MARKET FAILURE (Part 2) ECONOMICS – A COURSE COMPANION Blink & Dorton , 2007. p135-146

1. MARKETFAILURE(Part 2) ECONOMICS – A COURSE COMPANION Blink & Dorton, 2007. p135-146 MICROECONOMICS

2. TYPES OF MARKET FAILUREThe existence of externalities • An externality occurs when the production or consumption of a good or service has an effect upon a third party. • If the effect is harmful then we talk about negative externality. There is an external cost that must be added to the private cost of the producer or consumer to reflect the full cost to society.

3. TYPES OF MARKET FAILUREThe existence of externalities • If the effect is beneficial, then we call it a positive externality . There has been an external benefit to add to the private benefits of the producer or consumer.

4. PRODUCTION EXTERNALITIES Marginal Private Cost (MPC) • The MPC is essentially the “private” supply curve that is based on the firm’s cost of production. It is does not include any external costs that this production may generate.

5. PRODUCTION EXTERNALITIES Marginal Social Cost (MSC) What is Marginal Social Cost? (MSC) • The marginal social cost of an activity is the total cost of that activity, both privately and externally. • The total cost to society, therefore, must include the private cost, because society's resources are being used in the production process, and the external cost, because some of society's resources must be used to clean up the mess. • The marginal social cost, represents the true supply curve (and, therefore, the true marginal cost of production) for society as a whole, allowing for the external cost of production.

6. Can there be no externalities of production? • YES in theory, (in perfect markets) but this is very unlikely. • If there are no externalities of consumption, then MSB = MPB.

7. What does it mean to have no externalities of production? • There is social efficiency and so maximum community surplus. • If externalities do exist, then MSC does not equal MSB. • There is market failure and inefficient allocation of society’s resources. (negative externalities of production)

8. CONSUMPTION EXTERNALITIES: Marginal Private Benefit (Key Concept) • The individual benefit obtained by a consumer using a product. • There is no consideration of external benefits for society. • The MPB is essentially the “private” demand curve that is based on the utility or benefits to consumers.

9. CONSUMPTION EXTERNALITIES:Marginal Social Benefit (Key Concept) What is Marginal Social Benefit? (MSB) • Marginal social benefit (MSB) is equal to the private marginal benefit a good provides plus any external benefits it creates. In other words, MSB gives the total marginal benefit of the good to society as a whole. • It is called the true or real demand curve for society.

10. How to graph Consumption Externalities:

11. How to graph Production Externalities:

12. TYPES OF EXTERNALITIES Externalities may be split into four types: • Negative Externalities of production/external costs. • Positive Externalities of production/external benefits. • Negative Externalities of consumption. • Positive Externalities of consumption.

13. 1. Negative Externalities of Production/External Costs • These occur when the production of a good or service creates external costs that are damaging to third parties. • These relate mainly, but not exclusively to environmental problems.

14. 1. Negative Externalities of Production/External Costs Example: Paint Factory emitting fumes • If a paint factory emits fumes that are harmful to people in the area, then there is a cost to the community that is greater than the costs of production by the firm. • The firm has private costs, but then, on top of that, is creating external costs. • The marginal social cost of production is greater than the marginal private cost.

15. NEGATIVE EXTERNALITY OF PRODUCTION In this diagram the marginal private costs of the firm are below the marginal social cost, because there is an extra costs to society caused by the pollution that is created. This could be respiratory problems for people in the neighbourhood of the polluting firm. The firm will only be concerned with its private costs and will produce at Q1. It is not producing at Q* where the marginal social cost is equal to the marginal social benefit and so it is a market failure. There is a misallocation of society’s resources: too much paint is being produced at too low a price. If the price of paint was increased money could be spent on reducing the pollution from the factoryand or cleaning up the mess. There is a welfare loss to society of the extra units from Q1 to Q* because the MSC is greater than the MSB for those units. This is shown by the shaded triangle.

16. Negative Externalities – Government Action to address issue Taxes on Pollution • The government could tax a firm in order to increase the firm’s private costs and so shift the MPC curve upwards towards the point of social efficiency. • If the tax is equal to the external cost of the production, then we say the government has internalised the externality. • If the tax is not equal to the external cost, then it will reduce the deadweight burden, but not eliminate it.

17. TAXING A NEGATIVE EXTERNALITY OF PRODUCTION The government decides to impose a tax on a paint factory emitting pollution. However, the tax is not equal to the external cost. It reduces the deadweight burden, but does not eliminate it. This is illustrated in this graph. There is still a welfare loss, but it less than under the free market with no government interference.

