Market Failure Solutions A review of various approaches to address imperfections of the free market system

Objectives The learner will be able to: 1. List the different approaches available to address externalities. 2. Define the Coase Theorem. 3. Explain the efficiency challenge of direct control policies. 4. Identify, explain and provide examples of market based solutions.

The Issue Demerit goods are goods that generate negative externalities – costs not borne by the producer or provider of a product or service. Demerit goods are goods that generate negative externalities – costs not borne by the producer or provider of a product or service. All costs to society are not factored into the output decision All costs to society are not factored into the output decision Leads to overallocation of resources and excess production. Leads to overallocation of resources and excess production. How can we move the allocation of resources closer to the social optimum? How can we move the allocation of resources closer to the social optimum?

Possible Remedies 1. Private solutions 2. Direct controls (regulation) 3. Market based policies

Private Solutions Social sanctions and moral code Social sanctions and moral code  Generally accepted sense of what is right or proper behavior within a given society  Individual sense of right and wrong is a way of internalizing negative social externalities  Examples:  Playing loud music  Littering

Charities Non-profit organizations and charities are often established to deal with positive and negative externalities. Non-profit organizations and charities are often established to deal with positive and negative externalities. Examples: Examples:  Sierra Club and other environmental groups  Colleges and universities  United Way  Local : Arts & Science Campaign

Direct Private Negotiation Belief that if private parties can bargain without cost over the allocation of resources, they should be able to solve the problem of externalities on their own. Belief that if private parties can bargain without cost over the allocation of resources, they should be able to solve the problem of externalities on their own. This is known as the Coase Theorem This is known as the Coase Theorem People impacted should be able to reach an agreement based on the value of the benefit or harm borne by each party. People impacted should be able to reach an agreement based on the value of the benefit or harm borne by each party. A simple example … A simple example …

Coase Theorem (Cont’d) In the real world, this sort of bargaining does not always work – Why? In the real world, this sort of bargaining does not always work – Why? Transaction costs Transaction costs Transaction costs usually = legal costs Transaction costs usually = legal costs Local ordinances and property rights often make the issue more about legal claims versus theoretical value of harm or benefit. Local ordinances and property rights often make the issue more about legal claims versus theoretical value of harm or benefit. Rarely as simple as a one on one negotiation (although class action lawsuits can reduce the number of players involved) Rarely as simple as a one on one negotiation (although class action lawsuits can reduce the number of players involved)

Direct Controls Otherwise known as “command and control” policies Otherwise known as “command and control” policies Governments can prohibit or restrict certain actions, or mandate certain actions (i.e. use of technology) Governments can prohibit or restrict certain actions, or mandate certain actions (i.e. use of technology) Often difficult or impossible to impose an outright ban (consider pollution) Often difficult or impossible to impose an outright ban (consider pollution) Society must weight the costs and benefits of these restrictions Society must weight the costs and benefits of these restrictions

Direct Controls (Cont’d) Direct controls can be very effective, especially in the case of limiting or eliminating actions that are deemed extremely costly (or dangerous) to society. Direct controls can be very effective, especially in the case of limiting or eliminating actions that are deemed extremely costly (or dangerous) to society. But are these command and control policies efficient? But are these command and control policies efficient? Is there a more efficient way to achieve the same (or better) results? Is there a more efficient way to achieve the same (or better) results?

Market Based Solutions Remember, the basic problem with demerit goods is that full costs to society are not factored into the output decision. Remember, the basic problem with demerit goods is that full costs to society are not factored into the output decision. MSC MPC MPB

Market Based Solutions Instead of directly regulating behavior, governments can use market based policies to more closely align private incentives with social objectives. Instead of directly regulating behavior, governments can use market based policies to more closely align private incentives with social objectives. Two basic approaches: Two basic approaches: 1. Corrective taxes and subsidies 2. Tradeable Pollution permits

Corrective Taxes/Subsidies Tax activities with negative externalities Tax activities with negative externalities  Known as a Pigovian Tax  Ideal tax would equal the external cost to society from an activity Subsidize activities with positive externalities Subsidize activities with positive externalities  Ideal subsidy would equal the external benefit from an activity Both of these policies would narrow the spillover gap from externalities Both of these policies would narrow the spillover gap from externalities

A Graphical Look MSC MPC 1 MPB Q p1 Q p2 QsQs MPC 2

Pigovian Taxes Economists prefer taxes over regulation as remedies for negative externalities – Why? Economists prefer taxes over regulation as remedies for negative externalities – Why? Regulations require everyone to behave the same (reduce pollution by the same amount), regardless of their cost structure. Regulations require everyone to behave the same (reduce pollution by the same amount), regardless of their cost structure. Corrective taxes place a price on the right to pollute and allow producers to efficiently factor this cost into their output decisions. Corrective taxes place a price on the right to pollute and allow producers to efficiently factor this cost into their output decisions.

Pigovian Taxes (Cont’d) Without diving deeply into taxation policy... Without diving deeply into taxation policy... Note that the impact of a corrective tax is to move the allocation of resources closer to the social optimum point. Note that the impact of a corrective tax is to move the allocation of resources closer to the social optimum point. This makes Pigovian Taxes (which deal with externalities) very different from “normal” taxes, which have a net negative economic impact – otherwise known as a deadweight loss. This makes Pigovian Taxes (which deal with externalities) very different from “normal” taxes, which have a net negative economic impact – otherwise known as a deadweight loss.

Tradeable Pollution Permits This approach starts with the creation of a new scarce resource – pollution permits (rights to pollute) This approach starts with the creation of a new scarce resource – pollution permits (rights to pollute) If these rights are transferable a market will develop If these rights are transferable a market will develop The forces of supply and demand will determine the pricing and allocation of these permits The forces of supply and demand will determine the pricing and allocation of these permits

Tradeable Pollution Permits By definition, these permits will be owned (acquired) by firms that value these permits most highly – based on their willingness to pay By definition, these permits will be owned (acquired) by firms that value these permits most highly – based on their willingness to pay Willingness to pay will be determined by a firm’s cost of reducing pollution Willingness to pay will be determined by a firm’s cost of reducing pollution Result is an efficient allocation of permits among firms based on their cost of reducing pollution Result is an efficient allocation of permits among firms based on their cost of reducing pollution Also provides a market incentive to reduce pollution below “target” levels Also provides a market incentive to reduce pollution below “target” levels

Tradeable Pollution Permits So, could this market based system actually work in practice? So, could this market based system actually work in practice? A few real world examples: A few real world examples: 1. Acid Rain Program (SO 2 ) 2. Northeastern NOx market 3. EU Carbon Trading Scheme

Tradeable Pollution Permits What are some of the objections to these programs? What are some of the objections to these programs? Philosophical problem with “licenses to pollute” Philosophical problem with “licenses to pollute” Standards based approaches tend to hide the costs of pollution control, versus market based systems which make the costs explicit Standards based approaches tend to hide the costs of pollution control, versus market based systems which make the costs explicit The political process is dominated by lawyers – and lawyers prefer legal solutions The political process is dominated by lawyers – and lawyers prefer legal solutions Direct controls appear more certain Direct controls appear more certain

A Market Based Approach to a Different Problem Read the article “Stockholm’s Syndrome” Read the article “Stockholm’s Syndrome” 1. What are the externalities that are being addressed? 2. What new “markets” are being created? 3. How do you expect driver “buying” patterns will change? 4. Do you think this new system will be effective?