1、Externalities & Market Failure,What is Market Failure?,A condition in which a market does not efficiently allocate resources to achieve the greatest possible consumer satisfaction. The four main market failures are Externalities (social costs and social benefits) Monopolies (Competition policy) Fact
2、or immobility Imperfect information,MIND MAP,Externalities,Externalities are the effect of a decision on a third party that is not taken into account by the decision-maker. Externalities cause markets to be inefficient, and thus fail to maximize total surplus. Four types of externalities: Negative p
3、roduction externalities Positive production externalities Negative consumption externalities Positive consumption externalities,Barking dogs (loud pets),Automobile exhaust,Research into new technologies,Restored historic buildings,Private/External & Social Costs,Private costs are paid by the consume
4、r or producer concerned they are internal costs of production and consumption Ex. Paint producing company private costs might be wages, electricity, transportation External costs Economic activities of one group has a negative impact on others The impact is not taken into account or paid for by thos
5、e creating itthe production & consumption of these goods cause harm to third parties Ex of these are as follows -,External & Social Costs,Smoking - passive smoking causes health problems for people who do not consume cigarettes themselves. Pollution - causes health problems and long term environment
6、al problems Alcohol abuse - clean-up costs of fights, vomiting etc. as well as long term health problems from binge drinking.Negative externalities lead markets to produce a larger quantity than is socially desirable. Social costs Total economic cost of an activity to a society (includes private cos
7、ts incurred by firms) As well as consumers who bear these costs and are not involved in the activity,Social cost,Social Costs = Private costs + External costs This can lead to a misallocation of resources (causing a loss of allocative efficiency)In either case, resources are not being used in their
8、highest-valued activity and market failure can occur.,Costs Compared,Private Benefit,Private benefits occur when they provide satisfaction/pleasure from consumption or productionex- Health benefits from consuming (moderate levels of alcohol) Consumer surplus (e.g. from drinking at a price lower than
9、 a consumers willingness to pay) Ex taking vaccination - individual will not catch the disease Ex- of private benefits enjoyed by producers through the revenue genenerated from the sale of goods & services. Production revenue generated by firms from the sale of goods and services.,External Benefit,E
10、xternal benefits created when economic activities of one group have a positive impact on others The impact was not taken into account or paid for by those who benefit from itEx- vaccination taken by an individual in order to prevent a specific disease. (thus others now will not catch the disease The
11、 social value of the good exceeds the private value. An engineer undertakes training if he moves to another company the other company benefits from his skills & experience without paying for it.,External & Social Benefits,A technology spillover is a type of positive externality that exists when a fi
12、rms innovation or design not only benefits the firm, but enters societys pool of technological knowledge and benefits society as a whole.Social benefit the total benefits of an activity, the sum of Private benefit + External benefit Positive externalities lead markets to produce a smaller quantity t
13、han is socially desirable.,Negative Externalities,Causes an overproduction of goods and services (too much resources are being allocated to the production of this specific good/service) with prices that are also too low,Illustrating Market Failure,the private costs of the supplier are the same as th
14、e costs for society if there are negative externalities, we must add the external costs to the firms supply curve to find the social cost curve. If the market fails to include these external costs, then the equilibrium output will be Q2 and the price P2 From a society view of point this is an econom
15、ic bad and a less level of output is more desirable A socially-efficient output would be Q1 with a higher price P1. At this price level, the external costs have been taken into account.,Positive Externalities,the normal market equilibrium is at P1 and Q1 but if there are external benefits, the Q1 is
16、 an output below the level that maximises social welfare. the govt wishes to increase consumption towards output level Q2 so as to increase economic welfare.,Quantity Bought and Sold,SB,PC,5,100,SC = PC + External Cost,12,7,80,Socially efficient output is where SC = SB,Value of the negativeexternali
