Transcript Market Failure-Part 2 File

MARKET
FAILURE (Part 2)
ECONOMICS – A COURSE COMPANION
Blink & Dorton, 2007. p135-146
MICROECONOMICS
TYPES OF MARKET FAILURE
The 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.
TYPES OF MARKET FAILURE
The 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.
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.
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.
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.
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)
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.
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.
How to graph Consumption Externalities:
CONSUMPTION
Externalities
NEGATIVE Externalities of
Consumption
POSITIVE Externalities of
Consumption
What is a practical example?
Smoking – there are some private
benefits of smoking, but there are greater
external costs for other people & society.
The Marginal Social benefits are less than
the Marginal Private Benefits.
Health Care: there are many benefits
for the individual from additional
health care, but the benefits to
society are greater . The Marginal
Social benefits are greater than the
Marginal Private Benefits.
What does it mean in theory?
What curves do I draw?
What terms are used?
2 Demand Curves: Marginal Private Benefit (MPB)
Marginal Social Benefit (MSB)
1 Supply Curve:
Marginal Social Cost (MSC)
How do I draw the curves?
The MPB Curve is above the MSB Curve.
The MPB Curve is below the MSB
Curve
What do I shade?
Shading between the demand curves to
show welfare loss. Shade below the
supply curve, according to the change in
quantity.
Shading between the demand curves
to show welfare gain. Shade above
the supply curve according to the
change in quantity.
How do I fix the problem or
improve the outcome?
(Demand Curves)
Advertising / Non Price Measures
Move the MPB curve towards the MSB Curve, through non-price measures. (eg:
advertising) Just show arrows.
How do I fix the problem or
improve the outcome?
(Supply Curve)
New Tax
By imposing a tax. Draw a new MSC
curve above the original MSC curve.
Subsidy
By introducing a subsidy. Draw a
new MSC curve below the original
MSC curve.
How to graph Production Externalities:
PRODUCTION
Externalities
NEGATIVE Externalities of
PRODUCTION
POSITIVE Externalities of
PRODUCTION
What is a practical example?
Pollution from a Factory: The pollution
from a factory has greater cost to society
(clean up/damage to other industries) than
the cost of making the factory product
itself.
Education/Training: A company that
provides specialist training for its
workers will incur costs, but this leads
to lower costs for society in the long
term (eg: other companies will not
have to train these workers)
What does it mean in theory?
The Marginal Social Costs are greater than
the Marginal Private Costs.
The Marginal Social Costs are less
than the Marginal Private Costs.
What curves do I draw?
2 Supply Curves:
How do I draw the curves?
The MSC Curve is above the MPC Curve.
The MSC Curve is below the MPC
Curve.
What do I shade?
Shading between supply curves to show
welfare loss. Shade above the demand
curve, according to the change in quantity.
Shading between supply curves to
show potential welfare gain. Shade
below the demand curve, according to
the change in quantity.
How do I fix the problem or
improve the outcome?
(Supply Curves)
New Tax
Draw a new MPC curve+tax above the
original MPC Curve.
Subsidy
Draw a new MPC curve below the
original MPC Curve.
Marginal Social Cost (MSC)
Marginal Private Costs (MPC)
1 Demand Curve: Marginal Social Benefit (MSB)
TYPES OF EXTERNALITIES
Externalities may be split into four types:
1. Negative Externalities of production/external
costs.
2. Positive Externalities of production/external
benefits.
3. Negative Externalities of consumption.
4. Positive Externalities of consumption.
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.
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.
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 factory and 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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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
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.
3. Negative Externalities of Consumption
Government 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.
3. Negative Externalities of Consumption
Government 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.
3. Negative Externalities of Consumption
Government Action to Remedy
Taxes on Cigarettes
• The government could impose indirect taxes
on cigarettes in order to reduce consumption.
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.
3. Negative Externalities of Consumption
Government 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!)
3. Negative Externalities of Consumption
Government 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.
3. Negative Externalities of Consumption
Government 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.
3. Negative Externalities of Consumption
Government 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.
NEGATIVE EXTERNALITIES OF PRODUCTION –
ENVIRONMENTAL PROBLEMS IN CHINA
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 a benefit for the whole population.
• Thus the MSB of consuming health care is greater than
the MPB.
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.
4. Positive Externalities of Consumption
Government Action to assist Consumers
Subsidies for Health Care
• The government could subsidise the supply of
health care.
