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MARKET FAILURE IB ECONOMICS JANUARY 2012 M. PADULA QUESTIONS TO CONSIDER • What is Market Failure? • Why do we care when the market fails? • Does price always reflect true costs and true value? • Is monopoly bad for society? Always? • When should government intervene? Topics in…Market Failure • Overview—What is Market Failure? • Externalities • Positive Externalities (Consumption and Production) • Negative Externalities (Consumption and Production) • • • • (Lack of) Public Goods Common Access to Resources & Sustainability Asymmetrical Information Abuse of Monopoly Power THE MARKET Tell me again why the market was so great? (3 minutes at your table) • • • • _____________________ _____________________ _____________________ _____________________ THE MARKET Tell me again why the market was so great? •Invisible hand as “supercomputer” •Price Rationing: • Productive efficiency—output with lowest possible cost (how to produce) • Allocative efficiency—goods and services most wanted by society (what to produce) •Self-interest Incentives that promote growth WHAT IS MARKET FAILURE? • Sorry Mr. Sowell, the market isn’t perfect • It fails when the market mechanism, working freely, fails to allocate resources efficiently: • Marginal Cost ¹ Marginal Benefit • Market not providing the optimal combination of goods and services desired by society • Market failure is a major justification for government intervention, which leads to a prevalence of mixed market economies • Allocative efficiency: An ideal difficult to realize MARKET FAILURE • What does Market Failure look like: • Under-provision of a good/service, or • Over-provision of a good/service • What are the “Classics”? • • • • • • Externalities Merit goods/Demerit goods Lack of Public goods Common Access Resources Asymmetrical Information Monopoly Power MARKET FAILURE: EXTERNALITIES • An externality occurs when the actions of consumers or producers create positive or negative side-effects on other people: • Who are not part of the actions • Whose interests are not taken into consideration • Or, when Private Benefits/Costs ¹ Social Benefits/Costs Positive or Negative? Consumption or Production? Known as… 1. Negative Production Spillover costs 2. Negative Consumption Spillover costs 3. Positive Production Spillover benefits 4. Positive Consumption Spillover benefits EXTERNALITIES IN ACTION Price MPC Demand = Marginal Benefit = Marginal PRIVATE Benefit Supply = Marginal Cost = Marginal PRIVATE Cost We normally speak of “equilibrium” as society’s most efficient level of output—this works well when there are no Externalities Pe MPB Qopt Quantity Bought and Sold 1. NEGATIVE PRODUCTION COSTS Spillover Production Costs • Decision makers do not take into account the cost imposed on society and others as a result of their decision • Negative Production Costs: • Pollution • Environmental degradation • Depletion of the ozone layer Excellent news Smithers…widget sales are up! 1. GRAPHING EXTERNAL COSTS MSC = MPC + External Cost Price The Marginal Social Benefit curve The MPC does not take into (MSB) represents the sum of the The true cost therefore the MSC account the costisto society of MPC benefits to consumers in society The difference between the (the MPC plus the external cost).level production. At an output as a whole –levels the and private and social value of the MSB the MSC Current output (100) therefore of 100, the private cost to the benefits. The Marginalof Private represents theelement to represent some market supplier iswelfare £5 perloss unit but the Cost (MPC) curve represents the society of 100 units being failure –cost price does not accurately to society is higher than costs to suppliers producing a produced. reflect the cost ofofproduction. thistrue (£10). given Value ofoutput. the negative £10 Social Cost £7 £5 externality (Welfare Loss) Socially efficient output is where MSC = MSB (in this case 80) MSB 80 100 Quantity Bought and Sold 1. GRAPHING EXTERNAL COSTS MSC = MPC + External Cost Price MPC £10 The MPC does not take into account the cost to society of production. At an output level of 100, the private cost to the supplier is £5 per unit but the cost to society is higher than this (£10). Value of the negative externality (Welfare Loss) £7 £5 Socially efficient output is where MSC = MSB (in this case 80) MSB 80 100 Quantity Bought and Sold 1. CORRECTING NEGATIVE PRODUCTION EXTERNALITIES How can the government correct these externalities? Goals: Bring MPC closer to the MSC, reduce output to Qopt •Legislation/Regulation: Legally forbid polluting activity, or • • • • Impose limits on allowable pollution Limit the quantity that can be produced Require polluting firms to install technology to limit/eliminate pollution In all cases, goal is to limit production bring the MPC closer to the MSC •Impose a tax on the firm’s production of the good • Target the tax to equal the spill-over cost •Tradable permits • • • • International body issues permits Firms can buy or sell based on Supply and Demand Incentive for firms to find ways to reduce externality—they can sell permits See page 163 2. NEGATIVE CONSUMPTION COSTS Spillover Consumption Costs • Decision makers do not take into account the cost imposed on society and others as a result of their decision • Negative Consumption Costs: • • • • • Misuse of alcohol, tobacco Anti-social behaviour Drug abuse Driving using fossil fuels A party with loud music late at night Yeah so I smoke…de al with it! 2. GRAPHING EXTERNAL COSTS Price MSC=MPC Socially efficient output is where MSC = MSB (in this case Qopt) Pm Spillover Cost Popt MPB MSB = MPB - Spillover Cost MSB Qopt Qm Quantity Bought and Sold 2. CORRECTING NEGATIVE CONSUMPTION EXTERNALITIES How can the government correct these externalities? Goals: Bring MPB closer to the MSB, reduce output to Qopt •Advertising/Persuasion (ant-smoking campaigns, PSA’s) • Decrease demand, bring MPB closer to MSB •Legislation/regulation • Anti-smoking laws • Curfews • Public trash cans •Taxing the firm that produces the good • Increases the MPC so high that Qm moves to Qopt • Price increases (extent of the increase depends on PED of the good)