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Possible Government Response to Market Failure

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Presentation on theme: "Possible Government Response to Market Failure"— Presentation transcript:

1 Possible Government Response to Market Failure

2 Legislation Take for example a firm that emits fumes or pollutants that are harmful to the people in the area. What can be done because obviously this is a negative externality.

3 The government could legislate and could ban the polluting firms, or restrict their output in some way. It could also pass laws relating to measurable environmental standards in the firm’s production units. To meet the standards, the firms would have to spend money, thus increasing their private costs.

4 One problem with this solution is that a ban or restriction may lead to job losses and the non-consumption of whatever was being produced, which may have been a valuable product. Also, the cost of setting and then policing standards may be greater than the cost of the pollution.

5 Influencing production and consumption
Oftenlegislation is less extreme and seeks instead to limit production and consumption by imposing restrictions on sales and use. Any number of laws seek to limit access to tobacco; opening hours; restricting sales licenses; age requirements etc. In addition to this, government seeks to limit demand by decreeing that all tobacco products must have clear warning labels on each package, such as ‘Smoking kills’.

6 Legislation is also used to force producers and consumers to produce/consume certain goods which have positive externalities, for example, car manufacturers are forced to attain certain minimum safety standards and consumers are commonly bound by law to use seat-belts.

7 Regulating externalities
In order to lower overall environmental impact, many countries set increasingly tight limits on pollutants and emissions. This means that externalities are kept in check by using penalties to dissuade firms from polluting. In order to uphold the law, for example the original Clean Air Act (USA 1955), a regulatory body is often formed, in this case the Environmental Protection Agency (EPA) in the US.

8 The regulations can cover both the extent] degree of pollution (such as setting standards for parts-per-million for particulate emissions) and the production process itself (forcing firms to install water and air filters). Such regulatory agencies can be given wide-ranging legal powers to prevent pollution and environmental damage, from simple fines to plant closure. Increasingly, firms can be held accountable to the extent where managers risk prison sentences for disregarding environment laws.

9 Regulating competition
Virtually all industrialized countries have a body of law regulating competition. Legislation pre-supposes that oligopolies and monopolies will not act in the best interest of the public and should therefore be forced to circumscribe their activities. Governments seek to limit the effects of imperfect competition by way of limiting the degree to which firms can control markets.

10 Limiting market power is often the objective of monopoly laws and anti-trust (‘trust’ being an older termfor cartel) legislation and is frequently upheld by regulatory agencies, e.g. Competition Commissions which monitor and regulate market abuses. Firms can be fined up to 10% of their revenue.

11 Downside All these moves do have some downsides.
A ban can create and perpetuate a black market. Government legislation need to be backed up by government action which costs the taxpayers. Harsh regulations can drive up costs leading to loss of competitiveness and output.

12 Government have been accused of not standing up to large firms and powerful lobbyists .

Merit goods, which have clear benefits for non-users, will be under-provided for in the competitive market since users cannot see how their use benefits others — or themselves in the long run. This is the case with public goods, which by their very nature of non-rivalry and non-excludability make such goods impossible to provide privately.

14 Merit goods A merit good is a good where there are positive externalities to such an extent that society deems the good to be under-provided by free market forces. Subsequently the good is also under-consumed, since consumers lack sufficient information to consume the ‘correct’ amount. Merit goods such as education, health care and pensions are considered highly beneficial to society and are therefore in many countries supplied by public monies. It is viewed as socially beneficial for more of the good to be produced and consumed than would be supplied by a competitive market.

15 Public goods: Public goods also come with large positive externalities, yet with the troublesome attachment of being very difficult to charge users for. Since the private benefits would be very small (or non-existent) compared to the public benefits, competitive markets would fail quite massively here.

16 Virtually all countries have a degree of government supply of public goods.
What is potentially contentious is the quantity to provide since there is no market mechanism to gauge demand. The market fails to achieve optimal resource allocation and so society must make up for it. This is another example of how the planning element cannot ever be completely discarded — all economies must have a mixture of private and public it seems.

17 TAXATION One way of creating an ‘improved’ market is to use market forces to internalize the externality, i.e. intervene in such a way so as to make hidden costs visible and burden those responsible for them in some way One of the most common ways to bring external costs back into the fold of the market place is to levy an indirect tax on goods which have negative externalities.