18. Negative Externalities – Government Action to remedy Problems with Taxes • Although taxes are seen as a way of making the polluter pay, there are some problems with this solution. • First is often difficult to measure the accurately the pollution created and to put a value on it, which can be regained by the tax. • Second, it also difficult to identify which firms are polluting and to what extent each firm is responsible for the pollution. • Third, it is often argued that taxes do not actually stop the pollution from taking place.

19. Negative Externalities – Government Action to remedy Legislation • The government could legislate and could ban the polluting firms or restrict their output in some way. • It also pass laws relating to measureable environmental standards in the firms production units. • To meet the standards, the firm would have to spend money, thus increasing their private costs.

20. Negative Externalities – Government Action to remedy Problems with Restricting Output • A ban or restriction may lead to job losses and the non-consumption of whatever was being produced, which may have been a valuable product. • Also the cost of setting and policing (enforcing) standards may be greater than the cost of the pollution.

21. Negative Externalities – Government Action to remedy Tradeable Emission Permits • The government could issues tradeable emission permits. • These are a market-based solution to negative externalities of production. • Tradeable emission permits are issued by the government and give firms the licence to create pollution up to a set level. • Once they are issued firms can buy, sell and trade permits on the market.

22. Negative Externalities – Government Action to remedy Tradeable Emission Permits (continued) • The government decides upon the level of pollution that will permit each year and then splits the total level of pollution up into a number of tradeable emission permits, each allowing a certain level of pollution. • The government then allocates these permits to individual firms. • Thus each firm now has a quota of emissions that it is allowed to produce.

23. Negative Externalities – Government Action to remedy Tradeable Emission Permits – Market Operation • The trading system means that it is the interests of firms to pollute as little as possible. • If a firms pollutes at a higher level that its permit allows, it will need to buy permits from other firms and this will raise its costs. • If a firm pollutes less than they are allowed, then they can sell their permit and make money. • In the USA, the emission of chloroflurocarbons (CFCSs) is controlled by the use of tradable emission permits.

24. Negative Externalities – Government Action to remedy Tradeable Emission Permits – Problems • One problem with this solution is that it does not lead to the reduction of pollution, once the allowable limit has been set. • Firms simply pay the cost of polluting, some polluting heavily and other not. • Also the government faces a difficult decision when setting an acceptable level of pollution and it also difficult to measure firm’s pollution output.

25. The Kyoto Protocol • A form of tradable emission permits is being used an international level to reduce the emission of greenhouse gases (GHG) • The Kyoto Protocol is an agreement made under the United Nations Framework Convention on Climate Change. • Its objective is to cut global emissions of greenhouse gases. • The treaty was negotiated in Kyoto, Japan in 1997 and came into force in February 2005.

26. The Kyoto Protocol • The treaty covers more than 163 countries globally and over 65% of global GHG emissions. • Two countries – Australia & the US signed the treated but did not initially ratify it. However, this all changed in November 2007, with the election of the Rudd Government in Australia and the Obama Administration in January 2009.

27. 2: Positive Externalities of Production/External Benefits • These occur when the production of a good or service creates external benefits that are good/ advantangeous for third parties.

28. 2: Positive Externalities of Production/External Benefits Example • A large printing firm provides high quality training to its employees. • This is a cost of the firm. • When employees leave the printing firm and go to other firms, there is a benefit to the other firms who do not have spend money on training their new workers. • Society has gained from the training, given by the printing firm. • The marginal private cost to the firm, is greater than the marginal social cost.

29. POSITIVE EXTERNALITY OF PRODUCTION In this graph, the printing firm produces at a level of output Q1 that is above the socially efficient level of, Q*. Between Q1 and Q* there is a potential welfare gain shown by the shaded triangle. If output could be increased to Q* then welfare would be gained, because for all of the units from Q1 to Q* MSB is greater than MSC.

30. 2: Positive Externalities Government Action to Assist Firms • On face value positive externalities, should not require any government assistance. • However, if firms have to provide extensive training to their employees this increases their costs, and lowers their profitability. • Therefore the government may decide to assist these firms in some form.

31. 2: Positive Externalities Government Action to Assist Firms Training Subsidies • The government could subsidise the firms that offer the training. • If this were to happen, then the MPC curve would be shifted downwards by the subsidy, and if a full subsidy was given, then MPC would be the same as the MSC and the socially efficient point of “a” would be reached.

32. 2: Positive Externalities Government Action to Assist Firms Training Subsidies – Problems • Two main problems. • First, it very difficult for government to estimate the level of subsidy deserved by individual firms. • Second the cost of the subsidies would probably imply an opportunity cost and it is likely that the government would cut back on spending in other areas, which may be more worthy than this one.

33. 2: Positive Externalities Government Action to Assist Firms Training Centres • The government could provide vocational training, by setting up training centres for workers in certain industries. • Although this is a possibility, the costs would be high, the trainers may lack the expertise found in firms and it may dissuade firms from offering training of their own.

