Ch. 14: More Market Failures: Externalities, Public Goods and Imperfect Information

1. Ch. 14: More Market Failures: Externalities, Public Goods and Imperfect Information An externality is an external cost or benefit resulting from some activity or transaction that is imposed or bestowed upon parties outside the activity or transaction (“bystander”). Sometimes called spillovers or neighborhood effects. • When external costs are not considered in economic decisions, we may engage in activities or produce products are not “worth it.” • When external benefits are not considered, we may fail to do things that are indeed “worth it.” The result of an externality is an inefficient allocation of resources  P  MC Market Failure (when a market fails to allocate resources efficiently P=MC) Buyers and sellers neglect the external effects of their actions when deciding how much to demand or supply market equilibrium is inefficient. (The equilibrium fails to maximize the total benefit to society as a whole.)

2. Production vs. Consumption Externalities Externalities in Production: Negative: classic example is pollution Positive: beekeeper and the orchard Externalities in Consumption: Negative: drunk driving Positive: vaccinations, education

3. Negative Externalities:Marginal Social Cost and Marginal-Cost Pricing Marginal social cost (MSC) is the total cost to society of producing an additional unit of a good or service. • When there is no external cost, there is no difference between MC and MSC • When there is an external cost, MSC is equal to the sum of the marginal cost of producing the product (MC) + the correctly measured marginal damage costs involved in the process of production. MSC = MC + marginal damage costs Example: Suppose a firm that produces widgets also produces pollution as a by-product that is dumped into the local river.

4. Negative Externalities:Marginal Social Cost and Marginal-Cost Pricing At q*, marginal social cost exceeds the price paid by consumers. Output is too high. Market price takes into account only part of the full cost of producing the good.

5. Negative Externalities:Marginal Social Cost and Marginal-Cost Pricing Inefficiency arises because P ≠ MSC. Too much of the good is being produced because we find that P < MSC. This happens because the firm ignores the damage costs. How can we improve the situation? One method is to impose a tax equal to the marginal damage cost What does this achieve? It internalizes the externality Issues: • It may be difficult to measure these damage costs • It will not eliminate the externality; we didn’t advocate zero pollution levels.

6. Internalizing Externalities A tax per unit equal to MDC is imposed on the firm. The firm will weigh the tax, and thus the damage costs, in its decisions.

7. Negative Externalities from Living in a Dorm Marginal private cost (MPC) is the amount that a consumer pays to consume an additional unit of a particular good. Marginal benefit (MB) is the benefit derived from each successive hour of music, or the maximum amount of money Harry is willing to pay for an additional hour of music.

8. Negative Externalities from Living in a Dorm Marginal damage cost (MDC) is the additional harm done by increasing the level of an externality-producing activity by one unit. • Marginal social cost (MSC) is the total cost to society of playing an additional hour of music Playing the stereo beyond more than five hours is inefficient because the benefits to Harry are less than the social cost for every hour above five.

9. Positive Externalities In the case of positive externalities, we again have a market failure in that the free market will produce an inefficient allocation of resources. Marginal private benefit is less than marginal social benefit  not enough is produced (market failure) Solutions? Want to increase the production/consumption of these “positive-externality” producing activities through subsidies Ex: education, vaccinations

10. The Coase Theorem • Government need not be involved in every case of externality. • Private bargains and negotiations are likely to lead to an efficient solution in many social damage cases without any government involvement at all. This argument is referred to as the Coase Theorem. Three conditions must be satisfied for Coase’s solution to work: • Basic rights at issue must be assigned and clearly understood. • There are no impediments to bargaining. • Only a few people can be involved.  Bargaining will bring the contending parties to the right solution regardless of where rights are initially assigned.

11. Indirect and Direct Regulations When the conditions behind the Coase Theorem don’t hold, we often need government intervention to improve the situation • Taxes, subsidies, legal rules, and public auction are all methods of indirect regulation designed to induce firms and households to weigh the social costs of their actions against the benefits. • Direct regulation includes legislation that regulates activities that, for example, are likely to harm the environment.

12. Public Goods Public goods (social or collective goods) are goods that are nonrival in consumption and/or their benefits are nonexcludable. Characteristics of a Public Good: • A good is nonrival in consumption when A’s consumption of it does not interfere with B’s consumption of it. The benefits of the good are collective—they accrue to everyone. • A good is nonexcludable if, once produced, no one can be excluded from enjoying its benefits. The good cannot be withheld from those that don’t pay for it.  These characteristics make it difficult for the private sector to produce them profitably  market failure

13. Why the Market Fails • Because people can enjoy the benefits of public goods whether they pay for them or not, they are usually unwilling to pay for them. This is referred to as the free-rider problem. • The drop-in-the-bucket problem: The good or service is usually so costly that its provision generally does not depend on whether or not any single person pays. Consumers acting in their own self-interest have no incentive to contribute voluntarily to the production of public goods. Solution: public provision • Public provision does not imply public production of public goods. • Problems of public provision include frequent dissatisfaction. Individuals don’t get to choose the quantity they want to buy—it is a collective purchase. We are all dissatisfied!

14. Remember the Provision of Private Goods With private goods, consumers decide what quantity to buy; market demand is the sum of those quantities at each price.

15. Optimal Provision of Public Goods • With public goods, there is only one level of output, and consumers are willing to pay different amounts for each level. • The market demand for a public good is the vertical sum of the amounts that individual households are willing to pay for each potential level of output.

16. Optimal Production of a Public Good Optimal production of a public good means producing as long as society’s total willingness to pay per unit D(A+B) is greater than the marginal cost of producing the good. Problem: figuring out what these demand curves look like • Dictator • Representative Government • Vote

17. Local Provision of Public Goods • According to the Tiebout hypothesis, an efficient mix of public goods is produced when local land/housing prices and taxes come to reflect consumer preferences just as they do in the market for private goods. • The diagram on the previous slide is difficult to identify realistically because people won’t/can’t express their preferences. However, they do vote with their feet. • Local communities with low crime and good schools attract people who value these public goods the highest. In turn, they agree to the high taxes these services necessitate.

18. Imperfect Information Remember that complete and perfect information was necessary for markets (through voluntary exchanges) to achieve the efficient allocation of resources. Most voluntary exchanges are efficient, but in the presence of imperfect information, not all exchanges are efficient. Adverse selection can occur when a buyer or seller enters into an exchange with another party who has more information. Examples: the market for “lemons” the market for insurance

19. Imperfect Information Moral hazard arises when one party to a contract passes the cost of his or her behavior on to the other party to the contract. The moral hazard problem is an information problem, in which contracting parties cannot always determine the future behavior of the person with whom they are contracting. Examples: insurance and 1) risky behavior 2) excessive consumption of medical care

20. Solutions to Imperfect Information Market Solutions: As with any other good, there is an efficient quantity of information production. (will the market achieve this?) • Utility-maximizing Consumers and profit-maximizing firms will gather information as long as the marginal benefits from continued search are greater than the marginal costs. • The World Wide Web has (to some extent) made information gathering less costly  we are acquiring more of it. Government Solutions Information is nonrival in consumption (somewhat like a public good) When information is very costly for individuals to collect and disperse, it may be cheaper for government to produce it once for everybody. Examples: Federal Trade Commission Consumer Product Safety Commission Food and Drug Administration