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Market Failure The Case of Externalities. Market Failure = the inability of a system of private markets to provide certain goods or services, either at all, or at the most desirable or ‘optimal’ levels. Externality = where there are effects, either good or bad,

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market failure the case of externalities
Market FailureThe Case of Externalities

Market Failure = the inability of a system of private markets

to provide certain goods or services, either at all, or at the most

desirable or ‘optimal’ levels.

Externality = where there are effects, either good or bad,

of an economic action (usually production or consumption),

on parties not directly involved in that action.

Government may act to force the party causing the externality

to account for the external effects in their decision making

process, i.e., to internalize the externality.

slide2

At one time, there were no neighbors to be affected by one’s decisions.(Homestead remains from the early 1900’s in the Lost River Valley above Arco, ID)

in modern society almost any consumption or production affects somebody
In modern society, almost any consumption or production affects somebody.

Source: USDA, NRCS

http://photogallery.nrcs.usda.gov

how to offset or mitigate your property value damages caused by bad neighbors
How to offset or mitigate your property value damages caused by bad neighbors?

Source: USDA, NRCS

http://photogallery.nrcs.usda.gov

slide5
Neighbors help each other with landscaping projects – it increases their property values and satisfaction.

Source: USDA, NRCS

http://photogallery.nrcs.usda.gov

private marginal benefit mpb
Private Marginal Benefit - MPB

The price that represents what a consumer is willing to pay

for another unit of a good is referred to as the PMB,

using a standard market demand and supply graph.

Price

D = MPB = Demand

Quantity

private marginal cost mpc
Private Marginal Cost - MPC

The price at which a producer is willing to bring another

unit of a good to the market is referred to as the MPC,

using a standard market Demand and Supply graph.

Price

S = MPC = Supply

Quantity

marginal external costs mec
Marginal External Costs - MEC

Production may impose Marginal External Costs on other

producers. These may be negative, increasing the costs of the

3rd party, or positive, reducing the costs of the 3rd party.

Price

S = PMC

MEC for

Negative

Externality

Quantity

MEC for Positive

Externality

marginal external benefits meb
Marginal External Benefits - MEB

Consumption may impose Marginal External Benefits on other

consumers. These may be positive, increasing the benefits of the

3rd party, or negative, reducing the benefits of the 3rd party.

Price

D = PMB

MEB for

Positive

Externality

Quantity

MEB, Negative

Externality

competitive outcome
Competitive Outcome

Occurs at the quantity where the demand and supply curves

intersect, where MPB = MPC.

This is the best alternative private use of the resources.

D = MPB

S = MPC

Price

P*

Quantity

Q*

optimal social outcome
Optimal Social Outcome

Marginal Social Benefit (MSB) = Marginal Social Cost (MSC),

the best alternative Social use of the resources.

MSC =

MPC + MEC

D = MPB = MSB

Price

S = MPC

MSB = MSC

P1

P*

MEC for Negative

Externality

Quantity

Q1 Q*

neighbor s decision on patio stereo system size negative externality consumer affect on a consumer
Neighbor’s Decision on Patio Stereo System SizeNegative Externality, Consumer Affect on a Consumer
internalizing your damage in neighbor s stereo purchase decision
Internalizing Your Damage in Neighbor’s Stereo Purchase Decision

Competitive

Outcome

Optimal

Social

Outcome

Q

competitive vs optimal social level of dog production
Competitive vs Optimal Social Level of Dog Production

Optimal

Social

Outcome

Competitive

Outcome

Q

slide16
How Much Should Rancher Spend on Brush Control and Trail Maintenance?Positive Externality, Producer on Producer
production results in positive externality to 3 rd party producer
Production results in positive externality to 3rd party producer

Optimal

Social

Outcome

Competitive

Outcome

coase theorem
Coase Theorem

Externalities do not give rise to misallocation of resources if

transactions costs are small and property rights are defined

and enforceable.

The Parties involved would have a market incentive to

negotiate a mutually beneficial trade to internalize the

externality.

The neutrality theorem says that the physical outcome,

but not the distribution of welfare, does not depend on

which party holds the property rights.

coase theorem result
Coase Theorem Result

Whether or not the 3rd party or the producer has the property

right, the consumer pays P1 and Q1 is produced

MSC =

MPC +MEC

Price

D = MPB

S = MPC

a + b = Max. potential bribe

from 3rd party to producer

where producer has property right.

b

P1

a

P*

P2

Damages at Q1

= Min.Potential

compensation

to 3rd party where

3rd party has

Property right.

MEC

Q1

Q*

Quantity

government tools to address externalities
Government Tools to Address Externalities
  • Impose a tax equal to the MEC for negative externalities
  • Give a subsidy equal to the MEB for positive externalities
  • Impose a regulation limiting Q to the Optimal Social Level
  • Establish property rights so that affected parties can seek compensation
  • Establish markets for trading of pollutant rights
  • Establish an educational program
  • Support Research and Development activity to alter
  • production technology or mitigate externalities
single firm price taker producer welfare loss for output tax vs regulation vs externality tax
Single Firm (Price Taker) Producer Welfare Loss for Output Tax vs Regulation vs Externality Tax

P

MSC =

MPC + MEC

Output

Tax

Regulation

MPC

Market

Price

Tax

Externality Tax

MEC

Q

Q1

Q2

pollutant trading reduces compliance cost
Pollutant Trading Reduces Compliance Cost

C outbids B and purchases 90 permits from A and then 10 from B.

Final market price would be about $5. For permits that A would be

Willing to sell, C would outbid B, but wouldn’t need to go above $5.

