Market failure: Externalities & Public goods

1. Market failure: Externalities & Public goods

2. Part I: Externalities

3. Price Competitive markets achieve Allocative efficiency (maximum satisfaction) when the highest price the consumer is willing to pay = the cost of producing the next unit of the good(P= MB = MC)... …this means the market price reflects ALL benefits received and ALL costs of production. In many circumstances, there are costs or benefitsfrom producing or consuming a good that go toothers that are not involved in this market. This results in MARKET FAILURE. Supply = Sum of MC The Competitive Situation MB = MC MC PC PC d = MR = MB Demand = MB qC QC Quantity quantity Competitive Market Competitive firm in Market

4. Market Failure • Competitive markets become Allocatively inefficient because buyers and sellers do not take into accountall benefits and/or all costsfrom production of a good... …because they haveno incentiveto take into account EXTERNAL COSTS and BENEFITS which accrue to someone besides themselves(buyers & sellers). Why? Because they either don’t have to pay for them(costs) or don’t receive the benefit. • Therefore, themarket price of the goodwill not reflect ALL costs or benefits(ignore external costs or benefits) • These external costs or benefits are called EXTERNALITIES or spillover effects... …they represent theimpact on third partiesfrom market transactions.

5. Price Supply =MC Negative Externality MC } } MEC MEC PC PC d = MR = MB Demand = MB qC QC Quantity quantity Competitive Market Competitive firm in Market Negative Externality (external cost):a cost (beyond the firms cost) imposed on others in the production of a good or service... ...this cost is called themarginal external (or damage) cost (MEC or MDC)... ...and is defined as the extra costimposed on third parties when a negative externality is present. Examples: Dumping waste products into the air and water, secondhand smoke, traffic congestion, loud music played at 3:00 in the morning, airplane noise, etc

6. Price MSC Supply =MC Negative Externality MC+MEC=MSC MC } } MEC MEC PC PC d = MR = MB Demand = MB qC QC Quantity quantity Competitive Market Competitive firm in Market To find the cost to EVERYONE, we must add theMECto theMC of the firm... …which gives us the total cost of production. This is called: MARGINAL SOCIAL COST(MSC) = MC (from firms) + MEC (additional external cost imposed on others)

7. Price MSC Supply =MC Negative Externality MC+MEC=MSC MC } } PE PE MEC MEC PC PC d = MR = MB Demand = MB qE qC QE QC Quantity quantity Competitive Market Competitive firm in Market Allocative efficiency occurs when ALL cost and benefits are considered. This will now occur whenMSC= MB. AtQcwith price Pc , MSC> MB(because of the external costs) Competitive equilibrium is no longer efficient because of the negative externality. MSC >MBindicates that the competitive market overproducesthe good ata price lower than the total (social) cost of production To reach efficiency, price must rise and quantity decline.

8. Positive Externality Price Supply = MC MC { { MEB MEB PC PC d = MR = MB Demand = MB qC quantity QC Quantity Competitive Market Competitive firm in Market Positive Externality (external benefit):a benefit (beyond the consumers benefit) that is bestowed on others in the production or consumption of a good or service which we call... ...the marginal external benefit (MEB)... ...the extra benefitbestowed on third parties when a positive externality is present. Examples: Smoke detector in an apartment, vaccinations, college education, Christmas decorations on a house.

9. MSB = MB + MEB Positive Externality Price Supply = MC MC MSB { { MEB MEB PC PC d = MR = MB Demand = MB qC quantity QC Quantity Competitive Market Competitive firm in Market To find the benefit to EVERYONE,we must add theMEBto theMB of the consumer... …which gives us the total benefit of production. This is called: MARGINAL SOCIAL BENEFIT(MSB) = MB (from consumers) + MEB (bestowed on others)

10. MSB = MB + MEB Positive Externality Price Supply = MC MC MSB { { MEB MEB PC PC d = MR = MB PE A firm would not produce more at a lower price Demand = MB qC quantity QE QC Quantity Competitive Market Competitive firm in Market At Qc with price Pc , MSB > MC (because of the external benefits) Competitive equilibrium is no longer efficient because of the positive externality. Allocative efficiency occurs when MSB = MC MSB > MC indicates that the competitive market underproduces the good at a higher price than is efficient. To reach efficiency, more of this good must be produced and sold. However, Consumers need a price lower thanPC in order to buy more of this good.

