this positive externality in effect
when deciding to go to college.
The government can make students (and colleges) take these
external benefits into account by subsidizing production.
Pric
e
$4,000
$3,000
Competitive Market
Subsidy to
firms = MEB
}
Supply
= MC
Competitive firm in Market
MC MC - Subsidy
}
Supply
$4,000
after
Subsid
y
$3,000
Demand = MB
Quantity
of Students
QC QS
MEB
d = MR
d = MR
qC q
S
quantity
of students
Correction of a positive externality
In this case the subsidy goes directly to the firm, which lowers cost
..and causing the Supply curve to increase (shift to the right).
By lowering the price of education, more students will go to
college.
As long as the subsidy = MEB, efficiency will be achieved.
This occurs whether the firm or the consumer receives the
subsidy.
Correcting Externalities
3. Market Solutions....
...Assigning property rights
If the government can assign property rights
to resources where there were none before....
...and allowing owners of these property
rights to bargain, negotiate, and sell them...
...the market itself will be able to internalize
an externality and achieve efficiency....
An economist named Ronald Coase first
developed this idea...
Coase Theorem
Common Land
Rancher
Up to 800
cows
Who causes an externality is not always obvious. It takes at
least two or more to cause externalities.
Example: The octagon above represents open common land
Suppose a rancher sets up a few buildings and an area for his
cows to graze on.
Assume the grazing area has the capacity to fully feed up to 800
cows
Coase Theorem
Common Land
Rancher
Up to 800
cows
Farmer
Carrots
Next, a farmer begins to plant his crop, carrots, on another part
of this common land
There are no fences between these two, so if the rancher has
more than 800 cows, some of those cows stray off the blue area
in order to feed themselves (i.e. Rancher’s firm gets bigger)
Occasionally, some cows stray onto the land where the farmer
planted his crops and they eat them! (This is the MEC)
This lowers the amount of production for the farmer and will
cost him revenue and profits.
Coase Theorem
Common Land
Rancher
Up to 800
cows
Farmer
Carrots
Farmer is upset about the damages, but, since rancher was
there first, claims it is not his fault.This is a negative externality
Solutions for this negative externality:
1) Farmer can move; Rancher can move
2) Build a fence (either around rancher or farmer)
3) Rancher can keep cows to less than 800
(voluntarily or through government regulation and/or taxes)
Coase: By assigning property rights to the common land, these
two can solve the negative externality for themselves.
It will be done in the same way no matter who gets the
property rights
Coase Theorem
• Suppose we collect the following information from
the rancher and farmer:
• The rancher will maximize his profit by raising 1000 cows.
But this leads to straying cattle and an
external cost on the Farmer.
• Cost to the rancher to cut production back to 800
cows is $10,000 lost profit (200 x $50/cow)
• Cost to move cows or move the farm = $25,000
• Cost to build a fence around ranch or farm
= $16,000
• Maximum damage to farmers crops from
straying cows is $20,000 (200 x $100/cow)
Coase Theorem
Cost to cut production back to 800 cows is $10,000 ($50/cow)
Cost to move cows or move the farm = $25,000
Cost to build a fence around ranch or farm = $16,000
Max damage to farmers crops from is $20,000 (MEC=$100/cow)
• Which alternative will be chosen?
• Suppose the rancher gets the property rights...
…the rancher will keep only 800 cows! Why?
Because the MEC > profit/cow, the farmer is willing to pay
$10,000 to the rancher if he will limit his cows.
(It is better to lose $10,000 than $20,000)
• What if the farmer gets the property rights?
The rancher will keep only 800 cows! Why?
• Because it is cheaper than paying $100/cow to the farmer for
each cow over 800.
• Practical application: In some circumstances there is no
need for taxes and/or government regulation to correct
externalities. If property rights can be assigned then the
market system may be able to correct them.
Summary: Externalities
• An Externality is a cost or a benefit that affects others
not involved with a market transaction.