34. 3. Negative Externalities of Consumption • There are many products, that when consumed by individuals adversely affect third parties. • Examples include cigarettes and secondary smoking, cars and air pollution, loud music and noise pollution. • The negative externalities of consumption produced make the marginal social benefits in each case less than the marginal private benefits. • The private utility is diminished by the negative utility suffered by third parties.

35. 3. Negative Externalities of Consumption Cigarettes Case Study • People who smoke presumably enjoy some private benefits of smoking, but this will create external costs for other people. • This is commonly referred to as passive smoking, or second-hand smoking • Other than simple discomfort at the smell of cigarettes, the cost to others are significant

36. NEGATIVE EXTERNALITY – CIGARETTES As there is a free market, consumers will maximise their private utility (benefit) and consume at a level where MSC=MPB. They will ignore the negative externality they are creating. This means they will over-consume cigarettes by smoking Q1 cigarettes as a price of P1. The socially efficient output is at Q* and so there is over consumption of from Q* to Q1. Since the MSC is greater than the MSB for these units, there is a welfare loss to society and a market failure.

37. 3. Negative Externalities of ConsumptionGovernment Action to Remedy Cigarettes Case Study The government will act to reduce or eliminate The negative externality. There are number of options: • It could ban cigarette smoking totally – make it illegal to smoke.

38. 3. Negative Externalities of ConsumptionGovernment Action to Remedy Banning Smoking Totally – Problems • Banning smoking would have a large effect upon the tobacco industry in terms of shareholders and employments. • Governments also make a lot of revenue by taxing cigarettes, which have price inelastic demand, because they are habit forming. • It must also be remembered that governments need votes and smokers are not likely to vote for a government that bans smoking. • However, many governments have placed partial bans on smoking in certain places.

39. 3. Negative Externalities of ConsumptionGovernment Action to Remedy Taxes on Cigarettes • The government could impose indirect taxes on cigarettes in order to reduce consumption.

40. TAXES ON CIGARETTES If the government imposes an indirect tax then this will shift the MSC curve upwards to MSC + tax. This will reduce consumption to the socially efficient level of output Q*, but the price to consumers will be P2. The government will gain significant revenue and this may be used to correct some of negative externalities caused by smoking.

41. 3. Negative Externalities of ConsumptionGovernment Action to Remedy Problems with Taxes on Cigarettes • The inelastic demand for cigarettes tends to mean that taxes do not manage to reduce quantity demanded very much, and so while government revenue is raised, quantity demanded does not fall to the socially efficient level (which some would argue was zero!)

42. 3. Negative Externalities of ConsumptionGovernment Action to Remedy Problems with Taxes on Cigarettes • If taxes are raised too much, then experience suggests that people start to look for other sources of supply. • This can be seen in Europe, where smokers go to other countries where cigarettes are cheaper. For example Austrian smokers can go over the border to Slovakia. • Often this process is illegal and so a black market may be formed.

43. 3. Negative Externalities of ConsumptionGovernment Action to Remedy Education Programs Against Smoking • The government could provide education about the dangers of smoking and also fund negative advertising in order to reduce demand for cigarettes and thus shifting the MPB curve to the left.

44. 3. Negative Externalities of ConsumptionGovernment Action to Remedy Problems with Education programs • There are doubts as to the effectiveness of anti smoking programs. • Many teenagers, seem prepared to accept the dangers of smoking and are little affected by measures to put them off.

46. NEGATIVE EXTERNALITIES OF PRODUCTION – ENVIRONMENTAL PROBLEMS IN CHINA

47. 4. Positive Externalities of Consumption • There are certain goods or services which when consumed (used) will provide external benefits to third parties. • When people “consume” health care, for example, they create positive externality for society. • If people are healthier, then they will not pass on illnesses so that other people around them are less likely to become ill. In addition a healthier workforce means that the economy will be more productive, which may be abenefit for the whole population. • Thus the MSB of consuming health care is greater than the MPB.

48. POSITIVE EXTERNALITY OF PRODUCTION – HEALTH CARE In a free market for health care (no subsidy), people will consume at Q1 at a price of P1. However, the socially efficient level of consumption would be Q* where MSB = MSC. There is a potential welfare gain shown by the shaded triangle, because of the units Q1 to Q*, MSB is greater than MSC. If the consumption of health care increases from Q1 to Q* then welfare in society will increase.

49. 4. Positive Externalities of ConsumptionGovernment Action to assist Consumers Subsidies for Health Care • The government could subsidise the supply of health care.

50. SUBSIDIES FOR HEALTH CARE A subsidy would shift the MSC curve downwards and in this way, the socially efficient level of consumption at Q* would be reached, with a price of P2. The government may deem the importance of health care to be so great, that it will subsidise it to the point where it is free to consumers.