Externalities, Public Goods + Common Resources and Correcting Externalities

Question 1

market failure

Answer 1

when the market fails to produce the social optimum outcome and occurs when markets are not perfect

the public interest view
- focuses on the role of
governments in preventing market failure
- focuses on the negative consequences of rent-seeking behaviour by monopolists, polluters and others

Question 2

government failure

Answer 2

when the government fails to produce the social optimum outcome, by failing to correct a case of market failure or otherwise produce an inefficient outcome

the private interest view

• focuses on the role of private markets in preventing government failure
• focuses on the negative consequences of rent-seeking behaviour by firms, industries and individuals who try to influence regulators in order to capture more surplus

Question 3

what can cause market failure

Answer 3

markets can fail to deliver the social optimum outcome in a number of contexts

• the legal system and the rule of law
• maintaining and enforcing competition
• externalities
• common resources management
• public goods
• equitable distribution of resources within society

government failure tends to occur in situations where the government is not exposed to the market forces and therefore does not face the same incentive to improve efficiency as private markets face

Question 4

externalities

Answer 4

an externality arises when a person engages in an activity that influences the well-being of a bystander but neither pays nor receives compensation for that effect

• can be positive and negative, and occur from individuals’ consumption and firms’ production
• in the presence of externalities, society’s interest in a market outcome extends beyond the well-being of buyers and sellers who participate in the market to include the well-being of bystanders who are affected indirectly
• because buyers and sellers neglect the external effects of their actions when deciding how much to demand or supply, the market equilibrium is not efficient when there are externalities

Question 5

definition: private costs

Answer 5

costs or benefits that are borne by the individual or firm deciding to consume or produce a good or service

Question 6

definition: social costs

Answer 6

costs or benefits that are borne by the whole society as a result of the individual or firm deciding to consume or produce a good or service

Question 7

positive externalities (diagram)

Answer 7

when the social benefit of consumption or production is greater than the private benefit

e. g. you take the flu-vaccine
- the private benefit of consumption = the benefit to you of not getting the flu
- but other people also benefit from you not being able to get the flu and pass it on = the social benefit
- if too few people take the vaccine, we will not reach the social optimum and therefore market failure occurs

Question 8

positive externality DWL

Answer 8

DWL is the amount of total surplus lost when markets are not efficient

the DWL for each unit of under-production = the difference between social MB and social MC

total DWL for all units under-produced is the sum of these differences for each unit

represents the total lost benefit from society = all the units we should have produced but we didn’t

Question 9

negative externalities (diagram)

Answer 9

when the social cost of consumption it production is greater than the private cost

e. g. a factory emits pollution into the river
- the private cost to the factory of producing = the cost of inputs
- but society as a whole also bears a cost which is not borne by the producer = poor health, environmental decay, cost of cleaning up
- the social cost of production is the total cost of production to firm and other members of society
- the factory doesn’t take this external cost into account when making the decision of how much to produce, so they will produce too much which leads to market failure

Question 10

negative externality DWL

Answer 10

DWL is the amount of total surplus lost when markets are not efficient

the DWL for each unit of under-production = the difference between social MB and social MC

total DWL for all units under-produced is the sum of these differences for each unit

represents the total lost benefit from society = all the units we should have produced but we didn’t

Question 11

what can be done

Answer 11

market failure can be addressed and mitigated by various means

• self-correction = it is possible, under certain conditions, that markets can self- correct. if so, the government may try to facilitate this
• command and control = e.g. prohibiting recreational drugs
• price and quantity controls = e.g. quotas and licenses
• taxes and subsidies = “internalising the externality” e.g. carbon tax
• instating property rights = creating markets where there previously were none; e.g. pollution permits

Question 12

self correction: the coase theorem

Answer 12

if transaction costs are low, private bargaining will result in an effect solution to the problem of externalities

• there have been cases where consumers and stakeholders have acted either in concerted ways or individually to change firms’ behaviour
• this is what stakeholder activism is all about, and key to the concept of corporate social responsibility
• stakeholders can either do this by actively deciding to boycott or otherwise pressure a firm into better conduct, or by privately deciding not to buy the products of firms that pollute
• firms would have to respond to either by changing their ways
• in this case, it is market forces and consumer preferences that drives this shift, and not government intervention

many believe this to be the best way to deal with some externalities

but when the conditions for self-corrections aren’t met, it is ultimately up to the government to try to mitigate or fix these problems

typically, the problem with market failure is that the economy is either producing and consuming too much, or too little = the government can then intervene to either try to increase or decrease quantity

Question 13

command and control

Answer 13

the government can ban some goods or activities outright, like prostitution, recreational drugs or the sale of human tissue; or make goods or activities compulsory, like having defibrillators and wheelchair access in key public places

this can be justifiable in certain contexts, especially on moral and ethical grounds, but may be too blunt in others

i.e. what would happen if we banned pollution completely or made flu-vaccines compulsory?

even activities with positive externalities have a cost associated with them, and even activities with negative externalities have a benefit associated with them

• vaccines are not produced for free
• pollution is the by-product of production which is valued by society

Question 14

market intervention

Answer 14

unless there is a strong case for banning goods/activities or making them compulsory, we must consider the golden rule = try to get closer it where MSB equals MSC = allocative efficiency

the problem is usually that we need to get to the correct quantity, because we are either producing or consuming too much or too little

