5.

1 The meaning of market failure: allocative inefficiency

FAILURE TO ACHIEVE ALLOCATIVE EFFICIENCY
Allocative efficiency is achieved when marginal benefit equals marginal cost (MB = MC)
Unrealistic in real life.
Market failure suggests that markets need appropriate government support to reach
potential.
Market failure - failure of the market to allocate resources efficiency.
5.2 Externalities
EXTERNALITIES
An externality occurs when producer/consumer actions have positive/negative side
effects on other people not involved in the actions.
If the effect benefits the third party, there is a positive externality.
If it harms the third party, there is a negative externality.
MARGINAL BENEFITS AND COSTS
The demand curve also represents a marginal benefit curve. Since the benefit received is
to the owner of the good, it represents the marginal private benefits.
The supply curve represents the marginal private costs.
If there are no externalities, the MPB and MPC curves determine the equilibrium price
and quantity, where there is allocative efficiency.
If there is an externality, there will be benefits and costs for the third party, causing the full
society cost/benefit to differ from the private ones.
The intersection of MPC and MPB is no longer the social optimum
The intersection of the marginal social cost and marginal social benefit will result in
allocative efficiency.
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MARKET FAILURE
ECONOMICS SL
chapter five - market failure
5.3 Negative externalities
NEGATIVE PRODUCTION EXTERNALITIES
Negative production externalities are external costs created by producers.
Too much is being allocated to the
production of the good. Q
m
is greater
than the Q
opt
. At the point of production
(Q
m
), MSC > MSB.
There is welfare loss (loss in social
benefits; yellow shaded area >)
Equal to difference between MSC and
MSB and overproduced output.
CORRECTIONS
Government regulations
Govt uses authority to make
regulations to reduce/prevent the
externalities.
Lowers quantity produced, so the
MPC curve shifts up towards MSC.
Market-based policies (tax)
Govt can impose tax per unit of output produced or per unit of pollutants emitted.
Shifts supply curve from S = MPC to MSC (or MPC + tax).
Best to shift it so it overlaps with the MSC curve.
Taxes on output/taxes on pollutants
A tax on output works by correcting overallocation of resources and reducing overall
output.
A tax on pollutants works by making incentives for firms to use less polluting
resources.
A carbon tax is a tax per unit of carbon emissions: the more carbon emitted, the
higher the tax.
Market-based policies (tradable permits)
Governments can also issue tradable permits (cap and trade schemes) to firms that
permit them to produce a certain amount of pollutants.
If they need more, they can trade with other firms.
The supply curve for these permits is perfectly inelastic because there is a fixed
number of permits.
Encourages firms to use less polluting resources so they dont need to use permits.
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MARKET FAILURE
Negative Production Externalities
Q
P
D = MPB = MSB
S = MPC
MSC
Q
m
Q
opt
P
m
P
opt
external cost
EVALUATION
ADVANTAGES
DISADVANTAGES
MARKET-BASED POLICIES
Preferred by economists because they internalize the economy
(now paid for by producers and consumers)
Taxes on emission > taxes on output because they provide incentive
to be less polluting
Hard to design tax: what methods make more pollution? which
pollutants are harmful? what is the value of the harm?
Sometimes cap and trade schemes are set too high to have little
effect.
Political favoritism may come into play
ADVANTAGES
DISADVANTAGES
GOVERNMENT REGULATIONS
Simpler, easier to implement, and force firms to comply.
Dont allow market to be internalized.
Dont provide incentives
Costs of policing and enforcement
NEGATIVE CONSUMPTION EXTERNALITIES
Negative consumption externalities are
external costs made by consumers.
There is overallocation of the good, as Q
m
>
Q
opt
and MPB > MSB at Q
m
.
The welfare loss is the shaded area.
Demerit goods are goods that are
overprovided and undesirable, like cigarettes.
CORRECTIONS
Government regulation
Regulations to limit activities will shift
D=MPB curve.
Advertising
Can persuade consumers to use less of a good, which decreases demand.
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MARKET FAILURE
Negative Consumption Externalities
Q
P
MSB
S = MPC=MSC
Q
m
Q
opt
P
opt
P
m
external cost
D = MPB
Market-based policies
Imposition of excise tax will decrease the supply and shift supply curve upwards.
EVALUATION
ADVANTAGES
DISADVANTAGES
MARKET-BASED POLICIES
Preferred by economists because they internalize the economy
(now paid for by producers and consumers)
Indirect taxes incentivize consumers
Hard to measure value of the external costs.
Inelastic demand on some goods, so large tax needed.
ADVANTAGES
DISADVANTAGES
ADVERTISING/REGULATION
Simpler
Regulation can prohibit some, like smoking.
Advertising campaigns cost the government money that could be
spent somewhere else.
Regulation can be difficult on other NCEs like driving
5.4 Positive externalities
POSITIVE PRODUCTION EXTERNALITIES
PPEs are external benefits made by
producers. If a firm succeeds in making a new
technology that spreads through economy,
the society benefits from this new technology.
The market is underallocating resources. Q
m