18 Note how we assume that the ‘money’ cost of pollution or such can be estimated correctly. In fact, this would be virtually impossible in reality, as assigning a money cost to polluted rivers would be both highly subjective and arbitrary.)

19 In taxing the production/consumption of the good, the real costs have been brought forward and now burden those who are responsible. The tax can be imposed on either the consumer or the producer, such as a tax per pack of cigarettes or a pollution tax on emissions by firms.

20 SUBSIDIES A subsidy is a way for governments to increase the output of certain goods. Many societies subsidies goods whose consumption/production are considered to have positive effects. Milk is frequently subsidized as the health benefits are large. Research in cancer receives government moneys in most countries.

21 As governments aims to maximize social benefits the subsidy is set at the same amount as the positive externality (impossible to gauge) The government is setting output at the levels where MSC = MPB yet allowing consumers to enjoy a lower price than peq

22 Remember that that the costs to government in the form of funding the subsidies are considered to be less than the possible benefits — otherwise the subsidy would not exist. In other words, there is a net social benefit in increasing production/consumption of the good, the problem being that the private sector would not take care of the additional output without the incentive and cost- cutting effects of subsidies.

23 TRADABLE PERMITS This highly market-based solution to pollution is the establishment of programs wherein a government regulatory agency sets a ceiling on total emissions and then emits tradable ‘pollution permits’ to offending firms. A tradable permit scheme essentially means that government decides the ‘acceptable’ level of pollution and then issues credits or allowances to firms and fines firms which pollute more than their permits allow.

24 The permits are allowed to be re-sold to other firms, which in theory — and in practice in some cases — creates both an incentive to clean up production and a disincentive to exceed the limits imposed.

25 Advantages The main advantage is that there is a built-in mechanism of incentives to force firms to lower pollution levels. The opportunity costs of having potential investment tied up in non-yielding permits, plus the added incentive of being able to sell the permits will influence firms to become more efficient.

26 Disadvantages Many environmental groups feel that the market based system sends the wrong signal to both producers and consumers, in that there are ‘permissible or ‘non-harmful levels of pollution. The system might simply mislead society into believing that pollution is decreasing when in fact it is not — only the pollution per unit.

27 It is also feasible that heavy polluters buying up ever-cheaper permits due to the diligence of firms cleaning up their act might actually perpetuate the very pollution the permits attempt to reduce.

Extending property rights means there is an explicit right of use of an asset or resource. Ownership and responsibility is granted, creating an incentive for owners to take into consideration all costs (externalities). Grant the factory at the top of the river full rights to the river so it may be more profitable for them to clean up the river and use it for fishing, rafting etc.

29 It should be noted that the concept of expanding property rights is quite wide.
Many examples involve granting sufferers the right to litigate (= take legal action, sue) against offenders. For example, many cases of lung cancer have been brought within the legal jurisdiction (= responsibility) of firms which produced asbestos in the 1960s — firms will have to compensate these workers as the workers’ ownership of factors of production (= their own labor) has been harmed.

The objective is to alter peoples’ behavior. Educating and informing citizens of both possible costs of use or the benefits of use can change market demand and thereby correct over- and under-consumption of goods.



One of the problems of the previously mentioned solutions is that externalities know no borders. With regards to pollution, there are massive difficulties in getting a country to pay for externalities inflicted upon the domestic economy of another. Issues require extensive arrangements in cooperation which is why there are an increasing number of international agencies involved in information-sharing, monitoring and assessment.

34 Problems Accountability – how do you assess what countries have lots of demerit goods Cost estimates – how do you assess the cost of the negative externalities Countries disagree over the method to control certain externalities. Loss of competitive edge by spending money on the externalities.

The United Nations Intergovernmental Panel on Climate Change (IPCC) – scientist and researches . The United Nations Framework Convention on Climate Change (UNFCCC) – almost all UN members signed limiting greenhouse gases. The United Nations Environment Program (UNEP) and United Nations Conference on Environment & Development (UNCED) – sustainable development

36 AGREEMENTS The Montreal Protocol: In 1987 a total of 41 countries (12 acting under the EEC — now the EU) signed an agreement to severely limit and phase Out the use of substances that deplete the ozone layer. The Kyoto Protocol: The scheme calls for industrialized countries to reduce their emissions of GHG by an average of 5.2% from the 1990 level over the period 2008 — 2012, using a mixture of emissions trading and mechanisms to earn “emission credits”

37 Sources

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