11. Correcting Externalities • Problem: Private individuals and firms have no incentive to take into account external costs(MEC) or external benefits(MEB)... ...that is they don’t have to pay for the damage caused or receive the extra benefits of others. • Solution: Have individuals and firms incorporate(give them an incentive)or INTERNALIZE the external costs or benefits into their own cost-benefit calculations. • If this occurs the firm will adjust their MC so it reflects the MEC and will equal the MSC… ...if this is done then the market price and quantity WILL reflect both private and external costs. • Internalizing an externality can be done in numerous ways...

12. Correcting Externalities 1. Persuasion(Can work at a personal level) If a roommate is playing a stereo at 3:00 am, you can ask that person to stop so you and others can sleep. You can ask someone not to smoke by you. “Don’t Drink and Drive” is an attempt to get people to consider the external costs of this action. 2. Government intervention a) Direct regulation Government telling firms or individuals what to do and exactly how to do it. Why? In some cases the externality is too dangerous for any amount to occur, like plutonium or some chemicals Examples: Specific equipment on cars, tailpipe emission tests, use of a “cleaner” gasoline

13. Correcting Externalities 2. Government intervention, con’t b) Indirect intervention 1) Legal rules and procedures Various Product liability laws allow people to sue manufacturers if their product is defective Firms have greater incentive to improve their product so they don’t pay damages 2) Corrective taxes & Subsidies Firms ignore the MEC they impose on others The government can tax firms to simulate the external costs to others(society). By subsidizing a product that has a positive externality, the government can simulate the MEB and encourage more production.

14. Price New supply = MSC(MC + Tax) Supply =MC Tax = MEC (MDC) MC+Tax= MSC = firms cost MC } } dT = MRT = MBT Tax PT Tax PT PC PC d = MR = MB Demand = MB qT qC QT QC Quantity of Dry cleaning quantity Competitive Market Competitive firm in Market Correction of a negative externality A per unit tax adds to the cost of production for business firms that impose a negative externality The market supply curve will decrease (shift to the left) because the tax has increased the cost of production to business firms. This raises the market price and lowers market quantity. The per unit tax forces firms to take into account the external costs they impose on others… ...the MSC to society becomes the internal or private MC to the firm Because consumers pay a higher price, quantity does not go down the maximum amount

15. What have we learned from this? 1)For efficient use of resources the Tax = MEC. It can be difficult to measure external costs and to get the Tax rate = MEC In fact, it may only be possible by trial and error. 2)The cost of reducing pollution is lower output and/or higher prices (ceteris paribus) Of course, a firm has an incentive to choose the least costly option. If paying the full amount of taxes and not reducing output is the least costly, then the firm will do that. 3) If Tax = MEC then tax revenue generated is large enough to pay for all damages from the externality. • If the government could find people directly affected by the negative externality it could transfer the revenue to them..... …since this is not likely, many would like to see reductions beyond the efficient level, because they still have to bear the external costs (i.e. the pollution)

16. Price A well educated workforce tends to be more productive, which means more output for the economy and lower inflation…. …but students don’t take this positive externality in effect when deciding to go to college. The government can make students (and colleges) take these external benefits into account by subsidizing production. Competitive Market Supply = MC Competitive firm in Market MC $4,000 $4,000 d = MR Demand = MB Quantity of Students quantity of students qC QC Correction of a positive externality

17. Price Competitive Market Supply = MC Competitive firm in Market Subsidy to firms = MEB MC MC - Subsidy } MEB } Supply after Subsidy $4,000 $4,000 d = MR $3,000 $3,000 d = MR Demand = MB Quantity of Students quantity of students qS qC QS QC Correction of a positive externality In this case the subsidy goes directly to the firm, which lowers cost ..and causing the Supply curve to increase (shift to the right). By lowering the price of education, more students will go to college. As long as the subsidy = MEB, efficiency will be achieved. This occurs whether the firm or the consumer receives the subsidy.

18. Correcting Externalities 3. Market Solutions.... ...Assigning property rights If the government can assign property rights to resources where there were none before.... ...and allowing owners of these property rights to bargain, negotiate, and sell them... ...the market itself will be able to internalize an externality and achieve efficiency.... An economist named Ronald Coase first developed this idea...

19. Common Land Coase Theorem Rancher Up to 800 cows Who causes an externality is not always obvious. It takes at least two or more to cause externalities. Example: The octagon above represents open common land Suppose a rancher sets up a few buildings and an area for his cows to graze on. Assume the grazing area has the capacity to fully feed up to 800 cows

20. Common Land Coase Theorem Rancher Up to 800 cows Farmer Carrots Next, a farmer begins to plant his crop, carrots, on another part of this common land There are no fences between these two, so if the rancher has more than 800 cows, some of those cowsstray off the blue area in order to feed themselves (i.e. Rancher’s firm gets bigger) Occasionally, some cows stray onto the land where the farmer planted his crops and they eat them! (This is the MEC) This lowers the amount of production for the farmer and will cost him revenue and profits.

