17-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Chapter 17 Market failure and resource allocation

17-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Learning objectives Discuss the nature, and provide examples of, spillovers (externalities) Examine the implications of spillovers for the efficient allocation of resources Briefly discuss the problem of the commons and its implications Describe the characteristics of public goods — indivisibility and the inability to apply the exclusion principle — and the potential role of government in ensuring the adequate provisions of these goods

17-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Learning objectives (cont.) Show how we can evaluate government activity through cost–benefit analysis Determine the economic considerations that underlie environmental problems and examine some suggested solutions to the pollution problem

17-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Sources of market failure Two major sources of market failure. The market either Produces the wrong amounts of goods or services, resulting in externalities or ‘spillover’ effects, or Fails to allocate sufficient resources to the production of certain goods, called ‘public’ or ‘social’ goods

17-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Spillovers or externalities These are costs or benefits associated with the production or consumption of a good or service that flow on to parties that are external to the market transaction Spillovers –Costs or benefits associated with production or consumption that flow on to parties external to the market transaction –The market over-allocates resources –Also called externalities because these are costs or benefits that are external to the market transactions

17-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Spillovers or externalities (cont.) Spillover costs Production or consumption of a commodity that inflicts cost on some third party without compensation Example: environmental pollution Spillover costs arise in some cases due to the problem of the commons

17-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Spillover costs Q 0 D P QeQe Qo Qo S1S1S1S1 S

17-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Spillovers or externalities (cont.) Spillover benefits Production or consumption of goods and services which confer external benefits for which payment or compensation is not required The market under-allocates resources

17-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Spillover benefits Q 0 PS Qo Qo QeQe D D1D1D1D1

17-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Public goods and services Private goods are produced through the market system –They are divisible –Subject to the exclusion principle Public goods not provided by the market and are: –Indivisible –Not subjected to the exclusion principle

17-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Public goods and services (cont.) Public goods are goods and services that are not provided by the market system Pure public goods are goods and services that are both indivisible and not subjected to the exclusion principle A common problem of public good is the free-rider problem

17-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia P Q D When vertically added equals collective willingness to pay D2D2 D1D1 Demand for a public goodS 3 5 8

17-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Solutions to market failure Correcting for spillover costs Legislation Specific taxes Property rights and individual bargaining –Coase theorem  Property ownership is clearly defined  The number of people involved is small  Bargaining costs are negligible

17-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Over-allocation corrected P Q D 0 StSt S Spillover costs Tax Q0Q0 QeQe Correcting for spillover costs

17-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Correcting for spillover benefits Subsidise buyers –This would reduce the private cost to consumers and increase the consumption of the good Subsidise producers –Government can encourage the production by subsidising producers of the good or service

17-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Correcting for spillover benefits (cont.) P Q D S 0 DtDt Subsidy to consumer Under-allocationcorrected

17-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia P Q D 0 StSt S′tS′t Subsidy to producers increases supply Under-allocation corrected QeQe Q0Q0 Correcting for spillover benefits (cont.)

17-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Allocating resources to public goods Cost–benefit analysis Method used to allocate resources to public goods that maximises society’s welfare Problems associated with cost–benefit analysis include the difficulties in measuring the value of certain costs and benefits in practice

17-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia The pollution problem The law of conservation of matter and energy Four important causes of pollution 1. Population density 2. Rising incomes 3. Technology 4. Incentives

17-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Anti-pollution policies Individual bargaining and liability rules and lawsuits –The allocation of property rights to individuals may allow them to negotiate with polluters so that they are compensated for the damage caused by pollution — Coase theorem Government intervention: direct control and taxes –Direct controls: legislated standards –Specific taxes: emission fees Establishment of a market for pollution rights

17-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Market for pollution rights Involves the establishment of an allowable amount of pollution — in line with the ability of the environment to recycle — by a pollution control agency, and the development of a set of ‘rights’ to create units of pollution which would be sold or auctioned in the market

17-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Market for pollution rights (cont.) Rights to pollute would be sold or auctioned off to polluting firms, providing a market for pollution rights Polluters would bid for the pollution rights up to the point at which the cost of the pollution rights exceeds the private cost of pollution abatement A market for pollution rights ensures an efficient allocation of resources

17-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Market for pollution rights (cont.) Quantity of pollution rights (units) Price per pollution right $100 $500 D 2000 D 2008 S

17-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Next chapter: Inequality and poverty