2 TYPES OF MARKET FAILURE The existence of externalities An externality occurs when the production or consumption of a good or service has an effect upon a third party.If the effect is harmful then we talk about negative externality. There is an external cost that must be added to the private cost of the producer or consumer to reflect the full cost to society.
3 TYPES OF MARKET FAILURE The existence of externalities If the effect is beneficial, then we call it a positive externality . There has been an external benefit to add to the private benefits of the producer or consumer.
4 PRODUCTION EXTERNALITIES Marginal Private Cost (MPC) The MPC is essentially the “private” supply curve that is based on the firm’s cost of production. It is does not include any external costs that this production may generate.
5 PRODUCTION EXTERNALITIES Marginal Social Cost (MSC) What is Marginal Social Cost? (MSC)The marginal social cost of an activity is the total cost of that activity, both privately and externally.The total cost to society, therefore, must include the private cost, because society's resources are being used in the production process, and the external cost, because some of society's resources must be used to clean up the mess.The marginal social cost, represents the true supply curve (and, therefore, the true marginal cost of production) for society as a whole, allowing for the external cost of production.
6 Can there be no externalities of production? YES in theory, (in perfect markets) but this is very unlikely.If there are no externalities of consumption, then MSB = MPB.
7 What does it mean to have no externalities of production? There is social efficiency and so maximum community surplus.If externalities do exist, then MSC does not equal MSB.There is market failure and inefficient allocation of society’s resources. (negative externalities of production)
8 CONSUMPTION EXTERNALITIES: Marginal Private Benefit (Key Concept) The individual benefit obtained by a consumer using a product.There is no consideration of external benefits for society.The MPB is essentially the “private” demand curve that is based on the utility or benefits to consumers.
9 CONSUMPTION EXTERNALITIES: Marginal Social Benefit (Key Concept) What is Marginal Social Benefit? (MSB)Marginal social benefit (MSB) is equal to the private marginal benefit a good provides plus any external benefits it creates. In other words, MSB gives the total marginal benefit of the good to society as a whole.It is called the true or real demand curve for society.
10 How to graph Consumption Externalities: NEGATIVE Externalities of ConsumptionPOSITIVE Externalities of ConsumptionWhat is a practical example?What does it mean in theory?Smoking – there are some private benefits of smoking, but there are greater external costs for other people & society.The Marginal Social benefits are less than the Marginal Private Benefits.Health Care: there are many benefits for the individual from additional health care, but the benefits to society are greater . The Marginal Social benefits are greater than the Marginal Private Benefits.What curves do I draw?What terms are used?2 Demand Curves: Marginal Private Benefit (MPB)Marginal Social Benefit (MSB)1 Supply Curve: Marginal Social Cost (MSC)How do I draw the curves?The MPB Curve is above the MSB Curve.The MPB Curve is below the MSB CurveWhat do I shade?Shading between the demand curves to show welfare loss. Shade below the supply curve, according to the change in quantity.Shading between the demand curves to show welfare gain. Shade above the supply curve according to the change in quantity.How do I fix the problem or improve the outcome?(Demand Curves)Advertising / Non Price MeasuresMove the MPB curve towards the MSB Curve, through non-price measures. (eg: advertising) Just show arrows.How do I fix the problem or improve the outcome? (Supply Curve)New TaxBy imposing a tax. Draw a new MSC curve above the original MSC curve.SubsidyBy introducing a subsidy. Draw a new MSC curve below the original MSC curve.
