Market Failure: An Introduction

1. Market Failure:An Introduction Section 2.4 HL Extension

2. Section Overview : Why are there so many inconvenient truths?

3. Reasons for Market Failure Positive and Negative Externalities Missing markets (i.e. goods which are underprovided e.g. health care) Imperfect competition (i.e. monopolies)

4. Definitions and Concepts

5. Definitions and Concepts Cost and Benefits External Cost = costs to third parties External Benefits = benefits to third parties Prices Send signals about how resources should be allocated If Costs or Benefits are not correctly considered, the market has failed

6. Definitions and Concepts Marginal Social Cost (MSC) MSC = extra cost to society of producing one more unit. MSC upward sloping due to diminishing returns. Marginal Social Benefit (MSB) MSB = equals the extra benefit (utility) to society of producing one more unit. MSB downward sloping due to diminishing marginal utility Community Surplus Equilibrium price the market is Pareto Optimal i.e. it is impossible to make anyone better off without making someone worse off

7. Definitions and Concepts Externalities arise when the market clearing price creates benefits or inflicts costs on a third party Positive externalities arise when the social benefit of consuming another unit, i.e. the marginal social benefit (MSB), is greater than the marginal social cost (MSC) of producing it Negative externalities arise when MSB are outweighed by increased MSC - the market underestimates the true cost of the good to society and produced too much of it

8. Positive Externalities: Focus on Benefits

9. Negative Externalities: Focus on Costs

10. Sustainable Development

11. Sustainable Development The present use of resources in satisfying the needs of the economy should not lessen or limit future generations’ use of resources in satisfying needs To what degree is industrialization & resource consumption sustainable in the long run?

12. Public Goods

13. Public Goods Flood control Barriers on the Thames River

14. Types of Public Goods

15. Public Goods as Market Failure No incentive for Private Enterprise • E. g. Private benefit to one Londoner would be very small though the Social benefit would be very great. Presence of Free Riders • Individual who consume the good but pays nothing or little to cover the cost of that product

16. Possible Solution to this form of Market Failure Government provides the good or service Government subsidizes private forms to supply the good or service

17. Merit & Demerit Goods

18. Merit and Demerit Goods Health Care education Lack of Knowledge Alcohol Tobacco

19. Issues related to Merit Goods Issues Solutions

20. Monopolies

21. Abuse of Monopoly Power Market failure occurs under conditions of imperfect competition (monopoly, oligopoly & monopolistic competition) Monopolies have power to set output and price to maximize profits Monopolies gain this power due to a lack of viable substitutes or competition

22. Monopolies Monopolies can: Erect high barriers of entry to dissuade potential competitions Engage in predatory pricing Buy up rivals Own/control vital raw materials Set different prices on different markets (price discrimination)

23. Government Intervention

24. Legislation Legislation attempts to correct market failures by influencing both supply/demand for goods and includes: Bans (when net MSB is negative at all output levels - no amount of the good on the market adds to social well-being) Influencing production/consumption (restrictions on sales/use) Regulating externalities (limits on pollutants/emissions) Regulating competition (anti-trust laws) Legislation has drawbacks e.g. a ban could create a black market, harsh regulations could drive up costs/prices

25. Taxation & Subsidies

26. Definition Taxes are levied to internalize externalities i.e. make hidden costs visible & burden those responsible for them in some way Governments may levy an indirect tax on goods with negative externalities to provide a disincentive for consumption (e.g. tobacco/cigarettes) Subsidies are used to encourage the output of certain goods Goods are subsidized when consumption/production is considered to have positive effects OR when users cannot see future benefits or benefits to third parties (e.g. milk is subsidized by governments for its health benefits)

27. Tradable Permits

28. Definition Tradable Permit Schemes are a market-based solution to pollution Government agencies set a ceiling for total emissions then issue credits to firms and fine those who pollute more than their permits allow Permits may be resold to other firms, creating an incentive to clean up production & a disincentive to exceed the limits imposed Pollution does not decrease in this system - only pollution per unit Heavy polluters may buy ever cheaper permits due to more diligent firms cleaning up their act - and thus perpetuate the problem

29. Extension of Property Rights

30. Extending Property Rights By extending property rights, governments can internalize externalities - any damages to private property create a basis for claims on the offending party Previously un-attributed costs are thus clarified and responsibility is assigned To exert pressure on offending firms: grant property rights to all businesses along a beach front so they have the incentive to clean up the beach as they compete for tourists To get offending firms to exert pressure on themselves: extend property rights of a polluting firm to an entire river Assigning property rights has a market-based appeal - monitoring the extent/cost of externalities is done by offending firms & third party sufferers

31. Recap: The Tragedy of the Commons Externalities arise when the market clearing price creates benefits or inflicts costs on a third party Positive externalities arise when the social benefit of consuming another unit, i.e. the marginal social benefit (MSB), is greater than the marginal social cost (MSC) of producing it Negative externalities arise when MSB are outweighed by increased MSC - the market underestimates the true cost of the good to society and produced too much of it

32. Advertising & its impact on consumption

33. Advertising Advertising alters peoples’ behavior Educating/informing citizens of both possible costs/benefits of use can change market demand and thus correct over/under-consumption Governments use persuasive/informative advertising to change citizens’ behavior in order to limit externalities e.g. warning labels on cigarettes, drug education in schools

34. International cooperation among governments

35. International Cooperation on Environmental Issues Dealing with environmentally-related externalities on a global basis involves the following: Accountability (assigning blame & thus culpability) Cost estimation (setting appropriate costs) Method (debate on most efficient methods) Trade-offs (striking balance between growth & environmental impact) Loss of competitive edge (stricter legislation drives up production costs for firms)

36. Government Intervention Diagrams

37. Negative Consumption Externalities

38. Negative Consumption:Reducing Demand through Advertising and Persuasion

39. Negative Consumption:Raising Prices Through Taxation

40. Negative Production Externality

41. Negative Production Externality:Raising Prices Through Taxation

42. Positive Production Externality

43. Positive Production Externality:Increasing Supply through a subsidy

44. Positive Consumption Externality

45. Positive consumption Externality:Increasing Demand through legislation and advertising

46. Positive Consumption Externality:Increasing Supply through a subsidy