• Negative Externality: a cost imposed on society
• Positive Externality: A benefit bestowed on society
• Correcting Externalities (Internalizing)
Government solutions
1) Direct Regulation
2) Indirect intervention
a) Legal Rules and Procedures
b) Corrective taxes & Subsides
Must be equal to MEC or MEB to achieve efficiency
Market Solutions
Assigning property rights
Coase theorem: No matter who gets them, if the
conflicting parties can negotiate and trade, the efficient
outcome is achieved.
An application:
Pollution, a negative externality
Pollution: A negative externality
Two questions must be answered:
1)What is the optimal(MSC=MSB) reduction in pollution?
2)What is the lowest cost way to reach that reduction?
• Government could directly lower pollution by telling
firms how much they must reduce it and exactly how it
must be done...
…but some firms are in a better position (technology) to
reduce pollution than others, direct regulation is not the
most efficient(cheapest) way to reduce pollution...
...Pollutants that are not immediately hazardous to human
health can be reduced cheaper by using more market
based methods…for example...
…the polluter is given property rights to pollute...
...BUT THEY MUST PAY FOR THAT RIGHT
Market Solutions for reducing pollution
1. Emission charges
• Firms are charged for each unit of waste products they
dump into the air or water.
• Need to measure the emissions or effluent of a firm.
• These charges are similar to corrective taxes, but charge
directly for emitting pollutants rather than producing
the good...
…the difference is that emission charges give firms an
incentive to reduce emissions (and not output)...
...so they don’t have to pay the emissions charges.
• Moreover, firms have the responsibility to find ways to
reduce pollution.
• Recently, the EPA has found that costs can be reduced
even more by auctioning off certificates to emit
pollution...
...and allow firms to buy and sell these rights to pollute...
Tradable emission permits
MB
&
Price
$150
Supply of Permits
Tradable emission permits
Suppose the EPA decides that
emissions of sulfur dioxide
should be limited to 150,000
tons per year...
B
Marginal Benefit The EPA could issue 150,000
emission permits and auction
of emitting
them off to firms...
150,000
Tons of sulfur dioxide
emissions per year
ANumber of emission
280,000 permits issued
...who will need one of these permits for each ton of sulfur
dioxide they emit. What determines the price that is paid?
The Demand for the permits! Interaction between the buyers
for these permits establishes the price!
Once a firm purchases a permit it may use it to emit pollution
or to Re-sell it to another firm for profit if it does not need it.
Those firms that find it cheapest to reduce emissions will do so
and sell their unused permits to firms who find it too expensive.
MB
&
Price
Supply of Permits
Tradable emission permits
C
$250
B
$150
MB emitting 3
$50
MB emitting 2
MB emitting Tons of sulfur dioxide
emissions per year
ANumber of emission
150,000
280,000 permits issued
D
If demand for the product rises, firms may find it more beneficial
to emit more pollutants, the MB of emitting shifts to the right...
...then the price of permits is driven up
If firms can find better(improvement in technology) ways to
reduce emissions of pollutants then Marginal benefit of
emitting goes down... …and so will the price!
MB
&
Price
Supply of Permits
This allows the government to
have control over the total
amount of pollution.
$220
$150
Tradable emission permits
A
MB emitting Tons of sulfur dioxide
emissions per year
B Number of emission
100,000 150,000
280,000 permits issued
If the government ever want to further reduce emissions then
they simply buy up permits and retire them…
…shift the supply curve to the left.
Moreover, any environmental groups who wish to lower
emissions may buy up permits and hold them
(this lowers total emissions)
Characteristics of goods
• Many goods have the following characteristics:
1. If one person consumes a unit of a good (such as an
apple) then no one else can consume that unit of the
good (no one can eat that apple)
This is called rivalry in consumption…
...consumption of a good by one person reduces the
consumption by others.
2. If you don’t pay for it, you don’t get the good or
service.
This is called excludability… it is easy to prevent
someone from consuming a good once it has been
produced if they don’t pay for it.