11 How to graph Production Externalities: NEGATIVE Externalities ofPOSITIVE Externalities of PRODUCTIONWhat is a practical example?What does it mean in theory?Pollution from a Factory: The pollution from a factory has greater cost to society (clean up/damage to other industries) than the cost of making the factory product itself.The Marginal Social Costs are greater than the Marginal Private Costs.Education/Training: A company that provides specialist training for its workers will incur costs, but this leads to lower costs for society in the long term (eg: other companies will not have to train these workers)The Marginal Social Costs are less than the Marginal Private Costs.What curves do I draw?2 Supply Curves: Marginal Social Cost (MSC)Marginal Private Costs (MPC)1 Demand Curve: Marginal Social Benefit (MSB)How do I draw the curves?The MSC Curve is above the MPC Curve.The MSC Curve is below the MPC Curve.What do I shade?Shading between supply curves to show welfare loss. Shade above the demand curve, according to the change in quantity.Shading between supply curves to show potential welfare gain. Shade below the demand curve, according to the change in quantity.How do I fix the problem or improve the outcome?(Supply Curves)New TaxDraw a new MPC curve+tax above the original MPC Curve.SubsidyDraw a new MPC curve below the original MPC Curve.
12 TYPES OF EXTERNALITIES Externalities may be split into four types:Negative Externalities of production/external costs.Positive Externalities of production/external benefits.Negative Externalities of consumption.Positive Externalities of consumption.
13 1. Negative Externalities of Production/External Costs These occur when the production of a good or service creates external costs that are damaging to third parties.These relate mainly, but not exclusively to environmental problems.
14 1. Negative Externalities of Production/External Costs Example: Paint Factory emitting fumesIf a paint factory emits fumes that are harmful to people in the area, then there is a cost to the community that is greater than the costs of production by the firm.The firm has private costs, but then, on top of that, is creating external costs.The marginal social cost of production is greater than the marginal private cost.
15 NEGATIVE EXTERNALITY OF PRODUCTION In this diagram the marginal private costs of the firm are below the marginal social cost, because there is an extra costs to society caused by the pollution that is created. This could be respiratory problems for people in the neighbourhood of the polluting firm. The firm will only be concerned with its private costs and will produce at Q1. It is not producing at Q* where the marginal social cost is equal to the marginal social benefit and so it is a market failure. There is a misallocation of society’s resources: too much paint is being produced at too low a price. If the price of paint was increased money could be spent on reducing the pollution from the factory and or cleaning up the mess. There is a welfare loss to society of the extra units from Q1 to Q* because the MSC is greater than the MSB for those units. This is shown by the shaded triangle.
16 Negative Externalities – Government Action to address issue Taxes on PollutionThe government could tax a firm in order to increase the firm’s private costs and so shift the MPC curve upwards towards the point of social efficiency.If the tax is equal to the external cost of the production, then we say the government has internalised the externality.If the tax is not equal to the external cost, then it will reduce the deadweight burden, but not eliminate it.
17 TAXING A NEGATIVE EXTERNALITY OF PRODUCTION The government decides to impose a tax on a paint factory emitting pollution. However, the tax is not equal to the external cost. It reduces the deadweight burden, but does not eliminate it. This is illustrated in this graph. There is still a welfare loss, but it less than under the free market with no government interference.
18 Negative Externalities – Government Action to remedy Problems with TaxesAlthough taxes are seen as a way of making the polluter pay, there are some problems with this solution.First is often difficult to measure the accurately the pollution created and to put a value on it, which can be regained by the tax.Second, it also difficult to identify which firms are polluting and to what extent each firm is responsible for the pollution.Third, it is often argued that taxes do not actually stop the pollution from taking place.
19 Negative Externalities – Government Action to remedy LegislationThe government could legislate and could ban the polluting firms or restrict their output in some way.It also pass laws relating to measureable environmental standards in the firms production units.To meet the standards, the firm would have to spend money, thus increasing their private costs.
20 Negative Externalities – Government Action to remedy Problems with Restricting OutputA 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 policing (enforcing) standards may be greater than the cost of the pollution.
21 Negative Externalities – Government Action to remedy Tradeable Emission PermitsThe government could issues tradeable emission permits.These are a market-based solution to negative externalities of production.Tradeable emission permits are issued by the government and give firms the licence to create pollution up to a set level.Once they are issued firms can buy, sell and trade permits on the market.
22 Negative Externalities – Government Action to remedy Tradeable Emission Permits (continued)The government decides upon the level of pollution that will permit each year and then splits the total level of pollution up into a number of tradeable emission permits, each allowing a certain level of pollution.The government then allocates these permits to individual firms.Thus each firm now has a quota of emissions that it is allowed to produce.