17、ty (Welfare Loss),Social Cost,EXTERNAL COST,The Social Benefit curve (SB) is the total private benefit to producers & benefits to consumers( society as a whole). The Private Cost (PC) curve represents the costs to suppliers of producing a given output.,The PC does not include the cost to society of
18、production. At an output level of 100, the private cost to the supplier is 5 per unit but the cost to society is higher than this (12).,The true cost therefore is the SC (the PC plus the external cost). Current output levels therefore (100) represent some element of market failure price does show th
19、e true cost of production.,The difference between the value of the SB & the SC represents the welfare loss to society of 100 units being produced.,Price,Quantity Bought and Sold,PB,SC,5,100,Value of the positiveexternality (Welfare Loss),Socially efficient output is where SC = SB,SB,10,6.50,140,EXTE
20、RNAL BENEFIT,Social Benefits,There can be a position where output is less than would be socially desirable (education for example?) In this case, the sum of the benefits to society is greater than the private benefit to the individual.,Internalising Externalities,One class of solutions to the extern
21、ality problems involve internalizing the costs and benefits, so that the market can work better. Some of the choices are as follows - Contracts - parties through negotiation can agree as to how to regulate the externality Taxes Regulation Subsidies Property rights State-provided goods,Govt policies
22、towards 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. Command-and-Control Policies Usually take the form of regulations: Forbid certain behaviors. Requir
23、e certain behaviors. Examples: Requirements that all students be immunized. Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA).,Public Policies Contd,Market-Based Policies Government uses taxes and subsidies to align private incentives with social efficiency.
24、Pigovian taxes are taxes enacted to correct the effects of a negative externality. Examples of Regulation versus Pigovian Tax If the EPA decides it wants to reduce the amount of pollution coming from a specific plant. The EPA could tell the firm to reduce its pollution by a specific amount (i.e. reg
25、ulation). levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian tax).,Pigovian Tax,Public Policies Con td,Market-Based Policies Another approach to pollution is the introduction of marketable pollution permits. The government sells the permits, which in total allow th
26、e amount of pollution that the government believes to be acceptable. Demanders, typically firms, purchase the permits, allowing them to pollute up to the amount specified by the permits they own. If a firm is able to employ a cleaner technology, then it can enjoy additional revenues by selling its p
27、ollution rights to someone else.,Market for Pollution Permits,Pollution Tax- if a firm is creating a negative externality in the form of pollution, create a tax on the polluting firm equal to the cost of cleaning up,A Tax on a firm creates a negative externality reduces the quantity supplied and thu
28、s forces the firm to internalize the subsidy the externality Q2 is produced rather than Q.,Advantages & Disadvantages,PROS Provides incentives to reduce the negative externality such as pollution. E.g. cars have become more fuel efficient Social efficiency, 1st best solution.(where MSC = MSB) Taxes
29、raise revenue for the govt. This can be spent on alternatives,CONS Difficult to measure who & the level of negative costs If Demand is inelastic then higher taxes will not reduce demand much Taxes will cause inequality Cost of administration Possibility of evasion. E.g. with tax on disposing of rubb
30、ish there has been an increase in fly tipping (illegal rubbish being thrown),Optimum,Equilibrium,Cost of,pollution,Supply,(private cost),Demand,(private value),Price of Aluminum,Quantity of Aluminum,Pollution and the Social Optimum,The Market for Aluminum,The quantity produced and consumed in the ma
31、rket 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. For each unit of aluminum produced,
32、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
33、quantity.,Advantages & Disadvantages,PROS Increases social efficiency provides an alternative to the car,CONS Is expensive and will requires higher taxes. Difficult to estimate positive externality Giving subsidies to firms may encourage inefficiency, because the firms can rely on government aid. Go
34、vt Failure: The govt may have poor information about the service,Cost benefit analysis,Cost benefit analysis (COBA) is a technique for assessing the monetary social costs and benefits of a capital investment project over a given time period or Cost benefit analysis refers to a study that compares th
