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Market Failure

Market Failure. “It isn't pollution that's harming the environment. It's the impurities in our air and water that are doing it.” Dan Quayle 44 th US Vice President. NINE. Market Failure. In this chapter: Externalities as source of market failure External Costs External Benefits

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Market Failure

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  1. Market Failure “It isn't pollution that's harming the environment. It's the impurities in our air and water that are doing it.” Dan Quayle 44th US Vice President NINE

  2. Market Failure • In this chapter: • Externalities as source of market failure • External Costs • External Benefits • Market Failure and Provision of Public Goods • Government Failure: Theory of Public Choice • Voters and Rational Ignorance • Limits of Majority Voting

  3. Market Failure • Market Failure • A market’s JOB is to allocate resources efficiently based on demand and supply. • When markets “fail” to produce efficient quantities of goods and services, market failure occurs. • Either too much or too little is produced. • Market failure is often caused by externalities (external costs or benefits).

  4. Externalities • External Costs • Suppliers decide how much to produce and what resources to use in production by considering their OWN costs of production - private, or internal, costs. • If there are costs that occur because of the production or consumption of the goods that are borne by someone other than the parties in the market, they are called external costs, or negative externalities. • The market only knows about the private (internal) costs when drawing the supply curve, so it cannot accurately define market equilibrium.

  5. Externalities • External Costs http://perfectsubstitute.blogspot.com/2009/03/negative-externalities-example.html • Examples of External costs (negative externalities) • Second-hand smoke • Air and water pollution • Noise pollution • Alcohol-related accidents • Lower home values due to neighborhood foreclosures • When private costs (costs of players in the market) are less than social costs (private costs + external costs), negative externalities exist in the market. • When there are negative externalities, the market will over-produce the good or service (make too much) because it does not know about ALL the costs.

  6. The Impact of External Costs • A supply curve is a marginal cost curve. • S1 measures the marginal private costs of the producer, those costs on which the producer is basing his output decision. • S2 shows us the new supply curve after external costs are added to the private costs. • MSC = MPC + external costs.

  7. The Impact of External Costs • Considering only private costs, the market finds equilibrium at Q=120, P=$8. • If the market had some way to know about the external costs, output would be based on social costs, not private. • Based on social costs, equilibrium should be Q=100, P=$10. • Lower quantity, higher price. This market has failed to allocate resources efficiently (used too many).

  8. Externalities • External Benefits • Consumers decide what and how much to consume by considering their OWN benefits of consumption - private, or internal, benefits. • If there are benefits that occur because of the production or consumption of the goods that are enjoyed by someone other than the parties in the market, they are called external benefits, or positive externalities. • The market only knows about the private (internal) benefits when drawing the demand curve, so it cannot accurately define market equilibrium.

  9. Externalities • External Benefits • Examples of External Benefits (positive externalities) • Education benefits more than just students • Vaccinations benefit more than just the ones vaccinated • Good health benefits more than just the healthy • When private benefits (gains of players in the market) are less than social benefits (private benefits + external benefits), positive externalities exist in the market. • When there are positive externalities, the market will under-produce the good or service (make too little) because it does not know about ALL the benefits.

  10. The Impact of External Benefits • A demand curve is a marginal benefit curve. • D1 measures the marginal private benefit of the consumer, those benefits on which the buyer is basing his consumption decision. • D2 shows us the new demand curve after external benefits are added to the private benefits. • MSB = MPB + external benefits.

  11. The Impact of External Benefits • Considering only private benefits, the market finds equilibrium at Q=3 (million students), P=$3,000. • If the market had some way to know about the external benefits, output would be based on social benefits, not private. • Based on social benefits, equilibrium should be Q=5, P=$4,200. • Higher quantity, higher price. This market has failed to allocate resources efficiently (used too few). Society wants more.

  12. Internalizing the Externalities • External Costs • How does the market internalize the external costs (make the external costs private)? • Taxes • Limit or ban production • Private bargaining

  13. Internalizing the Externalities • External Benefits • How does the market internalize the external benefits (make the external benefits private)? • Subsidies • Govt. regulation • Private bargaining

  14. Market Failure & Provision of Public Goods • Market failure can also occur because some goods are not well suited to being provided in private markets. • Consider three types of goods: • Pure private goods – only consumer benefits. • Semi-private goods – paying consumer benefits most, but society also benefits (positive externalities). • Public goods – Paying and nonpaying consumers benefit equally.

  15. Market Failure & Provision of Public Goods • Public goods • No way to exclude non-paying consumers. • Subject to free-rider problem. • Why should I pay if you can get the same thing without paying? When I learn that, I’ll quit paying too. • The private free market will not provide this good because they cannot make a profit. • Government will have to provide the good. • Examples of public goods: national defense, hurricane warning, police protection, flood-prevention dams, public TV (until this year)

  16. Government Failure: Theory of Public Choice • Government Failure • Enactment of government policies that produce inefficient or inequitable results. • Public Choice Theory • Study of how government makes economic decisions. • Consider government to be collection of individuals, each pursuing his or her own self-interest. • Individuals remain rational and self-interested even when acting as voters, politicians and government bureaucrats. • Just as firms maximize profit, and consumers maximize utility: • Politicians maximize votes • Bureaucrats maximize income, power and longevity

  17. Government Failure: Theory of Public Choice • Voters and Rational Ignorance • Self-interested voters support politicians that will do most for them, providing greatest benefits at lowest cost. • Unfortunately, voters tend to be less well informed than consumers. • When shopping for an expensive item, consumers will spend time and effort (pay high opportunity cost) doing research. • Voters know their vote isn’t likely to determine the outcome, so they have little incentive to pay the cost of being informed. • Rational ignorance: Voters choose to remain uninformed because the cost of becoming informed outweighs the benefits. • This is one reason campaigning is so expensive – it’s difficult to get the attention of rationally ignorant voters.

  18. Government Failure: Theory of Public Choice • Limits of Majority Voting • The voting mechanism can also lead to inefficient outcomes, even when voters are perfectly informed about costs and benefits. • Consider a vote for whether a flood-control dam is going to be built: • The voters that live nearby will likely benefit much more than those living far away. • Voters far away may not be willing to pay the costs if they aren’t going to collect any benefits. • The dam project is likely to be rejected, even if it was an efficient use of society’s resources. • The problem? Voters cannot express the strength of their preference. They can vote for or against, but not HOW MUCH they are for it, or HOW AGAINST it they are.

  19. Market Failure • Key Terms: • External benefits • External costs • Externalities • Government failure • Internal benefits • Internal costs • Internalize costs • Market failure • Private benefits • Private costs • Public choice theory • Public goods • Pure private goods • Rational ignorance • Semi-private goods • Social benefit • Social cost

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