23 Negative Externalities – Government Action to remedy Tradeable Emission Permits – Market OperationThe trading system means that it is the interests of firms to pollute as little as possible.If a firms pollutes at a higher level that its permit allows, it will need to buy permits from other firms and this will raise its costs.If a firm pollutes less than they are allowed, then they can sell their permit and make money.In the USA, the emission of chloroflurocarbons (CFCSs) is controlled by the use of tradable emission permits.
24 Negative Externalities – Government Action to remedy Tradeable Emission Permits – ProblemsOne problem with this solution is that it does not lead to the reduction of pollution, once the allowable limit has been set.Firms simply pay the cost of polluting, some polluting heavily and other not.Also the government faces a difficult decision when setting an acceptable level of pollution and it also difficult to measure firm’s pollution output.
25 The Kyoto ProtocolA form of tradable emission permits is being used an international level to reduce the emission of greenhouse gases (GHG)The Kyoto Protocol is an agreement made under the United Nations Framework Convention on Climate Change.Its objective is to cut global emissions of greenhouse gases.The treaty was negotiated in Kyoto, Japan in 1997 and came into force in February 2005.
26 The Kyoto ProtocolThe treaty covers more than 163 countries globally and over 65% of global GHG emissions.Two countries – Australia & the US signed the treated but did not initially ratify it. However, this all changed in November 2007, with the election of the Rudd Government in Australia and the Obama Administration in January 2009.
27 2: Positive Externalities of Production/External Benefits These occur when the production of a good or service creates external benefits that are good/ advantangeous for third parties.
28 2: Positive Externalities of Production/External Benefits ExampleA large printing firm provides high quality training to its employees.This is a cost of the firm.When employees leave the printing firm and go to other firms, there is a benefit to the other firms who do not have spend money on training their new workers.Society has gained from the training, given by the printing firm.The marginal private cost to the firm, is greater than the marginal social cost.
29 POSITIVE EXTERNALITY OF PRODUCTION In this graph, the printing firm produces at a level of output Q1 that is above the socially efficient level of, Q*. Between Q1 and Q* there is a potential welfare gain shown by the shaded triangle. If output could be increased to Q* then welfare would be gained, because for all of the units from Q1 to Q* MSB is greater than MSC.
30 2: Positive Externalities Government Action to Assist Firms On face value positive externalities, should not require any government assistance.However, if firms have to provide extensive training to their employees this increases their costs, and lowers their profitability.Therefore the government may decide to assist these firms in some form.
31 2: Positive Externalities Government Action to Assist Firms Training SubsidiesThe government could subsidise the firms that offer the training.If this were to happen, then the MPC curve would be shifted downwards by the subsidy, and if a full subsidy was given, then MPC would be the same as the MSC and the socially efficient point of “a” would be reached.
32 2: Positive Externalities Government Action to Assist Firms Training Subsidies – ProblemsTwo main problems.First, it very difficult for government to estimate the level of subsidy deserved by individual firms.Second the cost of the subsidies would probably imply an opportunity cost and it is likely that the government would cut back on spending in other areas, which may be more worthy than this one.
33 2: Positive Externalities Government Action to Assist Firms Training CentresThe government could provide vocational training, by setting up training centres for workers in certain industries.Although this is a possibility, the costs would be high, the trainers may lack the expertise found in firms and it may dissuade firms from offering training of their own.
34 3. Negative Externalities of Consumption There are many products, that when consumed by individuals adversely affect third parties.Examples include cigarettes and secondary smoking, cars and air pollution, loud music and noise pollution.The negative externalities of consumption produced make the marginal social benefits in each case less than the marginal private benefits.The private utility is diminished by the negative utility suffered by third parties.
