Notesale: Turn your study into money

Document Preview

Extracts from the notes are below, to see the PDF you'll receive please use the links above

---

TEXTBOOK SUMMARY 4
Sunday, 21 December, 2014
9:55 pm

6 Market Failure


6
...

• It is often associated with market power, asymmetric information and
externalities

Markets function quite well if left free and competitive
...


Allocative efficiency is achieved when marginal benefit equal marginal costs: MB=MC
...


• Maximization of community surplus achieved at Pe and Qe, where MSB=MSC
(social efficiency)

Competitive markets provide Pareto optimality by maximizing community surplus
...


Markets tend to be allocatively efficient but they often do not meet the conditions of
free competition
...



6
...
They
range from lost money to poor health
...


Example:

•

•
•

The use of glues and chemicals to make furniture that contains wood particle
board
...

Oil production appears to be getting more costly, as spills and refinery pollution
cause significant external losses worldwide, not to mention the depletion of
reserves


Diagram


•

•

•
•
•
•

•
•




The supply curve is split into two, where MSC > MPC - cost paid by firms to
produce(MSC intersects at a higher point than MPC)
At market equilibrium of Pe, quantity Qe is produced
...

Also, because production is not where marginal costs are equal to marginal benefits,
resources are being misallocated
...


From IB COMPANION
• NEP occurs when the production of a good or service create external costs that
are damaging to third parties
• These relate mainly to environmental problems
• Pollution from firm-- the firm has its private costs but is also creating external
costs
• The cost to community is greater than costs of production paid by firm
o Thus, MSC is greater than MPC
o MSC = MPC + external cost - shown in graph
• In the diagram, MPC is below MSC, because there is an extra cost to society
caused by pollution such as respiratory problems
o The distance represents the size of the externality
• The firm will only be concerned with private costs and thus produce at P1 and
Q1
• It is not producing at the socially efficient output, where marginal social cost
equals marginal social benefit, so it is a market failure
• There is a misallocation of resources; too much is being produced at too low a
price
• There is welfare loss to society of the extra units from Q1 to Q* as MSC is
greater than MSB
...

Only covers a portion of the externality costs
Welfare loss triangle still present, though it is significantly reduced
...


Advantages:
Reduces the size of the externality (shaded triangle box)
Brings output level down towards the optimal level, Q*
'internalizes the externality' by compelling producers and consumers to pay the costs
of their transaction

Disadvantages:
Assessing the magnitude of the externality is extremely difficult; governments and
firms normally hire cost-benefit analysts to determine this
Determining the appropriate amount of tax is a challenge
Taxing the good may not deter pollution, only reduce it

•

•
•

•
•
•
•
•
•
•

•
•
•

•


Legislation and Regulation:

Governments can enact laws to deter production of products or services that cause
harm to others
• May force cleaner production with improved technology
• order the firms to reduce the amount of the good actually produced
Reduces spillover costs by moving MSC closer to MPC
May also move MPC to the left as new technology will increase the costs of production

Disadvantages:
Ban or restriction may lead to job losses and non-consumption
The complexity of lawmaking and enforcement is very challenging
...


MPB > MSB
For negative externalities of consumption, the marginal social benefits are less than
the benefits enjoyed by the private consumer
...
g
...
But others will eventually pay some of the costs of this
smoking (in higher insurance premiums or taxes for government health
programs) This cost to others actually reduces the overall benefit to
society
...

External costs are represented by the distance between MSB and MPB
...
This will give us the best allocation of resources
...

The shaded triangle area shows the amount of negative externality, also known as
welfare loss, resulting from problems that third parties will pay for
...

• The deem certain activities illegal for this reason
• E
...
consumption of alcohol or the use of phones while driving or require
new residential buildings to have garages and car parks
...

• Loss of tax revenue

Goods that have a long cultural history of acceptable use may be limited or restricted
by regulation
...


Taxation

Government may also tax the good the internalize the externality - compel market
actors involved to pay the costs to society instead of the third parties
This also has the benefit of generating tax revenue which could further be used to
deter smoking
A tax increases MPC and shifts it to the left - decrease the amount sold and raises the
market price to Ptax
• This reduces consumption to point close to the optimum level of Q*
• However, this depends on accurate assessment of external costs and accurate
application of the tax
Black markets may be formed as a result if the cost are too high
Inelastic demand for cigarettes mean that taxation may not be as effective

Advertising and persuasion + education

Governments can also attempt to persuade consumers to change their behaviour
• By advertising negative effects of the product and discourage further use
• Has been used for smoking, drinking and driving, littering, the sale of
endangered species, and to encourage recycling among many other
examples
• In combination with activism and legal changes, advertising could change the
value that consumers place on a good
• In turn, consumers may switch products that serve the same purpose or
merely reduce their consumption,
• Shifts demand left in either cases
• This brings the equilibrium price and quantity closer the more socially
optimal P* and Q*
...
-
For eg, how to reach certain audience?
• Govt
...
3 Positive Externalities


Positive externalities of Production

Production of some goods creates positive spillover effects, creating benefit for third
parties
...
g
...

• A school placed in a neighbourhood may improve the property values of families
with no children in school
• Workers trained by one company can be hired by another which enjoys the
benefits of the training
• Research and development by one firm can be used by another to make further
advance in a particular field
• Software companies create new technologies that may not succeed on their
own but inspire others to create valuable new products by imitation



•
•
•
•


The supply curve is split into two, where MPC> MSC
The distance between the two lines shows the amount of externality
Marginal social cost, the true cost to society is lower at every point than private cost
The market equilibrium is at Pe, there appears to be too little being produced

•

•

•
•
•

•

•
•
•

At Pe, the MPC indicates private costs at point A where the MSC indicates social costs
at point b
...
(lump-sum payment to the industry or per-unit subsidy)
Goal: push MPC outwards towards the production of the socially optimal Q* units of
output
...
It can be very expensive so the opportunity cost must be considered
...