35、e costs and benefits to society of providing a public good. Govt assess all the benefits of providing a public good to the cost of maintaining & providing the services. Ex such as new motorways, by-passes, dams, tunnels, bridges, flood relief schemes and new power stations. Terminal 5 for Heathrow a
36、irport,CBA contd,Stage 1 & 2,Calculation of social costs & social benefits Tangible Benefits & Costs (i.e. direct costs & benefits) Intangible Benefits & Costs (i.e. indirect costs & benefits externalities) This process is very imp it involves trying to identify all of the significant costs & benefi
37、ts Monetary, e.g. a new road may mean less money for train companies,Sensitivity analysis of events occurring Measures the probability of outcomes (benefits & costs) occurringthe scale of uncertainty about the actual values (costs & benefits),Stage 3 & 4,Discounting the future value of benefits cost
38、s and benefits accrue over time people prefer to enjoy the benefits now rather than laterso the value of future benefits has to be discounted these will also be discounted, for example, 100 now is worth more than 100 in the future (NPV),Comparing the costs and benefits to determine the net social ra
39、te of return Some costs may have a probability of occurring e.g. accident has a 10% chance of occurring but would cost 6,000. Therefore the cost is 0.1 * 6,000 = 600,Stage 5,Comparing net rate of return The govt evaluates the return for many projects due to limited funds Therefore faces a choice abo
40、ut which projects should be given the go-ahead This can be a very tedious & difficult process,Evaluation of CBA,Advantages Allows for efficient allocation of resources Decreases negative externalities,Disadvantages Can be hard to put values to social costs and benefits (costs are easy to value such
41、as the running costs (e.g. staff costs) + capital costs (new equipment). Other costs are more difficult not least when a project has a significant impact on the environment) Can be difficult to include all externalities Costs and benefits can be different for different groups (cannot include all sta
42、keholders that may be affected by the outcome of the project) some group of people might be left out and therefore the effects on them could be positive or negative),Case study - A national smoking ban,Economic Growth Provide jobs & businesses thousands of people (rapid market expansion,Transport Th
43、e terminal will be the centre of a world-class transport interchange, with new Tube & rail links. Traffic congestion will increase only slightly,The Economy & Trade The UK would lose airlines & investment to other European rivals if it does not meet demand The benefits of a world-beating industry wo
44、uld be diminished,Jobs The terminal 5 project will create an estimated 16,500 jobs, as well as creating 6,000 construction jobs during the building phases,Environment Any displaced wildlife and plant life will be replaced,The case for Terminal 5,Noise and night flights: BAA promises no increase in o
45、verall noise levels or in night flying. The number of flights would rise only 8%,Growth Forecast are misleading, uncontrolled expansion,Economy Already has the largest terminal (commercial prestige) rather than long term macro-benefits,Jobs: Only 6,000 jobs will be created - a tiny fraction of all t
46、he new jobs in the South East.,Transport: There will be a significant increase in road-widening & car parks to cater to thousands of extra journeys,Environment: Air pollution will increase significantly & hundreds of acres of wildlife and Green Belt land will be lost forever,Noise and night flights:
47、More flights will mean more noise under the flight paths & pressure for controversial night flights,Objections against Terminal 5,Summary,Market failure occurs when resources are not allocated efficiently e.g. in monopolies or where externalities exist A negative externality occurs if an activity cr
48、eates costs (harm or discomfort) for uninvolved people. Ex- of negative externalities: Cars and factories generate air pollution that affects peoples health. A positive externality occurs if an activity creates benefits for uninvolved people. Ex. of positive externalities: People who get vaccination
49、s against a communicable disease reduce other peoples chances of getting the disease. Private market transactions will lead to overproduction of goods with negative externalities & underproduction of goods with positive externalities. Social Cost” or SC curve. This curve represents all costs of prod
50、uction, including both private production costs and .,Summary contd,external costs The “Social Benefit” or SB curve, which includes all benefits to buyers and uninvolved people. It is to the right of the usual demand curve. Governments aim to reduce market failure with subsidies, taxation, regulation etc Command or market based approaches to solve externalities Cost benefit analysis aims to give values to social costs and benefits thereby resulting in more efficient allocation of resources,
