Market Failure

1
Market Failure
2
All pollution should be eliminated.

1. Strongly Agree
2. Agree
3. Neutral
4. Disagree
5. Strongly Disagree

1 2 3 4 5
3
Market Failure

• When the market does not efficiently allocate
  resources
• Either too much or too little is produced
• Monopoly
• Externalities
• Public goods

Justification for government intervention?
4
Externalities

• Occur when decision makers do not consider all
  costs (or benefits) of their actions
• Two views

Spillover effects
A. C. Pigou
Ronald Coase
5
Pigouvian Approach

• Social Cost Private Cost External Cost

Drinking Alcohol
6
Pollution
Ssocial

Sprivate

• Free Market P1, Q1
• Optimal Outcome P2, Q2

P2
P1
External cost
Free market overproduces goods that generate a
negative externality
D1
steel
Q1
Q2
How can society achieve social optimum?
? Impose tax marginal external cost
Pigou tax
Internalize the externality!
7
The efficient output will be less than the free
market output when

1. Marginal social cost and marginal private cost
   are equal
2. Marginal social cost is greater than marginal
   private cost
3. Marginal social benefit and marginal private
   benefit are equal
4. Marginal social benefit is greater than marginal
   private benefit

1 2 3 4 5
8
Education

S1

• Free Market P1, Q1
• Optimal Outcome P2, Q2

P2
External benefit
P1
Free market underproduces goods that generate a
positive externality
Dsocial
Dprivate
Years of College
Q1
Q2
How can society achieve social optimum?
? Provide subsidy marginal external benefit
9
If there is a positive externality, the

1. social benefits will be greater than the private
   benefits
2. external benefits will be greater than the social
   benefits
3. social benefits will be equal to the private
   benefits
4. private benefits will be greater than the social
   benefits

1 2 3 4 5
10
A consequence of a negative consumption
externality is that social benefits are ______
than private benefits, and the socially optimal
level of output is ______ than the private level
of output.

1. greater greater.
2. greater less.
3. less less.
4. less greater.

1 2 3 4 5
11
Cashmere Externalities
12
Coasian Approach

• Externalities are due to incomplete property
  rights assignment

It takes two to tango
13
Aunt Linda and the Nudist
Rifle River
Aunt Linda
Nudist
1500
1200
1000
Judge rules in favor of Aunt Linda Judge rules
in favor of Nudist
Fence comes down
2 rulings
Fence comes down (Linda pays Nudist)
14
Coasian Approach

• Externalities are due to incomplete assignment of
  property rights

Coase
Theorem If property rights are well-defined and
transactions costs are low enough, then private
bargaining can result in an efficient allocation
of resources.

Corollary Allocation of resources does not depend
on initial assignment of property rights.
15
Pollution Revisited
16
Cheshire, Ohio v. AEP

• AEP paid 20 million to buy the 221-resident town
  in 2002

17
A factory's production process creates sludge
that pours into a river. This sludge makes it
difficult to fish in the river, increasing the
costs of the local fishermen by 5000. The
factory can install a water filter system for
4100, and the fishermen can utilize a weighted
fishing net system (to get under the sludge) for
3250. Both systems would remedy the sludge
damage to the fishermen.
Factory
Nets 3250
Filter 4100
Damage 5000
a) Transactions costs low and factory is not
liable for damage?
b) Transactions costs low and factory is liable
for damage?
c) Transactions costs high and factory is liable
for damage?
18
Pollution Worksheet

• Optimal pollution for Marietta-Parkersburg area
  is 60,000 units of emissions
• Abatement Cost
• Cars 5
• Utilities 10
• Factories 20
• Controlling pollution through
• Standards
• Taxes
• Tradable Permits

