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Market Failure: An Introduction. Section 2.4 HL Extension. Section Overview : Why are there so many inconvenient truths?. Reasons for Market Failure. Positive and Negative Externalities Missing markets (i.e. goods which are underprovided e.g. health care)

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Market Failure: An Introduction

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Market Failure:An Introduction

Section 2.4 HL Extension


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Section Overview : Why are there so many inconvenient truths?


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Reasons for Market Failure

Positive and Negative Externalities

Missing markets (i.e. goods which are underprovided e.g. health care)

Imperfect competition (i.e. monopolies)


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Definitions and Concepts


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Definitions and Concepts

Cost and Benefits

External Cost = costs to third parties

External Benefits = benefits to third parties

Prices

Send signals about how resources should be allocated

If Costs or Benefits are not correctly considered, the market has failed


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Definitions and Concepts

Marginal Social Cost (MSC)

MSC = extra cost to society of producing one more unit. MSC upward sloping due to diminishing returns.

Marginal Social Benefit (MSB)

MSB = equals the extra benefit (utility) to society of producing one more unit. MSB downward sloping due to diminishing marginal utility

Community Surplus

Equilibrium price the market is Pareto Optimal i.e. it is impossible to make anyone better off without making someone worse off


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Definitions and Concepts

Externalities arise when the market clearing price creates benefits or inflicts costs on a third party

Positive externalities arise when the social benefit of consuming another unit, i.e. the marginal social benefit (MSB), is greater than the marginal social cost (MSC) of producing it

Negative externalities arise when MSB are outweighed by increased MSC - the market underestimates the true cost of the good to society and produced too much of it


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Positive Externalities: Focus on Benefits


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Negative Externalities: Focus on Costs


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Sustainable Development


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Sustainable Development

The present use of resources in satisfying the needs of the economy should not lessen or limit future generations’ use of resources in satisfying needs

To what degree is industrialization & resource consumption sustainable in the long run?


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Public Goods


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Public Goods

Flood control Barriers on the Thames River


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Types of Public Goods


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Public Goods as Market Failure

No incentive for Private Enterprise

  • E. g. Private benefit to one Londoner would be very small though the Social benefit would be very great.

    Presence of Free Riders

    • Individual who consume the good but pays nothing or little to cover the cost of that product


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Possible Solution to this form of Market Failure

Government provides the good or service

Government subsidizes private forms to supply the good or service


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Merit & Demerit Goods


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Merit and Demerit Goods

Health Care education

Lack of Knowledge

Alcohol

Tobacco


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Issues related to Merit Goods

Issues

Solutions


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Monopolies


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Abuse of Monopoly Power

Market failure occurs under conditions of imperfect competition (monopoly, oligopoly & monopolistic competition)

Monopolies have power to set output and price to maximize profits

Monopolies gain this power due to a lack of viable substitutes or competition


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Monopolies

Monopolies can:

Erect high barriers of entry to dissuade potential competitions

Engage in predatory pricing

Buy up rivals

Own/control vital raw materials

Set different prices on different markets (price discrimination)


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Government Intervention


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Legislation

Legislation attempts to correct market failures by influencing both supply/demand for goods and includes:

Bans (when net MSB is negative at all output levels - no amount of the good on the market adds to social well-being)

Influencing production/consumption (restrictions on sales/use)

Regulating externalities (limits on pollutants/emissions)

Regulating competition (anti-trust laws)

Legislation has drawbacks e.g. a ban could create a black market, harsh regulations could drive up costs/prices


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Taxation & Subsidies


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Definition

Taxes are levied to internalize externalities i.e. make hidden costs visible & burden those responsible for them in some way

Governments may levy an indirect tax on goods with negative externalities to provide a disincentive for consumption (e.g. tobacco/cigarettes)

Subsidies are used to encourage the output of certain goods

Goods are subsidized when consumption/production is considered to have positive effects OR when users cannot see future benefits or benefits to third parties (e.g. milk is subsidized by governments for its health benefits)


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Tradable Permits


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Definition

Tradable Permit Schemes are a market-based solution to pollution

Government agencies set a ceiling for total emissions then issue credits to firms and fine those who pollute more than their permits allow

Permits may be resold to other firms, creating an incentive to clean up production & a disincentive to exceed the limits imposed

Pollution does not decrease in this system - only pollution per unit

Heavy polluters may buy ever cheaper permits due to more diligent firms cleaning up their act - and thus perpetuate the problem


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Extension of Property Rights


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Extending Property Rights

By extending property rights, governments can internalize externalities - any damages to private property create a basis for claims on the offending party

Previously un-attributed costs are thus clarified and responsibility is assigned

To exert pressure on offending firms: grant property rights to all businesses along a beach front so they have the incentive to clean up the beach as they compete for tourists

To get offending firms to exert pressure on themselves: extend property rights of a polluting firm to an entire river

Assigning property rights has a market-based appeal - monitoring the extent/cost of externalities is done by offending firms & third party sufferers


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Recap: The Tragedy of the Commons

Externalities arise when the market clearing price creates benefits or inflicts costs on a third party

Positive externalities arise when the social benefit of consuming another unit, i.e. the marginal social benefit (MSB), is greater than the marginal social cost (MSC) of producing it

Negative externalities arise when MSB are outweighed by increased MSC - the market underestimates the true cost of the good to society and produced too much of it


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Advertising & its impact on consumption


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Advertising

Advertising alters peoples’ behavior

Educating/informing citizens of both possible costs/benefits of use can change market demand and thus correct over/under-consumption

Governments use persuasive/informative advertising to change citizens’ behavior in order to limit externalities e.g. warning labels on cigarettes, drug education in schools


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International cooperation among governments


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International Cooperation on Environmental Issues

Dealing with environmentally-related externalities on a global basis involves the following:

Accountability (assigning blame & thus culpability)

Cost estimation (setting appropriate costs)

Method (debate on most efficient methods)

Trade-offs (striking balance between growth & environmental impact)

Loss of competitive edge (stricter legislation drives up production costs for firms)


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Government Intervention Diagrams


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Negative Consumption Externalities


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Negative Consumption:Reducing Demand through Advertising and Persuasion


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Negative Consumption:Raising Prices Through Taxation


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Negative Production Externality


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Negative Production Externality:Raising Prices Through Taxation


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Positive Production Externality


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Positive Production Externality:Increasing Supply through a subsidy


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Positive Consumption Externality


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Positive consumption Externality:Increasing Demand through legislation and advertising


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Positive Consumption Externality:Increasing Supply through a subsidy


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