Total Net compliance cost is now reduced to $550:

A: $4 * (10 + 90) – ($5*90) = -$50

B: $5 * (20 + 10) – ($5*10) = $100

C: $5 * 100 = $500

government intervention is costly
Government Intervention is Costly
  • Internal costs to the government for salaries, supplies, etc.
    • Deadweight loss of 25 cents per dollar of tax collected
    • Administrative costs of as high as 25 percent for program
    • administration and oversight
  • B. Costs imposed on those regulated – direct external costs.
    • Change in cost of production (inputs and technology)
    • Costs of compliance such as red tape reporting
    • Losses in productivity due to decreased incentives for growth
  • C. Indirect 3rd party costs, sort of like externalities
    • 1. Such as a 3 year delay to bring a new drug on the market
government intervention may be imperfect
Government Intervention May Be Imperfect

1. Imperfect knowledge or foresight.

2. Rigidities, both technically and institutionally.

  • Inefficient tools.
  • A strict rule may be so difficult to enforce, that it does
  • less good than a milder one with higher compliance.

4. Myopic regulation; not seeing the big picture.

5. Political constraints.

6. Decision maker’s objectives.

government wide priority setting
Government Wide Priority Setting?

There are many “needs” that never get “sponsored” by a

congressman.

Demand for a government wide comparison of B:C ratios

across all programs is apparently very weak.

So what if all the natural environment programs have benefits

greatly exceeding cost?

Perhaps the funds would yield even greater benefits

if spent on housing, education, roads, etc.

environmental quality incentives program eqip
Environmental Quality Incentives Program (EQIP)
  • A voluntary conservation program that promotes
  • productive use of private land and environmental
  • quality as compatible National Goals.
  • Landowners may receive financial and technical
  • help to install structures on their land or change
  • their technology use and management choices in ways
  • that benefit the environment.
  • Federal assistance may be combined with assistance
  • from state and local government, and non-profit groups.
eqip internalizes externalities
EQIP Internalizes Externalities
  • Assists some landowners comply with regulations
  • that were originally imposed to correct environmental
  • externalities
  • For non-regulated landowners who choose to participate,
  • subsidies and educational assistance are given so that both
  • beneficial and harmful effects to the environment are
  • voluntarily internalized
government employee assists private landowners to plan and install environmental practices for eqip
Government employee assists private landowners to plan and install environmental practices for EQIP.

Source: USDA, NRCS

http://photogallery.nrcs.usda.gov

farm ponds provide many benefits including livestock water gully control fish and wildlife habitat
Farm ponds provide many benefits including livestock water, gully control, fish and wildlife habitat.

Source: USDA, NRCS

http://photogallery.nrcs.usda.gov

establishment of windbreak to protect highway from drifting snow and soil
Establishment of windbreak to protect highway from drifting snow and soil.

Source: USDA, NRCS

http://photogallery.nrcs.usda.gov

rockwork protecting bank from erosion and buffer strip to intercept pollutant runoff
Rockwork protecting bank from erosion and buffer strip to intercept pollutant runoff.

Source: USDA, NRCS

http://photogallery.nrcs.usda.gov

slide32
Forest stand improvement by thinning and removal of under story brush benefits landowner and wildlife.

Source: USDA, NRCS

http://photogallery.nrcs.usda.gov

establishment of wildlife habitat in critical areas
Establishment of wildlife habitat in critical areas.

Source: USDA, NRCS

http://photogallery.nrcs.usda.gov

slide34
Ranchers in Salmon River valley install improved irrigation water diversion structures that also benefit salmon migration.

Source: USDA, NRCS

http://photogallery.nrcs.usda.gov

slide35
Lined irrigation ditch and individual siphon tubes reduce water losses, reducing costs, making more water available for society.

Source: USDA, NRCS

http://photogallery.nrcs.usda.gov

slide36
With 10’s of thousands of cows, manure production exceeds assimilation capacity of nearby available land.
slide37

Buffer strips, terraces, windbreaks, and other practices in a complete conservation system protect the land and improve the water quality in Prairie Rose Lake in Shelby County, Iowa.

Source: USDA, NRCS

http://photogallery.nrcs.usda.gov

subsidy to induce technology switch maintain output social outcome improved but not optimized
Subsidy to induce technology switch, maintain outputSocial Outcome improved, but not optimized

P

Subsidy set at (P2 – P1) to

maintain production at Q1

S2=MPC2

S1=MPC1

P2

P1

D=MPB

MEC1

MEC2

Q

Q1

summary 1
Summary - 1

An externality is where effects of a consumption or production decision

affect a 3rd party, whose interests are not considered in the decision.

The presence of externalities may indicate market failure if they are

not internalized in the decision making – market failure because the

private competitive outcome is not the best social use of resources.

If a negative externality, generally too much is produced or consumed.

If a positive externality, generally too little is produced or consumed.

Presences of large transactions costs and lack of defined and

enforceable property rights inhibit private externality internalization.

And, society may not like the equity or welfare distribution

implications of that private internalization.

summary 2
Summary - 2

The government may force externality internalization with:

Taxes

Subsidies

Regulation

Establishment of property rights

Markets for the externality

Education and technical assistance

Research and Development for new technology

Government action may be less than optimal, fail, or even make things

worse due to information, enforcement, vision, and political constraints.

Critics have long referred to economics as the “Dismal Science”.

There are “pros and cons” and “tradeoffs” to every decision.

conclusion
Conclusion

Economics is fun.

Economics is truly the science of life.

Understanding of economic principles can greatly improve

ones ability to deal with the complexities of modern society.

  • Personal economic choices
  • Resolving conflicts in an equitable manner.
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