19
Standards

• Command-and-Control approach
• Emission standards
• Technology standards

Set a maximum emissions of 20,000 units per
source
SOURCE EMISSIONS EMISSIONS ABATED ABATEMENT COSTS
CARS
UTILITIES
FACTORIES
TOTAL
20,000
0
0
20,000
10,000
100,000
20,000
20,000
400,000
60,000
30,000
500,000
20
Standards
Require each source to cut emissions by 10,000
units
SOURCE EMISSIONS EMISSIONS ABATED ABATEMENT COSTS
CARS
UTILITIES
FACTORIES
TOTAL
10,000
10,000
50,000
20,000
10,000
100,000
30,000
10,000
200,000
60,000
30,000
350,000
21
Standards
Require each source to cut emissions by 1/3
SOURCE EMISSIONS EMISSIONS ABATED ABATEMENT COSTS
CARS
UTILITIES
FACTORIES
TOTAL
33,335
13,333
6,667
100,000
20,000
10,000
266,660
26,667
13,333
399,995
60,000
30,000
22
Standards
Cost minimizing strategy of reducing emissions by
30,000 units.
SOURCE EMISSIONS EMISSIONS ABATED ABATEMENT COSTS
CARS
UTILITIES
FACTORIES
TOTAL
0
20,000
100,000
20,000
10,000
100,000
40,000
0
0
60,000
30,000
200,000
200,000 Solution
23
Taxes
A tax of t 6 per unit of pollution is imposed
SOURCE EMISSIONS EMISSIONS ABATED ABATEMENT COSTS TAX COSTS
CARS
UTILITIES
FACTORIES
TOTAL
0
20,000
100,000
0
30,000
0
0
180,000
40,000
0
0
240,000
70,000
20,000
100,000
420,000
24
Taxes
A tax of t 11 per unit of pollution is
imposed
SOURCE EMISSIONS EMISSIONS ABATED ABATEMENT COSTS TAX COSTS
CARS
UTILITIES
FACTORIES
TOTAL
0
20,000
100,000
0
0
30,000
300,000
0
40,000
0
0
440,000
40,000
50,000
400,000
440,000
25
Taxes
A tax of t 10.05 per unit of pollution is
imposed only on factories for each unit of
pollution over the 60,000 limit, regardless of
the source.
SOURCE EMISSIONS EMISSIONS ABATED ABATEMENT COSTS TAX COSTS
CARS
UTILITIES
FACTORIES
TOTAL
20,000
0
0
0
30,000
0
0
0
40,000
0
0
301,500
90,000
0
0
301,500
If transactions costs low enough, then 200,000
solution can be achieved through private
bargaining.
26
Cap and Trade Program
S

F
20
Abatement Cost
P 10 Q 60,000
U
10
C
5
D
40
70
90
60
permits
2008 Spot Auction
2008 7-yr Advance Auction
200,000 Solution
27
(No Transcript)
28
Neighborhood Park Fund
29
Characteristics of Goods

• Excludability can you be excluded from consuming
  the good?
• Rivalry does my consumption hinder your
  consumption?

Rival in consumption Non-rival in consumption
Excludable
Non-Excludable
Artificially Scarce Goods
Private Goods
Common Resources
Public Goods
30
Government Provided Goods and Services

• Schools
• Roads
• Police
• Courts
• Fire Department
• Water
• Library
• Health Care
• Transportation

• National Defense
• Social Security
• Medicare
• Postal Service
• FBI, CIA, SEC, FTC, FCC, NSF, FDA, ARC, FDIC,
  NLRB, HUD

31
National Defense

• Federal Government spent 600 billion in 2006

Per capita expenditure
How do we pay for this?
National Defense Telethon?
? Taxes!
32
Public Goods

• Problems
• free-rider problem
• Under-provision by free market
• Social Optimum requires MSB MSC
• Must find some way to aggregate individual
  marginal benefits

33
Fireworks in Marietta
Quantity Mikis MB Antonys MB Carlas MB SMB MC Total Benefit Total Cost Net Benefits
10 8 5 9 10
20 7 4 8 10
30 6 3 6 10
40 5 2 4 10
50 4 1 2 10
60 3 0 1 10
22
22
10
12
19
41
20
21
15
56
30
26
11
67
40
27
7
74
50
24
4
78
60
18
34
The table below shows the marginal benefit from
submarines for the only two citizens of a
country. Submarines are a public good. If
submarines cost 175 a piece to produce, what is
the efficient quantity of submarines?

1. 0
2. 1
3. 2
4. 3
5. 4
6. 5

Kathy Bobby
Marginal benefit (dollars per submarine) Quantity Marginal benefit (dollars per submarine)
100 1 150
75 2 100
50 3 50
25 4 10
0 5 0
1 2 3 4 5
35
Artificially Scarce Goods

• Excludable
• Non-Rival
• Examples
• Software
• Pay-per-view movies
• pharmaceuticals

Marginal Cost of provision is zero

P1
MC
D
MR
Drugs
Q1
Q0