Question 15

government tools

Answer 15

quantity restrictions

• targets the problem directly
• will only work if quantity is too high
• can lead to shortages

price restrictions

• targets the problem ‘semi-directly’
• can lead to shortages or surpluses in the market, with the associated problems

taxes and subsidies

• targets the problem indirectly
• will not lead to shortages or surpluses

Question 16

public goods

Answer 16

public goods are non-excludable, and non-rival

the combination of these two criteria leads to the essential market failure of these goods = the free-rider problem

free-rider problem = if i can consume this good without paying for it, then i won’t
- as everyone thinks this way, no one will pay for it and the good will never get produced

examples

• a lighthouse and street lighting
• national defence and police
• national parks
• immunisation programs

Question 17

common resources

Answer 17

tragedy of the commons

common resource = non excludable but rival

this can cause market failure, because it is in no individual’s interest to withhold from using the resource
- if i don’t get in and feed my cows now, someone else will, and there will be nothing left for mine

common resources tend to be over exploited

examples
- clean air and global climate, congested roads, oil deposits and fish, whales and other wildlife

Question 18

solutions to tragedy of the commons

Answer 18

private property rights
- if someone owned the common, then it would be in their interest to ensure its sustainability

if the problem is specific to a small area, people generally can bargain and work out a solution themselves

if the problem is broad, governments can either tax, or set quotas, issue permits
- e.g. rock lobster fishing in WA

sometimes, the problem is exceptionally difficult to co-ordinate = climate change and ocean fishing being two notable examples of this

Question 19

correcting externalities

Answer 19

externalities lead to production and consumption being too high or too low compared to what is optimal for society

the problem is always that the quantity is wrong leading to a deadweight loss

recall:

• socially optimal production and consumption requires that MSC=MSB
• markets will ensure production and consumption is such that MPC=MPB
• if we have externalities of production or consumption MSC is not necessarily equal to MPC and MSB is not necessarily equal to MPB
• in that case, a privately operating market will end up such that Q is either above or below the social optimum
• the government can then intervene in an attempt to correct the situation

Question 20

a positive externality

Answer 20

positive externalities typically result in too little being produced
and consumed in the market

solution = anything that will increase Q

we cant force people to produce and consume QE but we can
manipulate prices such that they will end up at QE
- introduce a subsidy

Question 21

using a subsidy to deal with a positive externality (diagram)

Answer 21

the government can correct the market failure by inducing market
participants to internalize the externality

to move the market equilibrium closer to the social optimum, a positive externality requires a subsidy

if the government paid firms a subsidy for each unit produced, the supply curve would shift down by the amount of the subsidy, and this shift would increase the equilibrium quantity

to ensure that the market equilibrium equals the social optimum, the subsidy should equal the value of the spill over

Question 22

a negative externality

Answer 22

negative externalities typically result in too much being produced
and consumed in the market

solution
- price control = if we set a price floor at PE, people will consume QE, but how do we ensure producers produce at
QE and how do we stop them from producing more
rather than less
- quota = we could impose a quota such that producers
are only allowed to produce QE, but this may lead to a shortage and all the associated problems that this implies
- a tax = this would drive a wedge in between the price consumers pay and the price producers receive, such that both parties choose to produce and consume = best method

Question 23

using a tax to deal with a negative externality (diagram)

Answer 23

the tax would shift the supply curve upward by the size of the tax

if the tax accurately reflected the external cost of the externality, the new supply curve would coincide with the social-cost curve = pigouvian tax

in the new market equilibrium, producers would produce the socially optimal quantity of the good

the use of such a tax is called internalizing the externality because it gives buyers and sellers in the market an incentive to take into account the external effects of their actions

producers would, in essence, take the costs of the externality into account when deciding how much to supply because the tax would make them pay for these external costs

because the market price would reflect the tax on producers, consumers would have an incentive to use a smaller quantity

Question 24

implementing taxes and subsidies

Answer 24

taxes and subsidies can be imposed/given either to producers or consumers

the burden of a tax and the benefit of a subsidy are both shared between consumers and producers, regardless of whether the tax/subsidy is imposed on/given to consumers or producers, so the outcome is the same

for producers

• a subsidy given directly to a producer = shifts the MPC curve left
• a tax imposed directly on a producer = shifts the MPC curve right

for consumers…

• a subsidy given directly to a consumer decreases price = so only a movement down along the MPB curve
• a tax charged directly on a consumer increases price = so only a movement up along the MPB curve

Question 25

tradable permits

Answer 25

supply of permits is fixed in the primary market, in the same way as for picasso paintings

however, we can allow for a secondary market where people who own permits can sell them to someone who needs them

• when the demand for permits is high, this drives the price for permits up, and will eventually induce someone who holds a permits to sell
• this way, those who really have few alternatives but to pollute will have the higher willingness to pay
• those who have more alternatives available can be easily induced to sell their permits
• eventually, permits will be allocated such that pollution is limited to those who have little alternative, and all those firms who can change their production methods will do so
• but if there are too many permits issued into the primary market in the first place, the secondary market collapses = price falls to zero and the permits become worthless

Question 26

tradable permits: advantages

Answer 26

overcomes the externality by again internalising it as a cost to firms

promotes technological progress by changing the relative prices between ‘clean’ and ‘dirty’ sources

tends to drive out the inefficient producers

• most inefficient firms need to buy the permits = this increases their costs, which then increases the price they charge to consumers who then buy less of it
• efficient producers can sell their permits = they earn revenue from this, and can therefore charge less for their product

Question 27

tradable permits: disadvantages

Answer 27

still the issue of getting the right level in the first place
- knowing what the socially efficient level of production is in order it get the right number of permits

appears to open up possibilities for rent-seeking from industry groups

if the problem is global, the system really should be global but getting agreement on this is often extremely difficult