Market failure and public policy
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Market Failure and Public Policy. February 7, 2005. An efficient market allocation:. Maximizes net benefits MB = MC MNB 0 =PV MNB 1 =PV MNB 2 =…=PV MNB n Cannot make anyone better off without making someone else worse off . Market Failure:. External costs (S=MPC only). S=MPC + MSC. $.

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An efficient market allocation
An efficient market allocation:

  • Maximizes net benefits

  • MB = MC

  • MNB0=PV MNB1=PV MNB2=…=PV MNBn

  • Cannot make anyone better off without making someone else worse off


Market failure
Market Failure:

  • External costs (S=MPC only)


S=MPC + MSC

$

S=MPC only

P*

pm

D

qm

q*

Tons of coal mined


Market failure1
Market Failure:

  • External costs (S=MPC only)

  • External benefits (D=MPB only)


$

MC

MSB + MPB

P*

pm

MPB

qm

q*

Acres of farmland


Market failure2
Market Failure:

  • External costs (S=MPC only)

  • External benefits (D=MPB only)

  • High exclusion costs

    • High exclusion costs limit incentive for private production of good or service


Market failure3
Market Failure:

  • External costs (S=MPC only)

  • External benefits (D=MPB only)

  • High exclusion costs

  • Non-rival goods (MC for additional user is 0)


Market failure4
Market Failure:

  • External costs (S=MPC only)

  • External benefits (D=MPB only)

  • High exclusion costs

  • Non-rival goods (MC for additional user is 0)

  • Open access

    • Individual users benefit but do not bear all costs of their use


MB = MC

12 – 4n = 8

n = 1, TB = 10

Rent = TB – TC

= 10 – 8 = 2

Case 1 - Privately owned land

Commodity produced with labor: Q = 12n – 2n2

Input is labor (n): n = number of laborers

P = $1 so TB = $1*Q so TB = 12n – 2n2

MB = 12 – 4n

MC = wage rate = 8


Rent = ½(4)(1) = 2

$

— MC

Number of laborers


Labor is added until all potential gains are exhausted

(on average, all costs are covered)

Case 2 – Open access land

Commodity produced with labor: Q = 12n – 2n2

n = number of laborers

First laborer earns rent. Second laborer observes this “surplus” and sees an opportunity to benefit.

P = $1 so Q = TB

AB= TB/n = (12n – 2n2)/n = 12 – 2n


$

— MC

Number of laborers


AB = MC

8 = 12 – 2n

n = 2, TB = 16

Case 2 (cont.)

AB = 12 – 2n

MC = wage rate = 8

Rent = 16 – 16 = 0

Rent is exhausted, or dissipated.


Rent dissipated

$

— MFC

Number of laborers


Market failure5
Market Failure:

  • External costs (S=MPC only)

  • External benefits (D=MPB only)

  • High exclusion costs

  • Non-rival goods

  • Open access

  • Planning horizon

    • Private vs. social discount rate


Reasons for public policy
Reasons for public policy:

  • Correct market failure

    • Internalize externalities

    • Provide public goods

    • Change/create property rights

  • Change outcome if we don’t like the efficient market outcome

    • Change/create property rights

  • Correct government failure


Incentive based policies
Incentive-based policies:

  • Property rights changes

    • Market failure: Open access shellfish flats on Cape Cod resulted in decreased quantity and quality of shellfish

    • Property rights change: Shellfish flats divided into individual parcels, sold or leased, and owners or lessees manage for the long run


Incentive based policies1
Incentive-based policies:

  • Property rights changes

  • Public (government) incentives

    • Taxes (increase cost of undesired activity)

    • Subsidies (increase benefits of desired activity)

    • These imply underlying property rights preferences


Example: Severance tax $t per ton of coal mined

$

S=MPC only

S=MPC + severance tax

P*

tax rate = p* - pm

pm

D

qm

q*

Tons of coal mined


Example: Subsidy payment for land retained in farming

$

MC

Total subsidy paid

MSB + MPB

P*

pm

MPB

qm

q*

Acres of farmland


Direct public action
Direct public action:

  • Command and control

    • Direct regulations or controls


Example: Zoning regulations limit development options

$

MC

MC with regulation

MSB

P*

pm

MPB

qm

q*

Acres of farmland


Direct public action1
Direct public action:

  • Command and control

    • Direct regulations or controls

  • Public goods production

    • Where no private incentive for production exists

    • High exclusion costs

    • Non-rival goods


Why attributes of things matter: Consider the following communication between Canadian authorities and the commander of a U.S. Navy ship off the coast of Newfoundland in October, 1995:

Americans: Please divert your course 15 degrees to the North to avoid a collision.

Canadians: Recommend you divert your course 15 degrees to the South to avoid a collision.

Americans: This is the Captain of a U.S. Navy ship. I say again, divert your course.

Canadians: No. I say again, you divert your course.

Americans: This is the aircraft carrier U.S.S. Lincoln, the second-largest ship in the United States’ Atlantic Fleet. We are accompanied by three destroyers, three cruisers, and numerous support vessels. I demand that you change your course 15 degrees North, That’s one-five degrees North, or counter measures will be undertaken to ensure the safety of this ship.

Canadians: This is a lighthouse. Your call.


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