Chapter 5 Market failure

advantages of market-based policies

'internalise the externality' - consumers + producers pay tax on emissions better than tax on output because incentive to economise on use of polluting resources + less polluting production methods taxation = lower pollution @ lower overall cost firms that can pollute less cheaply will have the incentive to do so = less tax/sell permits

quasi-public goods

= impure public goods non-rivalrous (public) but excludable (private) e.g. museums with entrance fee, toll roads very large positive externalities ∴ government provision

externality

actions of consumers/producers give rise to negative/positive side-effects on other people who are not part of these actions and whose interests are not considered

clean technologies

aim toward a more responsible and productive use of natural resources, which also reduce negative environmental impacts e.g. wind power, solar energy, nuclear power

allocative efficiency

allocative efficiency achieved when MPC=MSC=MPB=MSB externality creates divergence between MPC and MSC or MPB and MSB ∴ externality leads to an outcome where MPB=MPC but not MSB=MSC

social optimum

allocative efficiency, where marginal social costs = marginal social benefits

renewable resources

any natural resource that can be replenished naturally within a relatively short period of time

arguments in favour of cap and trade schemes

carbon taxes may be too low carbon taxes cannot target a particular level of carbon reduction carbon taxes are regressive (against principle of equity) carbon taxes must be adjusted for inflation (automatic rise for tradable permits)

common access resources in terms of rivalry and excludability

common access resources = rivalrous + non-excludable rivalry = consumption by some reduces availability for others non-excludable = consumers + producers use them abundantly and overuse them because no price

rivalrous

consumption by one person reduces availability for someone else

government regulations

decrease in demand: shift of demand curve by limiting consumers activities that impose costs on third parties (e.g. smoking in public places) = D₁=MPB → D₂=MSB ∴ externality eliminated, equilibrium = Qopt and Popt

merit goods

desirable for consumers but under provided positive externalities / low levels of income + poverty / consumer ignorance e.g. health care, medicines, education + recreational facilities

sustainable development

development that meets the needs of the present without compromising the ability of future generations to meet their own needs

two methods of correcting positive production externalities

direct government provision subsidies (downward shift in MPC to MSC + increase quantity supplied, decrease price)

non-renewable resources

does not renew itself at a sufficient rate for sustainable economic extraction ∴ only sustainably use = not at all

advertising

e.g. encourage sports facilities to improve health = increase demand (D₁=MPB → D₂=MSB) ∴ Qopt produced

direct government provision

e.g. government engagement in research and development (R&D) for technology, medicine, pharmaceuticals + training for workers - from taxes downward shift of supply curve (S=MPC → MSC) so new equilibrium = Qopt and Popt

arguments in favour of carbon taxes

energy prices more predictable easier to design + implement applied to all fossil fuel users no opportunity for government manipulation not as much monitoring/enforcement required cap and trade schemes = political pressure to set too high less likely to be used to restrict competition between firms

pollution of poverty

environmental degradation arising from production and consumption activities that are due to poverty ∼ mainly in developing countries

pollution of affluence

environmental degradation as the by-product of production and consumption activities resulting from increased quantities of output produced and consumed (economic growth)

disadvantages of government regulations

externality not internalised ∴ no market-based incentive (use less polluting resources) + no distinction between firms with higher or lower costs of reducing pollution = pollution reduced @ higher overall cost + technical information, enforcement expenses and problems

direct government provision

government (public) provision of education + health care = increase in supply (S=MPC=MSC → S+government provision), interest at D=MPB ∴ Qopt produced *Pc below Popt

policy failure

government intervention in markets results in less efficient outcomes that those that would have arisen without intervention

the problem of government failure (policy failure)

government intervention results in less efficient outcomes e.g. governments respond to political pressures - price supports to support farmers' incomes lack of necessary information unintended consequences cannot be easily changed - inflexibility of political process

correction negative consumption externalities

government regulations advertising market-based policies (decrease demand or decrease supply) (shift MPB toward MSB or MPC toward MSC)

two methods of correcting negative production externalities

government regulations market-based policies (must shift MPC upward to MSC + ↓Qopt ↑Popt)

the role of international cooperation

government responses to threats of sustainability limited by global nature of problem + lack of ownership of common access resource e.g. ozone layer suffered ozone depletion = globally everyone must stop nitrogen oxides + CFCs e.g. Montreal Protocol 1987: effect in 1989: phase out ozone depletion substances

government regulations to correct negative externalities of production

government uses authority to enact legislation and regulation in public interest e.g. limit emission of pollutants by setting maximum + limited quantity of output by polluting firm + require installation of pollution-reducing technologies aim to move MPC up to MSC

