Externalities, solutions and other market failure

Today’s presentation

What is market failure?

Externalities

Solutions

Other kinds of market failure

What is market failure?

This definition comes up regularly!

It pays to define this term whenever it appears in the question (just like other definitions)

Externalities

Things you need to know

What they are

Positive and

negative

The diagrams

What makes them

large/small

Solutions

What are externalities?

Positive externalities

Negative externalities

The costs or benefit

received by a third party

to an economic

transaction outside of the

market mechanism; i.e.

the spillover effects of an

economic activity.

What things go in externality diagrams?

MSC, MPC, MSB, MPB

Private = Social optimum

DWL Under/overproduction

Externality 1: a negative externalityPri

ce

Quantity

1. MSC, MPC, MSB, MPB

2. Private =

3. Social optimum

4. DWL

5. Under/overproduction

MPC

MSC

MPB = MSB

Q2

P2

Social optimum

Q1

P1 Private equilibrium

Deadweight welfare loss

Overproduction

Externality 1: a positive externalityPri

ce

Quantity

1. MSC, MPC, MSB, MPB

2. Private =

3. Social optimum

4. DWL

5. Under/overproduction

MPC

MSB

MPB

= MSC

Q2

P2 Social optimum

Q1

P1Private equilibrium

Deadweight welfare loss

Under-

production

How big is the externality?

Ways to think about size of

externality eval

Short run vslong run

Long run impact may be greater

since…

Ceteris paribus…?

Government intervention? New tech?

Magnitude of impact – link to

data

UK is very reliant on GM

since…

Do some external benefits outweigh costs?

External benefits in improved health…

Category Types

Are solutions good/ bad?

Cost/ revenue to government?

Government failure?

Effectiveness and enforcement?

Impact on firms and UK economy

Fairness?

Solution 1: taxationExplanation

•A pigouvian tax is set to shift the MPC

curve towards the MSC curve

•In theory the level of the tax per unit

should be exactly equal to the marginal

external cost

•This internalises the externality

Diagram

Example

Pri

ce

Quantity

MPC

MSC

MPB =

MSB

Q2

P2

Social

optimum

Q1

P1 Private equilibrium

Original

DWL

Over-

production

MPC TAX

Q3

P3

Reduced

DWLUnit

tax

Are solutions good/ bad?

Cost/ revenue to government?

Governments make revenue

from taxes

Government failure?Information

problem

Effectiveness and enforcement?

Risk of smuggling and black markets

Impact on firms and UK economy

International competitiveness

Fairness? Producer pays!

Solution 2: extending property rightsExplanation

•Through the extension of property rights

companies and consumers are able to seek

compensation from companies and individuals

which pollute.

•This raises costs for firms

•This is a means by which the problem of the

externality is internalised, and so eliminating

the problem by bringing it back into the market

mechanism.

Diagram

Example

•Extended property ownership over

bodies of water, or even the air above

your house

Pri

ce

Quantity

MPC

MSC

MPB =

MSB

Q2

P2

Social

optimum

Q1

P1 Private equilibrium

Original

DWL

Over-

production

MPC 2

Q3

P3

Reduced

DWLUnit

tax

Are solutions good/ bad?

Cost/ revenue to government? Very low (ignoring court costs)

Government failure?Lack of financial support for the

scheme?

Effectiveness and enforcement?

1) Information problem

2) Other countries?

Impact on firms and UK economy

International competitiveness

Fairness?

1) Costs to seek claim. Favours the rich

2) BUT those harmed get the compensation.

Solution 3: regulationExplanation

•Minimum standards can be put

in place that force firms to only

pollute below a certain amount

•This solution is very simply – it

simple caps the amount of

pollution the firm can produce

Example

Examples include:

1. Setting minimum standards for

health and safety at the workplace

2. Penalties for firms who pollute too

much

3. Banning cigarette advertising and

making workplaces no-smoking

environments

Are solutions good/ bad?