35 3. Negative Externalities of Consumption Cigarettes Case StudyPeople who smoke presumably enjoy some private benefits of smoking, but this will create external costs for other people.This is commonly referred to as passive smoking, or second-hand smokingOther than simple discomfort at the smell of cigarettes, the cost to others are significant
36 NEGATIVE EXTERNALITY – CIGARETTES As there is a free market, consumers will maximise their private utility (benefit) and consume at a level where MSC=MPB. They will ignore the negative externality they are creating. This means they will over-consume cigarettes by smoking Q1 cigarettes as a price of P1. The socially efficient output is at Q* and so there is over consumption of from Q* to Q1. Since the MSC is greater than the MSB for these units, there is a welfare loss to society and a market failure.
37 3. Negative Externalities of Consumption Government Action to Remedy Cigarettes Case StudyThe government will act to reduce or eliminateThe negative externality. There are number ofoptions:It could ban cigarette smoking totally – make it illegal to smoke.
38 3. Negative Externalities of Consumption Government Action to Remedy Banning Smoking Totally – ProblemsBanning smoking would have a large effect upon the tobacco industry in terms of shareholders and employments.Governments also make a lot of revenue by taxing cigarettes, which have price inelastic demand, because they are habit forming.It must also be remembered that governments need votes and smokers are not likely to vote for a government that bans smoking.However, many governments have placed partial bans on smoking in certain places.
39 3. Negative Externalities of Consumption Government Action to Remedy Taxes on CigarettesThe government could impose indirect taxes on cigarettes in order to reduce consumption.
40 TAXES ON CIGARETTESIf the government imposes an indirect tax then this will shift the MSC curve upwards to MSC + tax. This will reduce consumption to the socially efficient level of output Q*, but the price to consumers will be P2. The government will gain significant revenue and this may be used to correct some of negative externalities caused by smoking.
41 3. Negative Externalities of Consumption Government Action to Remedy Problems with Taxes on CigarettesThe inelastic demand for cigarettes tends to mean that taxes do not manage to reduce quantity demanded very much, and so while government revenue is raised, quantity demanded does not fall to the socially efficient level (which some would argue was zero!)
42 3. Negative Externalities of Consumption Government Action to Remedy Problems with Taxes on CigarettesIf taxes are raised too much, then experience suggests that people start to look for other sources of supply.This can be seen in Europe, where smokers go to other countries where cigarettes are cheaper. For example Austrian smokers can go over the border to Slovakia.Often this process is illegal and so a black market may be formed.
43 3. Negative Externalities of Consumption Government Action to Remedy Education Programs Against SmokingThe government could provide education about the dangers of smoking and also fund negative advertising in order to reduce demand for cigarettes and thus shifting the MPB curve to the left.
44 3. Negative Externalities of Consumption Government Action to Remedy Problems with Education programsThere are doubts as to the effectiveness of anti smoking programs.Many teenagers, seem prepared to accept the dangers of smoking and are little affected by measures to put them off.
46 NEGATIVE EXTERNALITIES OF PRODUCTION – ENVIRONMENTAL PROBLEMS IN CHINA
47 4. Positive Externalities of Consumption There are certain goods or services which when consumed (used) will provide external benefits to third parties.When people “consume” health care, for example, they create positive externality for society.If people are healthier, then they will not pass on illnesses so that other people around them are less likely to become ill. In addition a healthier workforce means that the economy will be more productive, which may be a benefit for the whole population.Thus the MSB of consuming health care is greater than the MPB.
48 POSITIVE EXTERNALITY OF PRODUCTION – HEALTH CARE In a free market for health care (no subsidy), people will consume at Q1 at a price of P1. However, the socially efficient level of consumption would be Q* where MSB = MSC. There is a potential welfare gain shown by the shaded triangle, because of the units Q1 to Q*, MSB is greater than MSC. If the consumption of health care increases from Q1 to Q* then welfare in society will increase.
49 4. Positive Externalities of Consumption Government Action to assist Consumers Subsidies for Health CareThe government could subsidise the supply of health care.
50 SUBSIDIES FOR HEALTH CARE A subsidy would shift the MSC curve downwards and in this way, the socially efficient level of consumption at Q* would be reached, with a price of P2. The government may deem the importance of health care to be so great, that it will subsidise it to the point where it is free to consumers.