evaluation of policies to correct positive production and consumption externalities

hard to calculate size of externality direct government supervision + subsidies = effective in increasing quantity consumed + lower price (though not Popt) difficulties: tax revenues used = opportunity cost: difficulty decided which goods and how much support, subject to political pressures legislation + advertising = raise price - make unaffordable to low income consumers implemented together most effective e.g. legislation + direct government provision for education

market-based policies

imposition of indirect (excise) tax → allocative efficiency = decrease in supply = upward shift of supply curve from MPC to MPC+tax if tax = external cost, MPC+tax interests MPB at Qopt → increase in price Pm to Pc(=Popt) *demand curve stays at MPB and does not shift!

market-based policies to correct negative externalities of production

imposition of indirect tax on output/pollutants issue of tradable permits

funding for clean technologies

lack of funding, has opportunity costs, developed countries playing leading role, governments should be contributing more + encouraging private sector funding + participation government spending on energy research, development, demonstration and deployment (RDD&D): 20% 1980 → 4% 2007

legislation

laws + regulations to limit threats = emissions standards, quotas, licences, permits, outright restrictions e.g. restrictions on quantity of logging, quotas for fishing simple + effective not effective in the case of emissions on pollutants as no incentive to reduce emissions/increase energy efficiency + switch fuels/do not distinguish between high- and low- cost polluters + costs of regulation ∴ dependent on specific use

advertising

leftward shift of demand curve: D₁=MPB → D₂=MSB e.g. anti-smoking campaigns, campaigns to use public transport to economise petrol, improve home insulation to reduce oil for heating, etc

methods of correcting positive consumption externalities

legislation advertising direct government provision subsidies (increasing demand or increasing supply) (MPB → MSB or MPC → MSC so Qopt and Popt)

government responses to threats to sustainability

legislation carbon taxes verus cap and trade schemes funding for clean technologies eliminating environmentally harmful subsidies

implications of direct government provision of public goods

limited tax revenue ∴ must choose what/how much to produce = opportunity cost difficulty calculating external benefit (market price reflects benefits consumers receive, no market price = no reflection of benefits) must use cost-benefit analysis e.g. votes/surveys (exaggeration of value) benefits < costs good should not be produced benefits > costs good should be produced until MB = MC

sustainability

maintaining the ability of the environment and economy to continue to produce and satisfy needs and wants into the future dependent on preservation of environment

evaluation of market-based policies, government intervention and advertising

market-based policies again preferred, however hard to determine value of negative externality and inelastic goods result in high government revenue but little change in demand advertising expensive = tax revenue = opportunity cost government regulation = effect in reduction of passive smoking but difficult for other goods ∴ can only hope to reduce size of externality, but never perfect

advantages of government regulations

more simple (no technical issues), guaranteed result (taxes don't always do the job)

the welfare loss of negative consumption externalities

negative consumption externalities = welfare loss = difference between MSC and MSB for amount that is produced relative to social optimum (Qm - Qopt)

welfare loss of negative production externalities

negative production externality = welfare loss = reduction in social benefits due to misallocation of resources welfare loss = difference between MSC and MSB for amount of output overproduced (Qm - Qopt)

(pure) public good

non-rivalrous and non-excludable e.g. police force, national defence, flood control, non-toll roads, lighthouses

market failure

occurs when the production of a good does not take place at the socially efficient level of output (allocative efficiency where MSC = MSB)

difference between tax on output and tax on pollutants (emissions)

output tax: reduce amount of output produced emissions tax e.g. tax per unit of carbon emissions by fossil fuels: imposition of tax → higher costs of production (S=MPC → MSC₁=MPC+tax) → incentive to reduce costs of production → switch to less polluting resources → increase in Qopt because negative externality of production is less

allocation of resources due to negative consumption externality

overallocation of resources Qm > Qopt an MSC > MSB at Qm ∴ negative externalities = overallocation + overprovision

allocation of resources due to negative production externality

overallocation of resources too much produced relative to the social optimum Qm > Qopt and MSC > MSB at Qm

poverty as a threat to sustainability

overexploitation by poor people of their scarce environmental resources lack modern agricultural inputs that keep soil fertility ∴ deplete soil fertility need for more land = deforestation, move to mountains (=soil erosion), overgraze animals on pasture lands = deplete nutrients

high income production and consumption based on fossil fuels as a threat to sustainability

