PART 10 Market Failures

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PART 10Market Failures

• Markets may fail to generate efficient results
  due to
• Monopoly
• Externalities
• Public Goods
• Open Access
• Markets may also have informational
  problemsadverse selection and moral hazard

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Externalities

• An externality is a cost or a benefit that is not
  reflected in market demand or supply curves
• An effect external to the market
• Environmental pollution, congestion in cities, etc

MSC

S (MC)
D (MB)
Q
Q
Output
3
Pollution and Abatement

• Pollution imposes costs
• Abatement of pollution is also costly
• Optimal amount of pollution is where MC of
  pollution is equal to its MB
• Marginal benefit of pollution is the abatement
  cost saved
• Can also think of this as the MC and MB of
  abatement

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Pollution and Abatement

• Optimal quantity of pollution

MC
MB
Pollution
P
P
If the affected parties cannot negotiate the
market will produce P pollution
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Pollution and Abatement

• Optimal quantity of abatement

MC
MB
0
Abatement
A
If the affected parties cannot negotiate the
market would produce no abatement.
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Externalities and Transactions Costs

• Externalities can be thought of a being caused by
  a lack of property rights or high transactions
  costs (costs of negotiation or litigation)
• The Coase Theorem
• Important point is that the world is a world of
  positive transactions costs, so that
  externalities are common

7
Externalities and Transactions Costs

• Example A lake which can be used for recreation
  (by a fishing club) or waste discharge by a firm
• We can think of the costs and benefits of the
  abatement of pollution
• The costs are the costs of reducing waste
  discharge, the benefits are the better fishing

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Externalities and Transactions Costs

MC
MB
0
A
A
Abatement
0 no abatement A complete abatement A
optimal level of abatement
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Externalities and Transactions Costs

• If the firm and the fishing club could negotiate
  without cost then regardless of who has the
  property right they would negotiate to A
• If there are high costs to negotiating and the
  fishing club has the property right end up at A
  (MCgtMB of abatement)
• If there are high costs to negotiating and the
  firm has the property right end up at 0 (MBgtMC of
  abatement)
• Transactions costs are usually high, so the
  market results in inefficient allocation of
  resources

10
Policy Towards Externalities

• Regulation by standards
• If the standard to be achieved is the same for
  all firms this can result in inefficiency

MB2

MB1
Pollution
Standard
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Policy Toward Externalities

• Taxes or charges

MB2
MB1
Unit charge
Pollution
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Policy Toward Externalities

• Emission Charges
• Polluter pays for pollution
• Problems of estimation
• Taxes
• Set tax equal to excess of the marginal social
  cost over the marginal private cost
• Marketable permits
• Potentially efficient results with correct market
  design.

13
Public Goods

• A public good is a good that has to be provided
  to everyone or to no one
• National defense, clean air, lighthouses, public
  health
• Pure public goods characterized by non-rival
  consumption and non-excludable use

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Public Goods

• Rivalry and excludability

Rival
Non-rival
Artificially scarce goods
Excludable
Most goods
Non- excludable
Public goods
Open access
Artificially scarce goods often have close
to zero MC of production. Private producers
have to find ways of limiting distribution to
those who pay. Examples include computer
software, downloadable music, pay per view TV.
Some inefficiency in private provision.
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Public Goods

• Public goods and the free rider problem
• If provided the good will be provided even to
  those who do not pay
• Lack of incentive to paypeople will try to free
  ride
• Provision by voluntary contribution
• Provision by government

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Benefits of a Public Good

• One persons consumption of a unit of a public
  good does not exclude others
• Marginal willingness to pay (MB) for the first
  unit of a public good is the vertical sum of the
  marginal willingness to pay of all individuals
• If I am willing to pay 100 for a one unit
  improvement in air quality and you are willing to
  pay 50 for a one unit improvement in air quality
  the MB of that improvement is 150

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Optimal Provision of a Public Good

• The optimal level of provision for a public good
  is where MBMC (economic efficiency)
• If left to the market the good will be
  under-provided (cannot capture peoples
  willingness to pay)
• Public provisionwill government provide the
  optimal amounts of a public good?

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Open Access

• Common property resources
• Problem of free entry and overuse of the resource
• Tragedy of the Commons
• Regulation, tax, assign some form of property
  right to individuals or groups
• System of tradable licenses
• Example of fisheries