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.
4. Positive Externalities of Consumption
Government Action to assist Consumers
Problems with Subsidising Health Care
• The main problem with such a solution is cost.
• While the provision is possible in many
developed countries, developing countries are
not able to fund such schemes and so do not
fully benefit from the positive externalities
that are to be gained from the consumption of
health care.
4. Positive Externalities of Consumption
Government Action to assist Consumers
Advertising to Consume Health Care Products
• The government could use positive advertising
to encourage people to consume more health
care products/services.
• This would shift the MPC curve to the right,
towards the MSC curve and would thus
increase welfare.
4. Positive Externalities of Consumption
Government Action to assist Consumers
Problems with Advertising
• The problem here is that there may be a high
cost in funding advertising and although the
effect may be beneficial in the long run, the
short run benefits may be minimal.
4. Positive Externalities of Consumption
Government Action to assist Consumers
Government Legislation
• The government could pass laws insisting that
citizens have vaccinations against certain diseases
or have regular checks, but this will only be
successful, if the governments provides this free
of charge.
• Also people often resent laws of this sort being
imposed by the government.
• They may see it as infringement on their civil
liberties.
4. Positive Externalities of Consumption
Another Example - Education
• An important example of a positive externality
of consumption is education, which may have
a marked effect on the welfare of society if its
consumption is increased.
4. Positive Externalities of Consumption
What determines the extent of
government intervention?
• The extent of government intervention will
depend on the amount of external benefits.
• In the case of merit goods such as health care and
education, the positive externalities are very
significant.
• Economic growth is heavily dependent on the
productivity of labour, which is course dependent
on the education and health of the people.
Therefore it is generally a government priority to
have an effective system for providing education
and health care.
OTHER CAUSES OF MARKET FAILURE
The Immobility of Factors of Production
• In a perfect market, in theory, resources more easily
between uses attracted by higher factor payments.
• In reality this does not happen so easily and shortages
of factors and time lags.
• Resources do not always find it easy to more between
industries quickly.
• For example, If the coal industry in the north of the
country is declining and the software industry in the
south is booming, then in theory resources should
move from one to the other. However, this does
happen in reality.
OTHER CAUSES OF MARKET FAILURE
The Immobility of Factors of Production
Structural Unemployment
• Workers may not be able to move easily to
take advantage of new job opportunities,
since they may lack the skills necessary and
may not be prepared to move their
geographical location.
• This results in structural unemployment
caused by occupational and geographical
immobility.
OTHER CAUSES OF MARKET FAILURE
Problems of Information
• Theory tells us that in a perfect market, both
consumers and producers have perfect knowledge of
the market.
• In reality of course, this is not the case and so decisions
are made based on incomplete information.
• This makes it very hard for marginal costs and marginal
benefits to be equated and this leads to market failure.
• Governments may try to improve the flow of
information to correct this market failure, but this is
expensive and may not be possible for all markets.
OTHER CAUSES OF MARKET FAILURE
The creation of Inequality
• The free market often leads to the existence of
large differences in income between different
groups of people in the economy.
• Remember that Pareto optimality does not
signify equality.
• It may be society sees the creation of inequality
as a failure of the market and attempt to use
progressive taxation to redistribute income from
one group of the population in order to benefit a
less fortunate group.
OTHER CAUSES OF MARKET FAILURE
Short-termism
Private Sector
• The private sector is often blamed for making
short-term profit based objectives at the cost of
long-term problems.
• Firms may use up resources in the short term at
rate that means that development in the future
will not be sustained at the present rate.
• This reduces the potential for sustainable
development.
OTHER CAUSES OF MARKET FAILURE
Short-termism
Government Sector
• Governments may intervene in the workings
of the market in the short term in order to
gain results that will lead to re-election, even
though this intervention may go against the
long term best interests of society.
EXAMINATION QUESTIONS
Short Response Questions
1.
With the help of a diagram, explain
why cigarette smoking is a cause of
market failure. (10 marks)
2.
With the help of a diagram, explain
why the provision of health care in an
economy is likely to require
government intervention. (10 marks)
EXAMINATION QUESTIONS
Essay Question
1a. Explain the concept of negative
externalities of production
(10 marks)
1b. Evaluate three policies that may be
used by government to reduce
external costs of production (15 marks)