Economics in Policy Analysis

1. Economics in Policy Analysis Market failure II

2. Market failures Market failure: violation of assumptions that underlie competitive markets, which makes decentralized market behavior inefficient. • Externalities • Monopoly • Information asymmetry • Public Goods

3. Negative externality • Social costs exceed private costs!

4. S (social costs) P S (private costs) Ps Pp D Qs Qp Q Negative externality

5. S (social costs) P S (private costs) a Ps f b d e Pp g c h D Qs Qp Q Negative externality

6. S (social costs) P S (private costs) a Ps f b d e Pp g c h D Qs Qp Q Negative externality (uncorrected) CS: abde Pollution costs: hgdefg PS: chg

7. S (social costs) P S (private costs) a Ps f b d e Pp g c h D Qs Qp Q Negative externality (uncorrected) Pollution costs imposed upon society if Q=Qp (hgdef)

8. S (social costs) P S (private costs) a Ps f b d e Pp g c h D Qs Qp Q Negative externality (corrected) CS: a Pollution costs: hd PS: bdch

9. Negative externality Free market Efficient Change (column 2 – 1) Consumer S abde a -b –d -e Producer S chg bdch -g +b +d Pollution * -hgdef -hd +g+e+f TOTAL CHANGE: f *Pollution is negative because it is BAD; think of it as a negative benefit. Consumer and Producer surpluses are positive benefits. -hd – (-hgdefg) = -hd+hgdefg = gef

10. S (social costs) P S (private costs) a Ps f b d e Pp g c h D Qs Qp Q Negative externality

11. Negative externality • Social costs exceed private costs! • Negative externality leads to overproduction and underpricing of relevant good/services.

12. Example: how to transport goods from CA to NC?

13. Example: trucks vs train

14. What policies could help? tax the good/service, restrictions, property rights Negative externality

15. Positive externality • Social benefits exceed private benefits!

16. P S (private costs) Pp D (private) Qp Q Positive externality

17. P ☺ ☺ S (private costs) ☺ Ps Pp ☺ D (private) Qp Qs Q Positive externality

18. P g S (private costs) f h Ps d e i Pp c ☺ a b D (private) Qp Qs Q Positive externality

19. P g S (private costs) f h Ps d e i Pp c ☺ a b D (private) Qp Qs Q Positive externality (efficient) Consumer S: f Additional social benefit: gh Producers surplus: aedi

20. P g S (private costs) f h Ps d e i Pp c ☺ a b D (private) Qp Qs Q Positive externality (uncorrected) Consumer S:ef Additional social benefit: gd Producers surplus: a

21. Positive externality (uncorrected) Free market Efficient Change (column 2 – 1) Consumer S ef f -e +Social benefits gd gh +h -d Producer S a aedi +e +d +i TOTAL CHANGE: i h

22. Positive externality • Social benefits exceed private benefits! /Graph/ • Positive externality leads to underproduction and overpricing of relevant goods/services; • Optimal consumption: social benefits= social costs

23. Examples of policy responses to externality problems (?) • Negative externality: tax, restrictions, property regulation • Positive externality: subsidy, vouchers, etc

24. Natural monopoly • Why are monopolies inefficient? • Natural monopolies: scale effect makes one large producer more efficient. • i.e. a single producer can produce the output at a lower cost • Examples? Infrastructure (electricity, water)

25. Policy responses to monopoly problems • Price/quality regulation • Government provision

26. Information asymmetry Search goods: consumers can determine its characteristics with certainty prior to purchase Experience goods: consumers can determine its characteristics only after purchase