21. Common Land Coase Theorem Rancher Up to 800 cows Farmer Carrots 1) Farmer can move; Rancher can move 2) Build a fence (either around rancher or farmer) 3) Rancher can keep cows to less than 800(voluntarily or through government regulation and/or taxes) Coase: By assigning property rights to the common land, these two can solve the negative externality for themselves. It will be done in the same way no matter who gets the property rights Farmer is upset about the damages, but, since rancher was there first, claims it is not his fault.This is a negative externality Solutions for this negative externality:

22. Coase Theorem • Suppose we collect the following information from the rancher and farmer: • The rancher will maximize his profit by raising 1000 cows. But this leads to straying cattle and an external cost on the Farmer. • Cost to the rancher to cut production back to 800 cows is $10,000 lost profit (200 x $50/cow) • Cost to move cows or move the farm = $25,000 • Cost to build a fence around ranch or farm = $16,000 • Maximum damage to farmers crops from straying cows is $20,000 (200 x $100/cow)

23. Cost to cut production back to 800 cows is $10,000 ($50/cow) Cost to move cows or move the farm = $25,000 Cost to build a fence around ranch or farm = $16,000 Max damage to farmers crops from is $20,000 (MEC=$100/cow) Coase Theorem • Which alternative will be chosen? • Suppose the rancher gets the property rights... …the rancher will keep only 800 cows! Why? Because theMEC > profit/cow, thefarmeris willing to pay $10,000 to therancherif he will limit his cows.(It is better to lose $10,000 than $20,000) • What if the farmer gets the property rights? The rancher will keep only 800 cows! Why? • Because it is cheaper than paying $100/cow to the farmer for each cow over 800. • Practical application: In some circumstances there is no need for taxes and/or government regulationto correct externalities. If property rightscan be assigned then the market system may be able to correct them.

24. Summary: Externalities • An Externality is a cost or a benefit that affects others not involved with a market transaction. • Negative Externality: a cost imposed on society • Positive Externality: A benefit bestowed on society • Correcting Externalities (Internalizing) Government solutions 1) Direct Regulation 2) Indirect intervention a) Legal Rules and Procedures b) Corrective taxes & Subsides Must be equal to MEC or MEB to achieve efficiency Market Solutions Assigning property rights Coase theorem: No matter who gets them, if the conflicting parties can negotiate and trade, the efficient outcome is achieved.

25. An application: Pollution, a negative externality

26. Pollution: A negative externality Two questions must be answered: 1)What is the optimal(MSC=MSB) reduction in pollution? 2)What is the lowest cost way to reach that reduction? • Government could directly lower pollution by telling firms how much they must reduce it and exactly how it must be done... …but some firms are in a better position (technology) to reduce pollution than others, direct regulation is not the most efficient(cheapest) way to reduce pollution... ...Pollutants that are not immediately hazardous to human health can be reduced cheaper by using more market based methods…for example... …the polluter is given property rights to pollute... ...BUT THEY MUST PAY FOR THAT RIGHT

27. Market Solutions for reducing pollution 1. Emission charges • Firms are charged for each unit of waste products they dump into the air or water. • Need to measure the emissions or effluent of a firm. • These charges are similar to corrective taxes, but charge directly for emitting pollutants rather than producing the good... …the difference is that emission charges give firms an incentive to reduce emissions (and not output)... ...so they don’t have to pay the emissions charges. • Moreover, firms have the responsibility to find ways to reduce pollution. • Recently, the EPA has found that costs can be reduced even more by auctioning off certificates to emit pollution... ...and allow firms to buy and sell these rights to pollute... Tradable emission permits

28. MB & Price Supply of Permits Tradable emission permits Suppose the EPA decides that emissions of sulfur dioxide should be limited to 150,000 tons per year... B $150 The EPA could issue 150,000 emission permits and auction them off to firms... Marginal Benefit of emitting Tons of sulfur dioxide emissions per year A Number of emission permits issued 150,000 280,000 ...who will need one of these permits for each ton of sulfur dioxide they emit. What determines the price that is paid? The Demand for the permits! Interaction between the buyers for these permits establishes the price! Once a firm purchases a permit it may use it to emit pollution or to Re-sell it to another firm for profit if it does not need it. Those firms that find it cheapest to reduce emissions will do so and sell their unused permits to firms who find it too expensive.

