1. When markets fail

1
1. When markets fail

• Public goods
• Nonrival
• Nonexclusive
• Incomplete information
• Monopoly
• Externalities

2
2. Externalities

• Negative
• Action by one party imposes a cost on another
  party
• Positive
• Action by one party benefits another party

3
3. External Costs
Price
Price
MC
S MCI
P1
P1
D
Industry output
q1
Q1
Firm output
4
4. External Costs
When there are negative externalities, the
marginal social cost MSC is higher than the
marginal cost.
MSC
Price
Price
MSCI
MC
S MCI
P1
P1
D
Industry output
q1
Q1
Firm output
5
5. External Costs
The differences is the marginal external cost MEC.
MSC
Price
Price
MSCI
MC
S MCI
P1
P1
MECI
MEC
D
Industry output
q1
Q1
Firm output
6
6. External Costs
Efficient output occurs at Q MSCI D
(marginal benefit)
MSC
Price
Price
MSCI
MC
S MCI
P
P1
P1
MECI
MEC
D
Industry output
q1
Q1
q
Q
Firm output
7
7. The Efficient Level of Emissions
Dollars per unit of Emissions
MSC
6
4
The profit-maximizing level of emissions is 26,
the level at which the marginal cost of abatement
is zero.
2
MCA
0
2
4
6
8
10
12
14
16
18
20
22
24
26
Level of Emissions
8
8. The Efficient Level of Emissions
Dollars per unit of Emissions
MSC
6
4
The efficient level of emissions is 12 (E) where
MCA MSC.
2
MCA
0
2
4
6
8
10
12
14
16
18
20
22
24
26
E
Level of Emissions
9
9. Ways of CorrectingMarket Failure

• Emission Standard
• Set a legal limit on emissions at E (12)
  enforced by monetary and criminal penalties
• Increases cost of production
• Issues
• Efficient level of emissions varies across firms
• No way for low-abatement-cost polluters to trade
  with high-abatement-cost polluters

10
10. Ways of CorrectingMarket Failure

• Emissions Fee
• Charge levied on each unit of emission
• Tradeoffs
• Every firm faces same incentive to reduce
  pollution
• Some firms will go beyond what standards would
  have required
• Uncertainty about which fee yields E

11
11. Ways of CorrectingMarket Failure

• Transferable Emissions Permits
• Permits help develop a competitive market for
  externalities.
• Agency determines the level of emissions and
  number of permits
• Permits are marketable
• High cost firm will purchase permits from low
  cost firms

12
12. Social responsibility of business
There is one and only one social responsibility
of businessto use its resources and engage in
activities designed to increase its profits so
long as it stays within the rules of the game,
which is to say, engages in open and free
competition without deception or fraud." Milton
Friedman
13
13. Friedmans key arguments

• Economic success is good for society
• Define socially responsible
• Principal-agent issues
• If causes are so great, why havent politicians
  dealt with them?
• Legal, ethical behavior expected

14
14. Strategic considerations

• Social and economic objectives can overlap if
  firm thinks strategically about both
• Corporations can do a better job at philanthropy
  than individuals, foundations, and governments

15
15. Short versus long term tradeoffs

• Relationships with employees and customers
• Meet societal expectations now, avoid onerous
  regulations later

16
16. Implementation issues

• Think social and business simultaneously when
  developing strategy
• Create proper incentives for employees
• Educate employees to do the right thing