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PART 10 Market Failures. Markets may fail to generate efficient results due to Monopoly Externalities Public Goods Open Access Markets may also have informational problems—adverse selection and moral hazard. Externalities.

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part 10 market failures
PART 10Market Failures
  • Markets may fail to generate efficient results due to
    • Monopoly
    • Externalities
    • Public Goods
    • Open Access
  • Markets may also have informational problems—adverse selection and moral hazard
externalities
Externalities
  • An externality is a cost or a benefit that is not reflected in market demand or supply curves
  • An effect external to the market
  • Environmental pollution, congestion in cities, etc

MSC

$

S (MC)

D (MB)

Q’

Q*

Output

pollution and abatement
Pollution and Abatement
  • Pollution imposes costs
  • Abatement of pollution is also costly
  • “Optimal” amount of pollution is where MC of pollution is equal to its MB
  • Marginal benefit of pollution is the abatement cost saved
  • Can also think of this as the MC and MB of abatement
pollution and abatement1
Pollution and Abatement

$

Optimal quantity of pollution

MC

MB

P*

P’

Pollution

If the affected parties cannot negotiate

the market will produce P’ pollution

pollution and abatement2
Pollution and Abatement

Optimal quantity of abatement

$

MC

MB

0

Abatement

A*

If the affected parties cannot negotiate

the market would produce no abatement.

externalities and transactions costs
Externalities and Transactions Costs
  • Externalities can be thought of a being caused by a lack of property rights or high transactions costs (costs of negotiation or litigation)
  • The Coase Theorem
  • Important point is that the world is a world of positive transactions costs, so that externalities are common
externalities and transactions costs1
Externalities and Transactions Costs
  • Example: A lake which can be used for recreation (by a fishing club) or waste discharge by a firm
  • We can think of the costs and benefits of the abatement of pollution
  • The costs are the costs of reducing waste discharge, the benefits are the better fishing
externalities and transactions costs2
Externalities and Transactions Costs

$

MC

MB

0

A*

A’

Abatement

0 = no abatement

A’ = complete abatement

A* = optimal level of abatement

externalities and transactions costs3
Externalities and Transactions Costs
  • If the firm and the fishing club could negotiate without cost then regardless of who has the property right they would negotiate to A*
  • If there are high costs to negotiating and the fishing club has the property right end up at A’ (MC>MB of abatement)
  • If there are high costs to negotiating and the firm has the property right end up at 0 (MB>MC of abatement)
  • Transactions costs are usually high, so the market results in inefficient allocation of resources
policy towards externalities
Policy Towards Externalities
  • Regulation by standards
    • If the standard to be achieved is the same for all firms this can result in inefficiency

MB2

$

MB1

Pollution

Standard

policy toward externalities
Policy Toward Externalities
  • Charges – Polluter pays a per unit charge

$

MB2

MB1

Unit

charge

Pollution

policy toward externalities1
Policy Toward Externalities
  • Tradable Permits: Set total pollution level and let firms trade

$

P

MB1+MB2

Pollution

$

$

P

MB2

MB1

Pollution 1

Pollution 2

policy toward externalities2
Policy Toward Externalities
  • Optimal (Pigovian) Taxes
    • Set tax equal to excess of the marginal social cost over the marginal private cost

$

MSC

MC+ Tax

MC

MB

Q

Q*

public goods
Public Goods
  • A public good is a good that has to be provided to everyone or to no one
  • National defense, clean air, lighthouses, public health
  • Pure public goods characterized by non-rival consumption and non-excludable use
public goods1
Public Goods

Rival

Non-rival

  • Rivalry and excludability

Artificially

scarce goods

Excludable

Most goods

Non-

excludable

Public goods

Open access

Artificially scarce goods often have close to

zero MC of production. Private producers have

to find ways of limiting distribution to those

who pay. Examples include computer software,

downloadable music, pay per view TV. Some

inefficiency in private provision.

public goods2
Public Goods
  • Public goods and the free rider problem
  • If provided the good will be provided even to those who do not pay
  • Lack of incentive to pay—people will try to free ride
  • Provision by voluntary contribution
  • Provision by government
benefits of a public good
Benefits of a Public Good
  • One person’s consumption of a unit of a public good does not exclude others
  • Marginal willingness to pay (MB) for the first unit of a public good is the vertical sum of the marginal willingness to pay of all individuals
  • If I am willing to pay $100 for a one unit improvement in air quality and you are willing to pay $50 for a one unit improvement in air quality the MB of that improvement is $150
optimal provision of a public good
Optimal Provision of a Public Good
  • The optimal level of provision for a public good is where MB=MC (economic efficiency)
  • If left to the market the good will be under-provided (cannot capture people’s willingness to pay)
  • Public provision—will government provide the optimal amounts of a public good?
open access
Open Access
  • Common property resources
  • Problem of free entry and overuse of the resource
  • “Tragedy of the Commons”
  • Regulation, tax, assign some form of property right to individuals or groups
  • System of tradable licenses
  • Example of fisheries
open access1
Open Access
  • Optimal level of effort

Yield

TC

TR

Effort

Open access

Max sustainable yield

Max Econ Yield

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