< Q
opt
and MSB > MSC and Q
m
.
An example of PPE: When a new medicine
benefits the user and those around it because
of the increased quality of life.
The shaded area is the welfare loss. They are
the benefits that are lost because not enough
of a good is being produced.
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MARKET FAILURE
Positive Production Externalities
Q
P
D = MPB = MSB
MSC
S=MPC
Q
opt
Q
m
P
opt
P
m
external benefit
CORRECTIONS
Government provision
The government can engage in R&D and pay for training. This is paid for by govt
funds. It results in the shifting of the MPC curve towards the MSC curve.
Subsidies
The govt can provide a subsidy and shift the S = MPC curve towards the MSC curve.
This is similar to government provisions.
POSITIVE CONSUMPTION EXTERNALITIES
PCEs have benefits made by consumers.
Consumption of education results in
benefits not only for the consumer but
society.
The market underallocates resources. Q
m

< Q
opt
and MSB > MPB at Q
m
.
The shaded area is the welfare loss, and
represents the lost benefits because of
the externality.
Merit goods are goods that are desirable
for consumers but are underprovided.
The reasons are:
the goods are positive externalities
there are low levels of income and
poverty
consumers are ignorant of the benefits
CORRECTIONS
Legislation
Legislations promote greater consumption, which shifts the MPB curve closer to the
MSB curve. Many countries have legislation that makes education mandatory.
Advertising
Promotes greater consumption. Same effect as legislation.
Direct govt provision
The govt is involved in provision of goods and services, like education and health
care. This has the effect of increasing supply and shifts the supply curve downwards.
Subsidies
This has the same effect as the government provisions by shifting supply downward.
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MARKET FAILURE
Positive Consumption Externalities
Q
P
D=MPB
S = MPC=MSC
Q
opt
Q
m
P
m
P
opt
external benefit
MSB
EVALUATION
ADVANTAGES
DISADVANTAGES
DIRECT GOVT PROVISION AND SUBSIDIES
very effective in increasing consumption
also lowers price of good
involves government funding and tax revenues (opportunity cost)
size of benefits hard to measure
ADVANTAGES
DISADVANTAGES
LEGISLATION AND ADVERTISING
Help shift the MPB curve
cant increase consumption on some goods/services
may cause price increases
5.5 Lack of public goods
PRIVATE AND PUBLIC GOODS
A private good is rivalrous and excludable.
rivalrous - consumption by one person reduces availability for someone else
excludable - people can be excluded from using good (usually because of price)
A public good is non-rivalrous and non-excludable (AKA pure public good)
non-rivalrous - consumption by one doesnt reduce consumption for someone else
non-excludable - not possible to exclude people from using the good
Examples of public goods: police force, national defense, etc.
A quasi-public good is non-rivalrous but excludable.
Examples are museums and toll roads because they exclude those that cant pay.
FREE RIDER PROBLEM
Comes from non-excludability because people cant be excluded from the use of a good.
Because of the free rider problem, private firms dont make these goods, so there is
resource misallocation.
CORRECTIONS
Public goods are directly provided by government so are made free of charge.
Which ones to provide and in what quantity? Govt has opportunity costs.
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MARKET FAILURE
Govt needs to perform cost-benefit analysis to see the benefits of a certain public good.
If benefits < costs, good shouldnt be provided.
Costs are easy to estimate, but the benefits are hard. Some people exaggerate values.
5.6 Common access resources and the threat to sustainability
COMMON ACCESS RESOURCES AND MARKET FAILURE
Common access resources are resources that are not owned by anyone and have no
price. Examples: clean air, fish, rivers, ozone layer, etc. They are rivalrous but non-
excludable.
Overused by consumers and producers because of non-excludability
Common access resources used without payment can cause serious environmental
problems.
SUSTAINABILITY
Sustainability - ability of something to be maintained or preserved over time
Conflicts between environmental and economic goals
Focusing on economic goals could cause destruction.
Focusing on environmental goals could result in unsatisfiable needs/wants.
Sustainable development - development that meets needs of the present without
compromising ability of future generations to meet their own needs.
Sustainable resource use - using resources at a rate so that they dont get depleted
POLLUTION
Pollution of affluence - pollution caused because of high consumption that rely on the
use of fossil fuels and open access resources
Negative externality of production.
Pollution of sustainability - environmental destruction caused by overexploitation by
poor people because of the lack of modern technology.
For example, they drain the nutrients of soil, making it less productive.
Sustainability is threatened by the increased economic activities.
GOVERNMENT RESPONSES
Legislation
The govt limits threats to sustainability by having licenses, permits, restrictions, etc.
They are easy to put in effect and oversee, and are effective. They dont offer
incentives, however.
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MARKET FAILURE
Carbon taxes vs. cap and trade schemes
Carbon tax - tax on carbon usage; fuels that have higher carbon emission taxed more.
Gives incentive for producers to switch to cleaner fuels
Makes energy prices more predictable
Easier to implement and can be applied to all users of fossil fuels
No manipulation and little monitoring
Less likely used to restrict competition
May be set too low
Cant target particular level of reduction
Regressive
Must be adjusted for inflation
Tradable permits - a cap of total CO
2
enforced and permits are distributed
Useless if cap is set too high
CLEAN TECHNOLOGIES
Clean technologies - aim toward more responsible and productive use of resources.
Already available but potential still not discovered due to the lack of policies for them.
Funding for them have opportunity costs -- government should allocate resources to
this area.
INTL COOPERATION
Cooperation among governments can be effective to reduce environmental damages.
Examples include the Montreal Protocol to phase out ozone-depleting substances and
the Kyoto Protocol to reduce carbon emissions.
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MARKET FAILURE