Goods with these two characteristics are called
Private goods
Public Goods
• Some very necessary goods DO NOT HAVE these
characteristics…
…instead they have the opposite...
1) Non-rival in consumption:
The consumption of a good by one person does NOT
reduce the consumption by others...
...these goods are COLLECTIVLEY consumed...
...everyone can consume the good or service at the
same time and not detract from anyone else’s
consumption.
Examples: National defense, Air, TV, Movies(up to a
point), Education, Fireworks display, Air traffic
control, Police and Fire protection
Public
Goods
1) Non-rival in consumption
2) Non-excludable:
it IS NOT possible or at least extremely expensive to
exclude someone from consuming the good once it
has been produced...
...whether you pay for the good or not you will be able
to consume the good.
Examples: National defense, Air, Fireworks display, Air
traffic control, Police and Fire protection
• Goods that have the characteristics of collective
consumption and non-excludability are called
PUBLIC GOODS
• Market Failure: Private firms will not produce
public goods because there is no profit to be made...
...because no one will willingly pay for the good.
Public Goods and their provision
• Since Public goods are consumed collectively, there is
usually only one level of production for that good...
Problem is getting people to voluntarily contribute(pay)
for production of a public good. Why? Two reasons:
a) Free-rider problem...people can benefit from a public
good even if they do not help pay for it...
...because a public good is non-excludable...
...therefore people have an incentive to enjoy the
benefits without paying for them...a FREE RIDER!
b) A drop in the bucket problem...since public goods
tend to be expensive their provision does not depend
on any single individual...
…the more people needed to contribute, the greater the
incentive to free ride because you believe someone else
will pay for the good.
Public Goods and their provision
• Solution: Since most people believe this good is
necessary the government can provide for the
production of the good...
…either by producing it themselves...
...or hiring a private firm to produce the good.
• The government pays for the good by taxing (charging)
people in order to pay for it.
• How much of the good to produce and what to charge
for it is determined by the system of government in
place.
• The reason many people are unhappy with these taxes is
that they may pay more in taxes than their marginal
benefit from the public good.
Public or Private goods?
• In the real world there is not a clear distinction
between public and private goods
Example: Education is supported by government
although it is excludable.
Television programs are a mix of collective viewing
and excludability.
There are private security firms in addition to police.
• Some goods are non-rival only up to a certain point,
then adding another consumer WILL REDUCE
enjoyment of other consumers:
• A public park or swimming pool, exercise club, etc...
...or even an expressway...
Public or Private goods?
• Goods that are non-rival for some levels of
consumption tend to be overused... because the
marginal cost of using these goods is close to
(if not) zero.
• Example: In the case of an expressway there tends to
be congestion at certain peak use times…
…but at other times there is no congestion.
• Economic solution: Charging for use of an
expressway when you use it would prevent
congestion…
...for example, efficient use of an expressway would be
to charge a higher price at rush hour than normal
times.
Traffic Choice:
An Experiment was conducted
with 400 drivers that were
given $600 to $3,000 and were
allowed to keep whatever was
left over as they “paid” for the
use of roads over an 8-month
period.
Results:
The participants did use
freeways less often and
undertook other actions to
“save” money.
Locally provided public goods
• Tiebout hypothesis
Consider two identical towns except for police protection...
One town spends a lot of money on police and is
likely to have lower crime rates…
…Households that do not want to take a risk of being a
victim of crime will move into this town and will pay
higher taxes to avoid crime...or…
...if a town finds a way to reduce crime without higher
taxes so many households will try to move in they
bid up housing prices…
...these higher housing prices are the “price” of lower
crime.
• Those households that willing to bear greater risk
would choose the lower tax/ higher crime risk town.
Locally provided public goods
• Tiebout hypothesis:
The efficient mix of public goods (police, fire,
schools, roads, etc) is produced when local
housing prices and/or taxes reflect consumer
preferences...
…this means local taxes and housing prices act like
market prices...
