1. University of Papua New Guinea Principles of Microeconomics Lecture 15: Market failures

2. The University of Papua New Guinea Slide 1 Lecture 15: Market failures Michael Cornish Overview Introduction Externalities Asymmetric information Low-equilibrium traps

3. The University of Papua New Guinea Slide 2 Lecture 15: Market failures Michael Cornish Introduction What is market failure? Why is it important to address? Efficiency and equity (again!)

4. The University of Papua New Guinea Slide 3 Lecture 15: Market failures Michael Cornish Introduction A typology to identify products where government intervention may be needed: Rivalrous: where the consumption of the product by one consumer prevents its consumption by another consumer Excludable: non-paying consumers can be excluded from consuming the product

5. The University of Papua New Guinea Slide 4 Lecture 15: Market failures Michael Cornish Private goods Examples: Hamburgers Clothes Common resources Examples: Tuna in the ocean Public parks Quasi-public goods Examples: Cable TV Fire-fighting Public goods Examples: National defence Street lighting Tragedy of the commons: Where (rational) self-interest leads to the depletion of common resources - Solved through cooperation, coupled with enforcement! Non-rival Rival ExcludableNon-excludable Are more likely to be subject to market failures

6. The University of Papua New Guinea Slide 5 Lecture 15: Market failures Michael Cornish Externalities An externality is a benefit or cost created by a market that is borne by people outside of the market –I.e., a benefit or cost external to the market We can categorise these externalities as: –Positive or negative; –Production or consumption

7. The University of Papua New Guinea Slide 6 Lecture 15: Market failures Michael Cornish Externalities Negative externalities: Production: –Classic example? Pollution Consumption: –Classic example? Passive-smoking How should we address negative externalities? –One approach: (Pigouvian) taxes!

8. The University of Papua New Guinea Slide 7 Lecture 15: Market failures Michael Cornish Price of electricity Quantity of electricity 0 P MARKET S 0 = Private cost Demand P EFFICIENT S 1 = Social cost Market equilibrium Q EFFICIENT Q MARKET Cost of pollution Deadweight loss Efficient equilibrium Negative production externality

9. The University of Papua New Guinea Slide 8 Lecture 15: Market failures Michael Cornish Dealing with a negative production externality Price of electricity Quantity of electricity 0 S 1 = Private cost before tax Demand Cost of pollution = amount of tax imposed by government S 2 = Social cost and private cost after tax Market equilibrium without tax Market equilibrium with tax P MARKET P EFFICIENT Q MARKET Q EFFICIENT Price paid by consumers Price received by producers

10. The University of Papua New Guinea Slide 9 Lecture 15: Market failures Michael Cornish Externalities Positive externalities: Production: –Classic example? Bee-keeping and crop pollination –There are not many great examples! Consumption –Classic examples? Education, immunisation How should we address positive externalities? –One approach: (Pigouvian) subsidies!

11. The University of Papua New Guinea Slide 10 Lecture 15: Market failures Michael Cornish Positive consumption externality Price of a university education Quantity of university education 0 Supply Efficient equilibrium Market equilibrium D 1 = Social benefit D 0 = Private benefit Deadweight loss P EFFICIENT P MARKET Q MARKET Q EFFICIENT Positive externality

12. The University of Papua New Guinea Slide 11 Lecture 15: Market failures Michael Cornish Dealing with a positive consumption externality Price of university education Quantity of university education 0 Supply Positive externality = amount of subsidy Market equilibrium with subsidy = efficient equilibrium Market equilibrium without subsidy D 1 = private benefit before subsidy Q EFFICIENT Q MARKET Price paid by consumers Price received by producers P EFFICIENT P MARKET D 2 = social benefit and private benefit after subsidy

13. The University of Papua New Guinea Slide 12 Lecture 15: Market failures Michael Cornish Externalities Another approach: The Coase Theorem Private bargaining will result in an efficient solution to the problem of externalities, as long as: –There is perfect information (‘full information’) –Transactions costs are sufficiently low –There are property rights

14. The University of Papua New Guinea Slide 13 Lecture 15: Market failures Michael Cornish Externalities The Coase Theorem (cont.) E.g., a company creating pollution could pay the victims for the right to pollute; or The victims could pay the polluting company to reduce its pollution

15. The University of Papua New Guinea Slide 14 Lecture 15: Market failures Michael Cornish Externalities Yet another approach: Market-based solutions Tradeable rights markets –Cap-and-trade (e.g. greenhouse gases) –Entitlements (e.g. Murray River water markets) And (another!) approach: Central planning Also known as ‘command and control’ –Use of quantitative controls

16. The University of Papua New Guinea Slide 15 Lecture 15: Market failures Michael Cornish Asymmetric information Where a party to a transaction has a different level of information than the other (‘information gaps’) –E.g. the second-hand car market, university education –Leads to inefficient distortions in the market

17. The University of Papua New Guinea Slide 16 Lecture 15: Market failures Michael Cornish Asymmetric information Adverse selection is where a party takes advantage of this asymmetric information –Leads to even more inefficient distortions in the market!

18. The University of Papua New Guinea Slide 17 Lecture 15: Market failures Michael Cornish Asymmetric information Asymmetric information can also lead to… Moral hazard: –Where one person takes more risks because they know that the burden of those risks is borne by another party –E.g. subprime mortgage crisis (the GFC!)

19. The University of Papua New Guinea Slide 18 Lecture 15: Market failures Michael Cornish Asymmetric information Asymmetric information can also lead to… Principal-agent problem: –Where an agent’s self-interest conflicts with that of their client –E.g. real estate agents

20. The University of Papua New Guinea Slide 19 Lecture 15: Market failures Michael Cornish Low-equilibrium traps Occurs where decisions by multiple parties are required simultaneously in order to achieve a more desirable outcome –E.g. creating a manufacturing sector in a poor developing country where none currently exists Instead, economic decision-makers (such as major investors) remain inactive until all the conditions for them to invest are fulfilled

21. The University of Papua New Guinea Slide 20 Lecture 15: Market failures Michael Cornish Multiple Equilibria Low- equilibrium trap

22. The University of Papua New Guinea Slide 21 Lecture 15: Market failures Michael Cornish Case Study: Latin American Time