1. Chapter 16 Market Failure?

2. Contents: Examples of Market Failure Counter Argument – the Market Works!

3. Examples of Market Failure

4. Externality Market failure ( 市場失效 ) refers to situations in which the invisible hand ( the market price) fails to allocate resources efficiently. Externality ( 界外影響 ) is the situation in which one’s action affects others without compensating them.

5. External cost Private cost ( 私人成本 ) is the cost borne by the one who acts. External cost ( 界外成本 ) is the uncompensated cost borne by others. Social cost ( 社會成本 ) is the total cost borne by the whole society (including all economic agents). It is equal to the sum of private cost and external cost.

6. Divergence between private and social costs ( 私人成本與社會耗費的分岐 ) is the situation in which private cost is different from social cost due to the presence of external cost. Example: Noise from a construction site

7. Deadweight loss External cost QsQs QpQp Over-production MPB= MSB MPC MSC S Q 0 Equilibrium & efficiency: Social optimum: Q S (MSB = MSC) Social optimum: Q S (MSB = MSC) Private optimum: Q S (MPB = MPC) Private optimum: Q S (MPB = MPC)

8. External benefit Private benefit ( 私人效益 ) is the benefit obtained by the one who acts. External benefit ( 界外效益 ) is the uncompensated benefit brought to others. Social benefit ( 社會效益 ) is the total benefit brought to the whole society. It is equal to the sum of private benefit and external benefit.

9. Divergence between private and social benefits ( 私人效益與社會效益的分岐 ) is the situation in which private benefit is different from social benefit due to the presence of external benefit. Example: Fundamental education

10. Deadweight loss QsQs QpQp Underproduction Social optimum: Q S (MSB = MSC) Social optimum: Q S (MSB = MSC) Private optimum: Q p (MPB = MPC) Private optimum: Q p (MPB = MPC) MPB MPC= MSC S Q 0 MSB External benefit Equilibrium & efficiency:

11. Result (by invisible hand) Remedy (by visible hand) External cost (e.g., congestion and pollution) Over-production (Qp > Qs) Imposition of unit tax (to internalize the external cost) External benefit (e.g., public goods and make- up) Under-production (Qp < Qs) Imposition of unit subsidy (to internalize the external benefit) Effect of externality

12. Public good Private good ( 私享品 ) is a commodity of which its consumption by any one person reduces the amount available for others, i.e., private good is exclusive ( 排他性 ) in consumption. (Pure) Public good ( 共享品 )is a commodity of which its consumption by any one person does not reduces the amount available for others, i.e., public good is non-exclusive in consumption.

13. Impure public good is a commodity that can be consumed by many individuals at the same time. However, not all individuals can consume it (or the whole amount of it) because additional cost is involved in its consumption. Examples: National defense Pure public good: Radio broadcast Stage performance Impure public good:

14. Q16.3 Explain why the above are examples of pure public goods & impure public goods. Q16.4 Distinguish between public goods & public services.

15. Demand for public good MUV 1 MUV 2 MUV 1 +MUV 2 =MSB MSC $ Q 0 The market demand curve of a public good is its MSB curve. Why? MSB curve is equal to the vertical sum of MUV curves of all individuals in the market.

16. Q16.5 Explain why the market demand curve for a private good is equal to the horizontal sum of MUV curves of all individuals but the market demand curve for a public good is equal to the vertical sum of MUV curves of all individuals.

17. The social optimum QsQs P2P2 P1P1 MSC MUV 1 MUV 2 MUV 1 +MUV 2 = MSB $ Q 0 MSC P2P2 P1P1 = Optimal output: MSB(=  MUV) = MSC(=MC) Optimal pricing scheme: Prefect price discrimination (i.e., Pi = MUVi) then ∑ Pi = MSC

18. Private optimum If uniform pricing is practiced: High MUV users: MUV>P Low MUV users: MUV<P and refuse to consume. So the marginal revenue collected (  P<  MUV) is much lower than MSB. In equating MR=MC, the private optimum is much smaller than the social optimum. Underproduction is resulted and allocative efficiency cannot be attained. Moreover, as low MUV users are excluded from consumption, consumption efficiency cannot be attained.

19. If perfect price discrimination is practiced: It is extremely costly for a producer to know the MUV curve of every individual. Individuals would pretend to be low MUV users. Then MR collected from perfect price discrimination would also be smaller than MSB. Underproduction is resulted and allocative efficiency cannot be attained.

20. The free rider problem: As public good is non-exclusive in consumption, it is difficult to prevent free- riders (non-payers) from consuming the good. As free riders appear in all kinds of pricing schemes, MR collected is lower than MSB. Underproduction is resulted.

21. Any Remedy? Pricing: The visible hand faces similar problems as the invisible hand. Zero pricing: Through financing the production of public good by tax revenue. Unfair to taxpayers who do not consume the public good. Inefficiency is passed to another sector of the economy. To estimate MSB, consumers may overstate their MUVs. Over- production may be resulted. Underproduction is resulted.

