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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)
slide4

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)
slide6

$

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
slide10

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

slide11

Rent = ½(4)(1) = 2

$

— MC

Number of laborers

slide12

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

slide13

$

— MC

Number of laborers

slide14

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.

slide15

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
slide20

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

slide21

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
slide23

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
slide25

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.