…and equilibrium is reached by consumers
“voting with their feet”
Summary of Public Goods
• Public goods have two characteristics:
1) Non-rival in consumption
2) Non-excludable when produced
• Problem: Firms won’t produce them because
there is no way to make a profit.
• Why?
Free-rider problem
Drop in the bucket problem
• Solution: Government raises funds through
taxation so they can provide for public goods
Market Failure: Imperfect Information
A lack of symmetrical information between buyers and sellers can
cause markets to be inefficient or not work at all:
This leads to the problem of Adverse Selection.
Example: Used Car market and the “Lemons” problem
Suppose half of used cars are lemons(bad cars) and half are
cherries(good cars)
Buyers are willing to pay $7,000 for a cherry, but only $1,000 for
a lemon.
Since you have a 50/50 chance of buying a lemon or a cherry and
don’t know ahead of time what you are going to get the price of
used cars is the average of the price of a lemon and a cherry
($7,000 + $1,000) / 2 = $4,000
Owners of used cars know the type of car they have. Lemon
owners would love to get $4,000 for their car and will enter the
used car market.
Cherry owners will not get “fair” value for their car and not enter
the market.
Therefore, with asymmetrical info there tends to be more lemons
than cherries and the market function barely if at all.
Market Failure: Imperfect Information
Adverse Selection is a problem in insurance markets:
Those who tend to have more accidents or bad health are more
likely to demand insurance than those less accident prone or
with good health if rates are the same for everyone.
To counter this insurance companies are very nosy and charge
different rates to customers with differing characteristics.
This also explains why health insurance companies need to
charge different rates depending on health, or only those with
bad health will want insurance.
Market Failure: Imperfect Information
Another asymmetrical info problem comes after the two parties
agree to a contract:
Moral Hazard: One party to a contract passes the cost of it’s
behavior onto the other party.
Why a problem: Can’t tell the future behavior of the party you
have entered into a contract with.
Another problem in the insurance markets.
The very fact that you are covered by insurance may lead you
to increase risky behavior that causes the insurance company
to have to pay up.
Insurance companies write into contacts behaviors they will not
pay out for, such as suicide for Life Insurance or the need to
have smoke detectors before agreeing to fire insurance.
Market Failure: Imperfect Information
Market Solutions to imperfect and asymmetric information:
1. Provide more information.
• Companies sell information about products, etc to consumers.
• The internet has increased the ability to gather information
tremendously.
• In labor markets, recruiters or “Headhunter” are hired by
business firms to avoid going through a job search.
2. Government solutions:
•Create laws, rules, and regulations that require companies to
make information available to consumers.
•Food labeling, and especially financial reports in equities
markets are subject to these government dictates.
Arrow’s Impossibility Theorem
Suppose society has 3 individuals, Amy ,Bob, Charlie
Three proposals are put before them. Their preferences are
ranked for each proposal. Which one will they agree on?
Proposal
Individual
X
Y
Z
Amy
1
2
3
Bob
3
1
2
Charlie
2
3
1
Results of Voting on Proposals
Votes of:
Vote
Amy Bob Charlie
Results
X
X
X beats Y
Y
X vs. Y
Y
Z
Y beats Z
Y
Y vs. Z
X vs. Z
Z
Z
Z beats X
X
The outcome is inconsistent, no proposal dominates the other
Impossibility Theorem
Kenneth Arrow: no system of aggregating individual
preferences into social decisions will always yield consistent,
non-arbitrary results.
Voting Paradox: An example of the impossibility theorem.
Importance: Who sets the agenda has power to determine the
outcomes of votes.
Logrolling: occurs when congressional representatives trade
votes, agreeing to help each other get their pieces of legislation
passed.
A person only has the incentive to gather info up to the point
where their marginal benefit = marginal cost.
Since the cost of government is spread over everyone, the
marginal cost of government policy is very small for an
individual, giving little incentive to keep up on issues facing
society.