22. Q16.7 Radio broadcast is a public good. What are the problems in its pricing? What are the ways to overcome the problems so that it can be provided privately? Is the situation efficient?

23. Counter Argument – the Market Works!

24. Coase Theorem ( 高斯理論 ) states that regardless of the initial assignment of property rights, the market equilibrium is identical and efficient – provided that property rights are well-defined and transaction costs are negligible. Zero transaction cost – Coase theorem

25. Factory in upstream Farm in downstream Illustration of the theorem Mr. B Ms. A

26. Factory pours sewage to the river Reduce the output of the farm Initial situation:

27. Case I: The farm does not have the right of enjoying clean water. Max. amount that Mr. B is willing to offer to Ms. A is the external cost he borne = MSC - MPC Suppose there is no law restricting pollution The farm owner Mr. B negotiate with Ms. A and pay her to cut her output and pollution. Min. amount that Ms. A is willing to accept is the her net receipt in producing that unit of output = MPB – MPC = MSB - MPC

28. (Max. amount offered = External cost) MSC - MPC = (Min. amount accepted = Net receipt) MSB - MPC MSC = MSB In equilibrium,

29. Case II: The farm has the right of enjoying clean water Max. amount that Ms. A is willing to offer to Mr. B is is the her net receipt = MPB – MPC = MSB - MPC Suppose there is a law restricting pollution The factory owner Ms. A negotiate with Mr. B and pay him to allow her production. Min. amount that Mr. B is willing to accept is the external cost he borne = MSC - MPC

30. (Max. amount offered = Net receipt) MSB - MPC = (Min. amount accepted = External cost) MSC - MPC MSB = MSC In equilibrium,

31. If transaction cost is zero, by Coase Theorem, private contracting would change the private optimum to the social optimum. Efficiency is achieved and no deadweight loss is resulted. Notice that the assignment of property rights has no influence on the allocation of resources. Conclusion

32. If pollution cannot be avoided in production (cost of preventing or eliminating pollution is too high), it is efficient to allow pollution whenever the marginal gain of pollution can cover its marginal cost. So there exists an optimal level of pollution. Remarks: 1. Optimal level of pollution 2. Reciprocal nature of the problem There exists no reason why someone should have the right of a resource (e.g., clean water). Whoever has the right will gain and whoever has to buy the right will lose. So who is the victim is reciprocal, depending on the assignment of right.

33. If the transaction cost in eliminating the deadweight loss is larger than the loss, no private contracting occurs. Although the private optimum is different from the ideal social optimum (that there exists deadweight loss), the resource allocation is still efficient (as no improvement is worth to be made). Prohibitively high transaction cost Achieving efficiency without reallocating resources

34. Deadweight loss MSC $ Q of factory 0 MPC MPB=MSB QSQS Q P1 If the farm does not have the right and the transaction cost is prohibitively high Assignment of property rights affects the allocation of resources (TC is prohibitively high) Q P1 Factory will produced at Q P1

35. Deadweight loss 0=Q P2 MSC $ Q of factory MPC MPB=MSB QSQS If the farm has the right and the transaction cost is prohibitively high 0=Q P2 The factory will be banned from production, i.e., 0=Q P2

36. As resource allocation by the invisible hand must be efficient, there is no market failure. No government intervention is needed. Moreover, the use of visible hand may be of ill-motive, involve high administrative and information cost, and restrict individual freedom. So even if there were “market failure”, the use of visible hand might not be appropriate. Government intervention is unnecessary and inappropriate

37. Survival Kit in Exam Question 3.1 (a) What is utility? Must the utility of a bad be a negative number? (b) Michael says, “Anderson fails in HKCEE and he commits suicide. The reason is that he is maximizing utility. Yet, Mary also fails in HKCEE but she does not commit suicide. Why? She is maximizing utility. Thus, the postulate of utility maximization is tautological.” Do you agree?

38. Correcting Misconceptions: 1. Public good is a good produced by the government. 2. The market demand curve of a public good is the horizontal sum of MUV curves of all individuals in the market. 3. To achieve efficiency, private good should be provided by the private sector and public good by the public sector.

39. 4. To achieve efficiency, pollution should be eliminated. 5. The existence of deadweight loss implies inefficiency. 6. Pareto efficiency requires zero transaction costs. Correcting Misconceptions:

40. 7. Pareto efficiency requires even distribution of wealth. 8. Pareto efficiency implies the maximization of social welfare. 9. To achieve efficiency, a polluting firm should be banned from production or it should compensated the victims. Correcting Misconceptions:

41. 10. There is no divergence between private and social costs. 11. As the market fails to allocate resources efficiently, the government should intervene. Correcting Misconceptions:

42. Survival Kit in Exam Q16.1 “A price-searching market allocates resources inefficiencyly.” Comment.

43. Q16.2 The construction of a rubbish collection point causes the value of nearly properties to fall. To attain economic efficiency, which of the following options should be adopted? (a)The rubbish collection point should compensate the nearby property owners. (b)The rubbish collection point should install pollution reduction device. (c)The rubbish collection point should be relocated. (d)The nearby properties should be relocated.