Cost/ revenue to government?High supervision and

enforcement costs

Government failure?

1) Information problem

2) Risk of regulatory capture and weak regulators

Effectiveness and enforcement?

Possibility of evading regulation

Impact on firms and UK economy

Impact of ‘red tape’ and bureaucracy on costs

Inefficient distribution

Fairness?Does not necessarily raise costs for polluter or compensate consumer

Solution 4: tradable permitsExplanation

•The regulation solution was

inefficient as it did not distribute

the costs of reducing

emissions well

•Tradable permits try and do this

•A firm that finds it difficult to cut

down emissions can buy from a

firm that finds it much easier.

That way the reduction in

pollution is done at minimum cost

Tonnes

of

Carbon

Firm A cost to

remove

Firm B cost to

remove

1 £12,500 £17,000

2 £12,000 £16,000

3 £11,500 £15,000

4 £11,000 £14,000

5 £10,500 £13,000

6 £10,000 £12,000

7 £9,500 £11,050

8 £9,000 £10,000

9 £8,500 £9,000

10 £8,000 £8,000

Are solutions good/ bad?

Cost/ revenue to government?

High supervision and enforcement costs

Government failure? Number of permits

Effectiveness and enforcement?

Possibility of evading regulation

Impact on firms and UK economy

Possibility of monopoly power

Fairness?How to fairly distribute permits? Given away?

Explanation•A pigouvian tax is set to shift the MPC

curve towards the MSC curve

•In theory the level of the tax per unit

should be exactly equal to the marginal

external cost

•This internalises the externality

Diagram

Example

Pri

ce

Quantity

MPC=MSC

MSB

MPB

Q2

P2 SO

Q1

P1

PE

Original DWL

Under-

production

Solving positive externalities 1: subsidies

MPC 2

Q3

P3

Reduced

DWLUnit

subsidy

Are solutions good/ bad?

Cost/ revenue to government?

High cost

Government failure?

Political self-interest –too large?

Effectiveness and enforcement?

Is the subsidy well targeted and used?

Impact on firms and UK economy

Create inefficiency?

Fairness?Consumers benefit from lower prices

Solving positive externalities 2 – direct

provisionExplanation

•In some cases governments

chose to directly provide the

goods themselves

•This is more often used in

cases such as public goods, but

can also be used for

externalities (especially positive

ones)

Example

Examples include:

1. Provision of healthcare

2. Provision of education

3. In the case of public

goods, street lighting and

national defence

Are solutions good/ bad?

Cost/ revenue to government?

High cost – will often require increased taxes

Government failure?Problems of self-interest and

myopia

Effectiveness and enforcement?

Lack of efficiency in the public sector

Potential over-consumption

Impact on firms and UK economy

Reduce size of private sector - potential SS impact

Fairness? Equitable distribution

Other market failure

Unstable prices

Causes

Inelastic supply

Inelastic

demand

Regular and

unpredictable

supply/demand

shocks

Pri

ce

Quantity

D

SS1

Q2

P2

Q1

P1

BIG

Change

In

Price

Problems

Problems for

Firms

Sudden loss of revenue and profit

Inefficiency – hard to know what to grow

Unpredictability leading to under-investment

Good firms can go bankrupt

Consumers

Lack of security

Inability to plan effectively

Potential impact on inflation

Buffer stock schemes

Q3

In good years…Pri

ce

Quantity

D

S

Ptarget

P1

Q1Q2

Spending on scheme

Q3

In bad years…Pri

ce

Quantity

D

S

Ptarget

P1

Q1Q2

Profit from scheme

Will they work?

Will it work?

Is the scheme open to

government failure?

Is successful cooperation

likely?

Can the good be stored?

Can the costs of storage be

paid?

Is there enough

finance for the scheme?

Public goods

Evaluating public goods

Parks

Non-rival?

Non-excludable?

TV signals

Non-rival?

Non-excludable?

Music downloads

Non-rival?

Non-excludable?

Other areas to look at