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Market Failure

Market Failure. 25. All pollution should be eliminated. Strongly Agree Agree Neutral Disagree Strongly Disagree. Market Failure. When the market does not efficiently allocate resources Either too much or too little is produced Monopoly Externalities Public goods.

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Market Failure

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  1. Market Failure

  2. 25 All pollution should be eliminated. • Strongly Agree • Agree • Neutral • Disagree • Strongly Disagree

  3. Market Failure • When the market does not efficiently allocate resources • Either too much or too little is produced • Monopoly • Externalities • Public goods Justification for government intervention?

  4. Externalities • Occur when decision makers do not consider all costs (or benefits) of their actions • Two views “Spillover effects” A. C. Pigou Ronald Coase

  5. Price of beer Hangover Damage to others Boorish behavior Pigouvian Approach Social Cost = Private Cost + External Cost Drinking Alcohol

  6. Pollution Ssocial $ Sprivate • Free Market: P1, Q1 • Optimal Outcome: P2, Q2 P2 P1 External cost Free market overproduces goods that generate a negative externality D1 Q2 Q1 steel How can society achieve social optimum?  Impose tax = marginal external cost “Pigou tax” Internalize the externality!

  7. The efficient output will be less than the free market output when: • Marginal social cost and marginal private cost are equal • Marginal social cost is greater than marginal private cost • Marginal social benefit and marginal private benefit are equal • Marginal social benefit is greater than marginal private benefit

  8. Education $ S1 • Free Market: P1, Q1 • Optimal Outcome: P2, Q2 P2 External benefit P1 Free market underproduces goods that generate a positive externality Dsocial Dprivate Q1 Q2 Years of College How can society achieve social optimum?  Provide subsidy = marginal external benefit

  9. If there is a positive externality, the: • social benefits will be greater than the private benefits • external benefits will be greater than the social benefits • social benefits will be equal to the private benefits • private benefits will be greater than the social benefits

  10. A consequence of a negative consumption externality is that social benefits are ______ than private benefits, and the socially optimal level of output is ______ than the private level of output. • greater; greater. • greater; less. • less; less. • less; greater.

  11. Cashmere Externalities

  12. Coasian Approach • Externalities are due to incomplete property rights assignment “It takes two to tango”

  13. Aunt Linda and the Nudist Rifle River Aunt Linda Nudist $1500 $1200 $1000 Judge rules in favor of Aunt Linda Judge rules in favor of Nudist Fence comes down 2 rulings Fence comes down (Linda pays Nudist)

  14. Coasian Approach • Externalities are due to incomplete assignment of property rights Coase Theorem If property rights are well-defined and transactions costs are low enough, then private bargaining can result in an efficient allocation of resources. Corollary Allocation of resources does not depend on initial assignment of property rights.

  15. Pollution Revisited

  16. Cheshire, Ohio v. AEP • AEP paid $20 million to buy the 221-resident town in 2002

  17. A factory's production process creates sludge that pours into a river. This sludge makes it difficult to fish in the river, increasing the costs of the local fishermen by $5000. The factory can install a water filter system for $4100, and the fishermen can utilize a weighted fishing net system (to get under the sludge) for $3250. Both systems would remedy the sludge damage to the fishermen. Factory Nets: $3250 Filter: $4100 Damage: $5000 a) Transactions costs low and factory is not liable for damage? b) Transactions costs low and factory is liable for damage? c) Transactions costs high and factory is liable for damage?

  18. Pollution Worksheet • Optimal pollution for Marietta-Parkersburg area is 60,000 units of emissions • Abatement Cost • Cars: $5 • Utilities: $10 • Factories: $20 • Controlling pollution through: • Standards • Taxes • Tradable Permits

  19. Standards • “Command-and-Control” approach • Emission standards • Technology standards Set a maximum emissions of 20,000 units per source: 20,000 0 0 20,000 10,000 $100,000 20,000 20,000 $400,000 60,000 30,000 $500,000

  20. Standards Require each source to cut emissions by 10,000 units: 10,000 10,000 $50,000 20,000 10,000 $100,000 30,000 10,000 $200,000 60,000 30,000 $350,000

  21. Standards Require each source to cut emissions by 1/3: 13,333 6,667 $ 33,335 20,000 10,000 $100,000 26,667 13,333 $266,660 60,000 30,000 $399,995

  22. Standards Cost minimizing strategy of reducing emissions by 30,000 units. 0 20,000 $100,000 20,000 10,000 $100,000 40,000 0 0 60,000 30,000 $200,000 “$200,000 Solution”

  23. Taxes A tax of t = $6 per unit of pollution is imposed: 0 20,000 $100,000 0 30,000 0 0 $180,000 40,000 0 0 $240,000 70,000 20,000 $100,000 $420,000

  24. Taxes A tax of t = $11 per unit of pollution is imposed: 0 20,000 $100,000 0 0 30,000 $300,000 0 40,000 0 0 $440,000 40,000 50,000 $400,000 $440,000

  25. Taxes A tax of t = $10.05 per unit of pollution is imposed only on factories for each unit of pollution over the 60,000 limit, regardless of the source. 20,000 0 0 0 30,000 0 0 0 40,000 0 0 $301,500 90,000 0 0 $301,500 If transactions costs low enough, then $200,000 solution can be achieved through private bargaining.

  26. Cap and Trade Program S $ F $20 Abatement Cost P = $10 Q = 60,000 U $10 C $5 D 40 60 70 90 permits 2008 Spot Auction 2008 7-yr Advance Auction “$200,000 Solution”

  27. Neighborhood Park Fund

  28. Characteristics of Goods • Excludability: can you be excluded from consuming the good? • Rivalry: does my consumption hinder your consumption? Artificially Scarce Goods Private Goods Common Resources Public Goods

  29. Schools Roads Police Courts Fire Department Water Library Health Care Transportation National Defense Social Security Medicare Postal Service FBI, CIA, SEC, FTC, FCC, NSF, FDA, ARC, FDIC, NLRB, HUD Government Provided Goods and Services

  30. Defense National Defense • Federal Government spent $600 billion in 2006 Per capita expenditure How do we pay for this? National Defense Telethon?  Taxes!

  31. Public Goods • Problems • “free-rider” problem • Under-provision by free market • Social Optimum requires: MSB = MSC • Must find some way to aggregate individual marginal benefits

  32. Fireworks in Marietta $22 $22 $10 $12 $19 $41 $20 $21 $15 $56 $30 $26 $11 $67 $40 $27 $7 $74 $50 $24 $4 $78 $60 $18

  33. The table below shows the marginal benefit from submarines for the only two citizens of a country. Submarines are a public good. If submarines cost $175 a piece to produce, what is the efficient quantity of submarines? • 0 • 1 • 2 • 3 • 4 • 5

  34. Artificially Scarce Goods • Excludable • Non-Rival • Examples • Software • Pay-per-view movies • pharmaceuticals Marginal Cost of provision is zero $ P1 MC D MR Drugs Q1 Q0

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