Lecture 2: Externalities and Market Failure

Adam Smith's "invisible hand"

leads self-interested buyers and sellers in a market to maximize the total benefit that society can derive from a market.

Rent seeking

where individuals or groups take actions to redirect resources to generate income (rents) for themselves or the group.

Cronyism

returning favours

Why Private Solutions Do Not Always Work?

- Bargaining Problems - Transactions Costs - Difficult to Coordinate the interested parties. - Asymmetric Information and Irrational Behaviour.

Private Solutions To Externalities

- Social norms and Moral Behavior - Charities - Self-interest - Social Contracts

Pollution and the Social Optimum

For each unit of aluminum produced, the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution. The intersection of the demand curve and the social- cost curve determines the optimal output level. The socially optimal output level is less than the market equilibrium quantity.

Command-and-Control Policies

Forbid or require certain behaviors. (ex. requirements that all students be immunized, stipulations on pollution emission levels set by the government.)

Government Behavior

Government decision-making is often flawed and not based on perfect information or rational, positive analysis. The benefits accrue to a small number of people but the costs are spread across large sections of the population.

Social Costs & Social Benefits of Decision Making

Market decisions are be based on weighing up private costs and private benefits. Social costs and social benefits are lost or gained by those not party to the initial decision. The market equilibrium is not efficient when there are externalities.

Examples of Externalities

Negative Externalities: Car exhaust fumes, Cigarette smoking, Barking dogs (loud pets), Loud stereos in an apartment building Positive Externalities: Immunizations, Restored historic buildings, Research into new technologies, Park transformation

Externalities And Market Inefficiency

Negative externalities lead markets to produce a larger quantity than is socially desirable. Positive externalities lead markets to produce a larger quantity than is socially desirable.

Positive Externality Graph

The intersection of the supply curve and the social value curve determines the optimal output level. The optimal output level is more than the equilibrium quantity. The market produces a smaller quantity than is socially desirable. The social value of the good exceeds the private value of the good.

The Market for aluminum

The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus. If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers.

Education and the Social Optimum

The social value of the good exceeds the private value. (A better-educated population leads to improved productivity and economic growth. The economic growth is the positive externality as it benefits everyone.) The marginal social benefit (MSB) is the private value plus the external benefit to society at each price.

Public Policy Toward Externalities

When externalities are significant and private solutions are not found, government may attempt to solve the problem through - Command-and-Control Policies - Market-based policies

The Coase Theorem

a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.

Government failure

a situation where political power and incentives distort decision making so that decisions are made which conflict with economic efficiency.

technology spillover

a type of positive externality that exists when a firm's innovation or design not only benefits the firm, but enters society's pool of technological knowledge and benefits society as a whole.

Tradable Pollution Permits

allow the voluntary transfer of the right to pollute from one firm to another. A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost. A market for these permits will eventually develop.

Internalizing an externality

altering incentives so that people take account of the external effects of their actions. The government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity

negative externality

an externality that adversely impacts a bystander

positive externality

an externality with an impact that is beneficial for the bystander

externality

an uncompensated impact of one person's actions on the well-being of a bystander; cause markets to be inefficient, and so fail to maximize total surplus; decision makers fail to take account of the external effects of their behavior.

Patent laws

give the individual (or firm) with patent protection a property right over its invention; without property rights there would be less research.

Transaction costs

incurred in the process of agreeing to and following through on a bargain. Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible.

Public interest

making decisions based on a principle where the maximum benefit is gained by the largest number of people at minimum cost.

special-interest effect

may lead to minorities gaining significant benefits but the cost is borne by the population as a whole.

Property rights

provide the exclusive right of an individual, group or organization to determine how a resource is used. However, it is a complex task to establish a system of such property rights and they may be expensive to enforce. (ex. If I have ownership rights over the air 1 km above my house then no one can legally pollute it. I can negotiate with a firm that wishes to pollute that air and agree a price for the right to do so.)

Pigovian Taxes

taxes enacted to correct the effects of a negative externality; an incentive to reduce pollution up to a point where the marginal abatement cost is equal to the tax rate imposed. Government uses taxes and subsidies to align private incentives with social efficiency. Firms that can reduce pollution with the least cost are likely to do so (to avoid the tax) while firms that encounter high costs when reducing pollution will pay the tax.

Logrolling

term used to describe vote trading in government.

Public choice theory

the analysis of governmental behaviour, and the behaviour of individuals who interact with government.

Subsidies

used to attempt to internalize positive externalities.