51 4. Positive Externalities of Consumption Government Action to assist Consumers Problems with Subsidising Health CareThe main problem with such a solution is cost.While the provision is possible in many developed countries, developing countries are not able to fund such schemes and so do not fully benefit from the positive externalities that are to be gained from the consumption of health care.
52 4. Positive Externalities of Consumption Government Action to assist Consumers Advertising to Consume Health Care ProductsThe government could use positive advertising to encourage people to consume more health care products/services.This would shift the MPC curve to the right, towards the MSC curve and would thus increase welfare.
53 4. Positive Externalities of Consumption Government Action to assist Consumers Problems with AdvertisingThe problem here is that there may be a high cost in funding advertising and although the effect may be beneficial in the long run, the short run benefits may be minimal.
54 4. Positive Externalities of Consumption Government Action to assist Consumers Government LegislationThe government could pass laws insisting that citizens have vaccinations against certain diseases or have regular checks, but this will only be successful, if the governments provides this free of charge.Also people often resent laws of this sort being imposed by the government.They may see it as infringement on their civil liberties.
55 4. Positive Externalities of Consumption Another Example - Education An important example of a positive externality of consumption is education, which may have a marked effect on the welfare of society if its consumption is increased.
56 4. Positive Externalities of Consumption What determines the extent of government intervention? The extent of government intervention will depend on the amount of external benefits.In the case of merit goods such as health care and education, the positive externalities are very significant.Economic growth is heavily dependent on the productivity of labour, which is course dependent on the education and health of the people. Therefore it is generally a government priority to have an effective system for providing education and health care.
57 OTHER CAUSES OF MARKET FAILURE The Immobility of Factors of Production In a perfect market, in theory, resources more easily between uses attracted by higher factor payments.In reality this does not happen so easily and shortages of factors and time lags.Resources do not always find it easy to more between industries quickly.For example, If the coal industry in the north of the country is declining and the software industry in the south is booming, then in theory resources should move from one to the other. However, this does happen in reality.
58 OTHER CAUSES OF MARKET FAILURE The Immobility of Factors of Production Structural UnemploymentWorkers may not be able to move easily to take advantage of new job opportunities, since they may lack the skills necessary and may not be prepared to move their geographical location.This results in structural unemployment caused by occupational and geographical immobility.
59 OTHER CAUSES OF MARKET FAILURE Problems of Information Theory tells us that in a perfect market, both consumers and producers have perfect knowledge of the market.In reality of course, this is not the case and so decisions are made based on incomplete information.This makes it very hard for marginal costs and marginal benefits to be equated and this leads to market failure.Governments may try to improve the flow of information to correct this market failure, but this is expensive and may not be possible for all markets.
60 OTHER CAUSES OF MARKET FAILURE The creation of Inequality The free market often leads to the existence of large differences in income between different groups of people in the economy.Remember that Pareto optimality does not signify equality.It may be society sees the creation of inequality as a failure of the market and attempt to use progressive taxation to redistribute income from one group of the population in order to benefit a less fortunate group.
61 OTHER CAUSES OF MARKET FAILURE Short-termism Private SectorThe private sector is often blamed for making short-term profit based objectives at the cost of long-term problems.Firms may use up resources in the short term at rate that means that development in the future will not be sustained at the present rate.This reduces the potential for sustainable development.
62 OTHER CAUSES OF MARKET FAILURE Short-termism Government SectorGovernments may intervene in the workings of the market in the short term in order to gain results that will lead to re-election, even though this intervention may go against the long term best interests of society.
63 EXAMINATION QUESTIONS Short Response Questions 1. With the help of a diagram, explain why cigarette smoking is a cause of market failure. (10 marks)2. With the help of a diagram, explain why the provision of health care in an economy is likely to require government intervention. (10 marks)
64 EXAMINATION QUESTIONS Essay Question 1a. Explain the concept of negative externalities of production (10 marks)1b. Evaluate three policies that may be used by government to reduce external costs of production (15 marks)