• Depends on accurate assessment of the value of the positive externality and
expert designation of the subsidy amount
...
(on the basis that of their product's external benefit)

State provision of the article
Government may decide to provide directly the good creating the positive externality
• For eg
...

However, this can be costly and depends on government accurately predicting the
need amount of product or service
Also the quality of training may not be as high
May dissuade firms from offering training of their own

•

Govt
...

• However, these decisions are subject to true value of externality and the
opportunity cost of using resources



6
...

E
...
additional years of education - strong spillover benefits - skilled &
productive member of the workforce, provide tax revenue and less likely to
engage in criminal activity




•
•
•
•
•


Left alone, the market will produce Q1 worth of product at a price of P1
The optimal production seems to be at Q* with a price of P*, where social costs and
benefits are equal
Thus, free market will not produce enough education by itself
If society's true value for education were included, if demand were reflected in MSB
curve, the demand and thus the price would be higher than it is
...

• Along the range of Q1 to Q*, MB increases


E
...

• Directly provide or partially subsidize
• (e
...
pubic education or encouraging education by paying for the majority
of the costs, leaving extra costs to be paid for by families)
Shifting supply curve (MPC) to the right
Lowers the price and increases availability
The new equilibrium is at socially efficient quantity of students at Q*
Schools receive revenue equal to what would be received at P* - difference between
Psub and P* is the per student subsidy
However, subsidy expenses are considerable - thus, opportunity cost of such subsidies
must be weighed against the weighed against relative merit of the good
• May not be possible in developing countries…unable to benefit

Advertising:
To encourage consumption, governments can advertise the benefits of positive
consumption
• For eg
...

Consumer taste change -> shifts MPB to the right, with the goal of pushing it nearer to
socially efficient quantity
With private demand increasing, society reduces the size of externality, in effect
absorbing or enjoying at least part of the potential welfare gain
• Effect of such advertising vary considerably depending on the type of goods
being advocated as well as strength of cultural attitudes
• Also, it may take a long time to have an effect so the short run benefits may be
minimal

Legal requirements
Governments can legally mandate behaviour that it deems beneficial to the public
• Require children go to school to a certain age, or to get vaccinations

However, unless the good is publicly provided, full compliance is unlikely -
mandates without reasonable government support will foster resentment
of government policy
Must consider the size of potential benefits - is the benefit large?

Degree of govt intervention dependent on size of externality

•

•

6
...
g
...
Negative
externality goods are generally considered to be demerit goods
...

• Govts often attempt to reduce consumption - public persuasion, regulation and
banning of the goods
• Pictures on the cigarettes
• Alcohol & cigarettes controlled by law
• Bans rarely destroy the market - drives the market underground to the
black market


6
...
g
...
g
...


Poverty in Less developed countries

Most LDC sell goods for which the demand is not increasing especially fast
• As global incomes rise, demand for advanced goods which these countries must
import is rising mush faster
• Incomes in poor countries are rising more slowly than in rich ones
• Must sell more of their agricultural or primary goods
• Depletion of resources
§ Indirectly caused by World Bank and International Monetary
Fund - requirements of foreign lenders in to maximize export
earnings

Potential solutions to sustainability problems

Extension of property rights
• Problem: lack of price mechanism
• Solution: extension of property rights to encourage the protection and
management of scarce resource
• Owners balance LT and ST benefits
• However - difficult in large scale and limited success

Carbon taxes
• Charged levied by govt on firms using fossil fuels in their production
process
• Tax fuel by carbon level
§ Internalizes the externality, decrease to optimal level of
output
§ However, no harmonized carbon tax system
• US, China failed to enact such policies - harm economic
growth
• EU - stalled because of reluctance of former Eastern
Bloc countries
Tradable permits

Uses market forces to encourage clean production and reward innovation
Locally, nationally, internationally

• Govt determines acceptable level of pollution and licenses the permitted
amount of pollution in shares or permits
• Works like a tax because firms effectively pay for a right to pollute
• They get their production below - can sell permits to other firms
• If they exceed - they can buy up extra permits


•

Creates a market --> High demand - would make polluting expensive
• Encourage firms to innovate and reduce their pollution levels
• Advantage: incentive to reduce pollution and compel polluter to pay more
as they pollute more


•
•
•

Supply --> perfectly inelastic
Increase in production --> lead demand to increase
Incentive to innovate and reduce pollution levels and sell their permits
Overtime the govt could gradually reduce Q --> shift supply to the left


Disadvantage: relies on strict enforcement and heavy fining, also does not deter
pollution, disadvantage to countries who are attempting to lure industry and
encourage business growth --> international cooperation


--------------------------------------------------------------------------------------------------------------------------------------------------------


6
...
7 Asymmetric information and abuse of monopoly power

•

•
•

•

•


Asymmetric information

Market theory presupposes that all actors in possession of the same, perfect levels of
information regarding market transactions
• This is highly unlikely - consumers are constrained by time and access to such
information
• More than likely for consumers to make mistakes regarding purchases
Consumers are also more likely to be subjected to sophisticated marketing techniques
that aim to limit information and choice
Antoher variety of asymmetric information has one party in transaction holding more
information than the other party
• Eg

---