ECONOMICS SL chapter five - market failure
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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5.3 Negative externalities NEGATIVE PRODUCTION EXTERNALITIES • Negative production externalities are external costs created by producers. • Too much is being allocated to the Negative Production Externalities production of the good. Qm is greater than the Qopt. At the point of production P MSC S = MPC (Qm), MSC > MSB. • There is welfare loss (loss in social benefits; yellow shaded area >) external cost • Equal to difference between MSC and Popt MSB and overproduced output. Pm CORRECTIONS • Government regulations • Gov’t uses authority to make regulations to reduce/prevent the externalities. D = MPB = MSB • Lowers quantity produced, so the Q Qopt Qm MPC curve shifts up towards MSC. • Market-based policies (tax) • Gov’t 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 don’t need to use permits. 2 MARKET FAILURE
EVALUATION MARKET-BASED POLICIES ADVANTAGES
•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
DISADVANTAGES •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 GOVERNMENT REGULATIONS ADVANTAGES
•Simpler, easier to implement, and force firms to comply.
DISADVANTAGES •Don’t allow market to be internalized. •Don’t 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 Qm > Qopt and MPB > MSB at Qm. • The welfare loss is the shaded area. • Demerit goods are goods that are overprovided and undesirable, like cigarettes.
Negative Consumption Externalities P
Pm Popt
CORRECTIONS • Government regulation • Regulations to limit activities will shift Qopt Qm D=MPB curve. • Advertising • Can persuade consumers to use less of a good, which decreases demand. 3 MARKET FAILURE
S = MPC=MSC
external cost
D = MPB MSB
Q
• Market-based policies • Imposition of excise tax will decrease the supply and shift supply curve upwards. EVALUATION MARKET-BASED POLICIES ADVANTAGES
•Preferred by economists because they internalize the economy (now paid for by producers and consumers) •Indirect taxes incentivize consumers
DISADVANTAGES •Hard to measure value of the external costs. •Inelastic demand on some goods, so large tax needed. ADVERTISING/REGULATION ADVANTAGES
•Simpler •Regulation can prohibit some, like smoking.
DISADVANTAGES •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. Qm < Qopt and MSB > MSC and Qm. • 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.
Positive Production Externalities
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P
S=MPC MSC
external benefit
Pm Popt
D = MPB = MSB
Qm Qopt
Q
CORRECTIONS • Government provision • The government can engage in R&D and pay for training. This is paid for by gov’t funds. It results in the shifting of the MPC curve towards the MSC curve. • Subsidies • The gov’t 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. Qm < Qopt and MSB > MPB at Qm. • 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
Positive Consumption Externalities P
S = MPC=MSC
Popt Pm external benefit
MSB D=MPB
Qm Qopt
Q
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 gov’t provision • The gov’t 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. 5 MARKET FAILURE
EVALUATION DIRECT GOV’T PROVISION AND SUBSIDIES ADVANTAGES
•very effective in increasing consumption •also lowers price of good
DISADVANTAGES •involves government funding and tax revenues (opportunity cost) •size of benefits hard to measure LEGISLATION AND ADVERTISING ADVANTAGES
•Help shift the MPB curve
DISADVANTAGES •can’t 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 doesn’t 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 can’t pay. FREE RIDER PROBLEM • Comes from non-excludability because people can’t be excluded from the use of a good. Because of the free rider problem, private firms don’t 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? Gov’t has opportunity costs. 6 MARKET FAILURE
• Gov’t needs to perform cost-benefit analysis to see the benefits of a certain public good. If benefits < costs, good shouldn’t 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 nonexcludable. • 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 don’t 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 gov’t limits threats to sustainability by having licenses, permits, restrictions, etc. • They are easy to put in effect and oversee, and are effective. They don’t offer incentives, however. 7 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 • Can’t target particular level of reduction • Regressive • Must be adjusted for inflation • Tradable permits - a cap of total CO2 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. INT’L 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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