1. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 1 Chapter 7 Market failure and resource allocation

2. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 2 Learning objectives 1.Discuss the nature, and provide examples of, spillovers (externalities). 2.Examine the implications of spillovers for the efficient allocation of resources. 3.Briefly discuss the problem of the commons and its implications. 4.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.

3. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 3 Learning objectives (cont.) 5.Show how we can evaluate government activity through cost–benefit analysis. 6.Determine the economic considerations that underlie environmental problems and examine some suggested solutions to the pollution problem.

4. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 4 Sources of market failure Two major sources of market failure occur when the market either: 1.produces the wrong amounts of goods or services, resulting in externalities or ‘spillover’ effects, or 2.fails to allocate sufficient resources to the production of certain goods, called ‘public’ or ‘social’ goods.

5. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 5 Spillovers or externalities 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.

6. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 6 Spillovers or externalities (cont.) Spillover costs Production or consumption of a commodity that inflicts cost on some third party without compensation An example is environmental pollution. Spillover costs arise in some cases due to the problem of the commons: –Absence of clear property rights for resources owned in ‘common’ by society as a whole –Abuse of such resources detrimental to that society

7. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 7 No spillover costs Q 0 D P QeQeS

8. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 8 Spillover costs Q 0 D P QeQe Qo Qo StStStStS T

9. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 9 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.

10. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 10 Spillover benefits Q 0 PS Qo Qo QeQe D D1D1D1D1 B

11. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 11 Public goods and services Private goods produced through the market system are: –divisible –subject to the exclusion principle. Public goods not provided by the market are: –indivisible –not subjected to the exclusion principle. Pure public good –Goods and services that are both indivisible and are not subject to the exclusion principle

12. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 12 P Q D When vertically added equals collective willingness to pay D2D2 D1D1 Demand for a public goodS

13. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 13 Quasi-public goods Governments may provide some goods (quasi-public goods and services) e.g. education, health, etc., which have large spillover benefits but could also be subject to the exclusion principle.

14. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 14 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.

15. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 15 P Q D 0 Spillover costs StSt S TAX Over-allocation corrected Q0Q0 QeQe Correcting for spillover costs

16. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 16 Correcting for spillover benefits Subsidise buyers Subsidise producers

17. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 17 Correcting for spillover benefits (cont.) P Q D S 0 DtDt Subsidy to consumer Under-allocation corrected

18. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 18 P Q D 0 Subsidy to producers increases supply StSt S′tS′t Under-allocation corrected QeQe Q0Q0 Correcting for spillover benefits (cont.)

19. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 19 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.

20. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 20 The pollution problem The law of conservation of matter and energy Four important causes of pollution are: 1.population density 2.rising incomes 3.technology 4.incentives.

21. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 21 Anti-pollution policies Individual bargaining and liability rules and lawsuits –Problem: costly to implement Government intervention: direct control and taxes –Direct controls: legislated standards  Problem: standards difficult to establish when information is incomplete –Specific taxes: emission fees  Problem: costly to administer and control Establishment of a market for pollution rights

22. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 22 A 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.

23. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 23 A market for pollution rights (cont.) 500 750 1000 Quantity of pollution rights (units) Price per pollution right $100 $200 D 2012 D 2015 S

24. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon 7- 24 Next chapter The macroeconomic environment and its measurement