29. MB & Price Supply of Permits Tradable emission permits C $250 B $150 MB emitting 3 MB emitting 2 D $50 MB emitting Tons of sulfur dioxide emissions per year A Number of emission permits issued 150,000 280,000 If demand for the product rises, firms may find it more beneficial to emit more pollutants, the MB of emitting shifts to the right... ...then the price of permits is driven up If firms can find better(improvement in technology) ways to reduce emissions of pollutants then Marginal benefit of emitting goes down... …and so will the price!

30. MB & Price Supply of Permits Tradable emission permits This allows the government to have control over the total amount of pollution. $220 A $150 MB emitting Tons of sulfur dioxide emissions per year B Number of emission permits issued 100,000 150,000 280,000 If the government ever want to further reduce emissions then they simply buy up permits and retire them… …shift the supply curve to the left. Moreover, any environmental groups who wish to lower emissions may buy up permits and hold them (this lowers total emissions)

31. Part II: Public Goods & their provision

32. Characteristics of goods • Many goods have the following characteristics: 1.If one person consumes a unit of a good (such as an apple)then no one else can consume that unit of the good (no one can eat that apple) This is called rivalry in consumption… ...consumption of a good by one person reduces the consumption by others. 2.If you don’t pay for it, you don’t get the good or service. This is called excludability… it is easy to prevent someone from consuming a goodonce it has been produced if they don’t pay for it. Goods with these two characteristics are called Private goods

33. Public Goods • Some very necessary goods DO NOT HAVE these characteristics… …instead they have the opposite... 1) Non-rival in consumption: The consumption of a good by one person does NOT reduce the consumption by others... ...these goods are COLLECTIVLEY consumed... ...everyone can consume the good or service at the same timeand not detract from anyone else’s consumption. Examples: National defense, Air, TV, Movies(up to a point),Education, Fireworks display, Air traffic control, Police and Fire protection

34. Public Goods 1) Non-rival in consumption 2) Non-excludable: it IS NOT possible or at least extremely expensive to exclude someone from consuming the good once it has been produced... ...whether you pay for the good or not you will be able to consume the good. Examples: National defense, Air, Fireworks display, Air traffic control, Police and Fire protection • Goods that have the characteristics of collective consumption and non-excludability are called PUBLIC GOODS • Market Failure: Private firms will not produce public goods because there is no profit to be made... ...because no one will willingly pay for the good.

35. Public Goods and their provision • Since Public goods are consumed collectively, there is usually only one level of production for that good... Problem is getting people to voluntarily contribute(pay) for production of a public good. Why? Two reasons: a) Free-rider problem...people can benefit from a public good even if they do not help pay for it... ...because a public good is non-excludable... ...therefore people have an incentive to enjoy the benefits without paying for them...a FREE RIDER! b) A drop in the bucket problem...since public goods tend to be expensivetheir provision does not depend on any single individual... …the more people needed to contribute, the greater the incentive to free ride because you believe someone else will pay for the good.

36. Public Goods and their provision • Solution: Since most people believe this good is necessary the government can provide for the production of the good... …either by producing it themselves... ...or hiring a private firm to produce the good. • The government pays for the good by taxing (charging) people in order to pay for it. • How much of the good to produce and what to charge for it is determined by the system of government in place. • The reason many people are unhappy with these taxes is thatthey may pay more in taxes than their marginal benefit from the public good.

37. Public or Private goods? • In the real world there is not a clear distinction between public andprivategoods Example: Education is supported by government although it is excludable. Television programs are a mix of collective viewing and excludability. There are private security firms in addition to police. • Some goods are non-rival only up to a certain point,then adding another consumer WILL REDUCE enjoyment of other consumers: • A public park or swimming pool, exercise club, etc... ...or even an expressway...

38. Public or Private goods? • Goods that are non-rival for some levels of consumption tend to be overused... because the marginal cost of using these goods is close to (if not) zero. • Example: In the case of an expressway there tends to be congestion at certain peak use times… …but at other times there is no congestion. • Economic solution: Charging for use of an expressway when you use itwould prevent congestion… ...for example, efficient use of an expressway would be to charge a higher price at rush hourthan normal times.

39. Traffic Choice: An Experiment was conducted with 400 drivers that were given $600 to $3,000 and were allowed to keep whatever was left over as they “paid” for the use of roads over an 8-month period. Results: The participants did use freeways less often and undertook other actions to “save” money.