overuse / degradation of common access resources = external cost of industrial production + high income production can also result from negative production externalities e.g. heating oil + overuse of clean air: MSB < MPB

the welfare loss of positive consumption externalities

positive consumption externalities = welfare loss = difference between MSB and MSC curve for amount of output that is underproduced relative to social optimum (Qopt - Qm)

the welfare loss of positive production externalities

positive production externalities = welfare loss = difference between MSB and MSC for amount of output that is underproduced relative to social optimum (Qopt - Qm) under demand curve

excludable

possible to exclude people from using the good e.g. charging a price = someone unwilling/unable to pay is excluded

demerit goods

products undesirable for consumers that are over-provided negative consumption externalities / consumer ignorance about harmful effects / lack of care e.g. cigarettes, alcohol, gambling

legislation

promote greater consumption of goods with positive externalities of consumption e.g. compulsory education = increase in demand (D₁=MPB → D₂=MSB) ∴ Qopt produced

marginal private benefits (MPB)

refer to benefits to consumers from consuming one more unit of a good

marginal social benefits (MSB)

refer to benefits to society from consuming one more unit of a good

marginal private costs (MPC)

refer to costs to producers of producing one more unit of a good

marginal social cost (MSC)

refer to costs to society of producing one more unit of a good

sustainable resource use

resources are used at a rate that allows them to reproduce themselves, so they do not become degraded or depleted

common access resources

resources not owned by anyone, no price, available to anyone for use without payment e.g. clean air, lakes, rivers, fish in open sea, ozone layer, the stable global climate etc (=type of market failure)

private good

rivalrous and excludable e.g. computer, textbook

subsidies

same effect as direct government provision increase in supply (S=MPC+MSC → MPC-subsidy), interest at D=MPB ∴ Qopt produced *Pc below Popt

eliminating environmentally harmful subsidies

subsidies = greater production + consumption of subsidised good ∴ environmentally harmful good subsidised = greater environmental damage e.g. subsidies to industrial forstry ∼ policy failure reasons to subsidise fossil fuels: promote industrial sector by keeping costs low, promote international competitiveness (less expensive in international markets), + support domestic fuel production

subsidies

subsidy → allocative efficiency ideally subsidy per unit = external benefit increase in supply = downward shift in supply curve = S=MPC → MSC ∴ increase in quantity (Qm → Qopt) and decrease in price (Pm → Popt)

imposition of indirect tax on output/pollutants

tax per unit of output/pollutants = upward shift of supply curve from S=MPC to MSC(=MPC+tax) optimal policy: [tax = external cost] so MPC overlaps MSC new equilibrium = [MSC and D=MPB=MSB] Pc=Popt = price paid by consumers Pp = price received by producers

disadvantages of market-based policies

taxes: hard to value tax + firms may pay tax and pollute tradable permits: cap need (=maximum acceptable level), if too high = no effect, too low = costly permits, political favouritism in distribution of permits

positive externality of consumption

the external benefits to a third party that occur when a product is consumed MSB > MSC e.g. consumption of education + healthcare services

positive externalities of production

the external benefits to a third party that occur when a product is production e.g. firms train workers who later swap jobs and work elsewhere new medication that benefits individual + others by improved life quality and increased life expectancy MSB > MSC

negative externalities of consumption

the external costs to a third party that occur when a product is consumed e.g. passive smoking MSC > MSB vertical distance between them represents cost

negative externalities of production

the external costs to third party that occur when a product is produced e.g. cement factory emits smoke + disposes of waste in ocean = bad for local inhabitants, swimmers, sea life ∴ MSC > MPC vertical distance between them represents external cost

underprovision

too few resources allocated to the production go a good (underallocation)

overprovision

too many resources allocated to the production of a good (overallocation)

tradable permits

tradable permit (cap and trade schemes) = permits to pollute issued to firms by government permits can be traded ∴ tradable permit market i.e. not needed can be sold, needed can be bought supply = perfectly inelastic = fixed by government growing economy = increase in demand (D₁ → D₂) fixed supply ∴ price increase (P₁ → P₂) incentive to produce less + sell extra permits + increase profit ∴ reduce quantity of pollutants emitted = reduce externality

resource allocation due to positive production externalities

under allocation of resources Qm < Qopt and MSB > MSC at Qm

resource allocation due to positive consumption externality

underallocation of resources Qm < Qopt and MSB > MSC at Qm ∴ positive externality = underallocation of resources

free rider problem

when people enjoy the use of a good/service without paying for it arises from non-excludability ∴ public goods = market failure: no profit → no firms produce them → no resources allocated to their production