40. Locally provided public goods • Tiebout hypothesis Consider two identical towns except for police protection... One town spends a lot of money on police and is likely to have lower crime rates… …Households that do not want to take a risk of being a victim of crime will move into this townand will pay higher taxes to avoid crime...or… ...if a town finds a way to reduce crime without higher taxesso many households will try to move in they bid up housing prices… ...these higher housing prices are the “price” of lower crime. • Those households that willing to bear greater risk would choose the lower tax/ higher crime risk town.

41. Locally provided public goods • Tiebout hypothesis: The efficient mix of public goods (police, fire, schools, roads, etc) is produced when local housing prices and/or taxes reflect consumer preferences... …this means local taxes and housing prices act like market prices... …and equilibrium is reached by consumers “voting with their feet”

42. Summary of Public Goods • Public goods have two characteristics: 1) Non-rival in consumption 2) Non-excludable when produced • Problem: Firms won’t produce them because there is no way to make a profit. • Why? Free-rider problem Drop in the bucket problem • Solution: Government raises funds through taxation so they can provide for public goods

43. Market Failure: Imperfect Information A lack of symmetrical information between buyers and sellers can cause markets to be inefficient or not work at all: This leads to the problem of Adverse Selection. Example: Used Car market and the “Lemons” problem Suppose half of used cars are lemons(bad cars) and half are cherries(good cars) Buyers are willing to pay $7,000 for a cherry, but only $1,000 for a lemon. Since you have a 50/50 chance of buying a lemon or a cherry and don’t know ahead of time what you are going to get the price of used cars is the average of the price of a lemon and a cherry($7,000 + $1,000) / 2 = $4,000 Owners of used cars know the type of car they have. Lemon owners would love to get $4,000 for their car and will enter the used car market. Cherry owners will not get “fair” value for their car and not enter the market. Therefore, with asymmetrical info there tends to be more lemons than cherries and the market function barely if at all.

44. Market Failure: Imperfect Information Adverse Selection is a problem in insurance markets: Those who tend to have more accidents or bad health are more likely to demand insurance than those less accident prone or with good health if rates are the same for everyone. To counter this insurance companies are very nosy and charge different rates to customers with differing characteristics. This also explains why health insurance companies need to charge different rates depending on health, or only those with bad health will want insurance.

45. Market Failure: Imperfect Information Another asymmetrical info problem comes after the two parties agree to a contract: Moral Hazard: One party to a contract passes the cost of it’s behavior onto the other party. Why a problem: Can’t tell the future behavior of the party you have entered into a contract with. Another problem in the insurance markets. The very fact that you are covered by insurance may lead you to increase risky behavior that causes the insurance company to have to pay up. Insurance companies write into contacts behaviors they will not pay out for, such as suicide for Life Insurance or the need to have smoke detectors before agreeing to fire insurance.

46. Market Failure: Imperfect Information • Market Solutions to imperfect and asymmetric information: • 1. Provide more information. • Companies sell information about products, etc to consumers. • The internet has increased the ability to gather information tremendously. • In labor markets, recruiters or “Headhunter” are hired by business firms to avoid going through a job search. • 2. Government solutions: • Create laws, rules, and regulations that require companies to make information available to consumers. • Food labeling, and especially financial reports in equities markets are subject to these government dictates.

47. Arrow’s Impossibility Theorem

48. Suppose society has 3 individuals, Amy ,Bob, Charlie Three proposals are put before them. Their preferences are ranked for each proposal. Which one will they agree on? Proposal Individual X Y Z Amy 1 2 3 Bob 3 1 2 Charlie 2 3 1 Results of Voting on Proposals Votes of: Vote AmyBobCharlie Results X X X beats Y Y X vs. Y Y Z Y beats Z Y Y vs. Z X vs. Z Z Z Z beats X X The outcome is inconsistent, no proposal dominates the other

49. Impossibility Theorem Kenneth Arrow: no system of aggregating individual preferences into social decisions will always yield consistent, non-arbitrary results. Voting Paradox: An example of the impossibility theorem. Importance: Who sets the agenda has power to determine the outcomes of votes. Logrolling: occurs when congressional representatives trade votes, agreeing to help each other get their pieces of legislation passed. A person only has the incentive to gather info up to the point where their marginal benefit = marginal cost. Since the cost of government is spread over everyone, the marginal cost of government policy is very small for an individual, giving little incentive to keep up on issues facing society.