1. Market Failure ***Externalities and Beyond! ***
Much info from Tragakes and Blink & Dorton

2. In other words, too much or too little of a good or service is
What is market failure?
Market failure is “a failure of the market to achieve __________________, resulting in an over-allocation of resources "(over-_______________) or an under- allocation of resources (under-_______________.)”
In other words, too much or too little of a good or service is
produced or consumed
allocative efficiency
provision of a good
provision of a good

3. What is an externality? (Simpler answer)
An externality is when producing or consuming a good causes an impact on third parties not directly related to the transaction
Question to ask: Does this transaction somehow affect another person (positively or negatively)?
If YES, then it has an externality.

4. With NO externalities…
The private cost for an individual producer and the private benefit for an individual consumer does not impact others (i.e. society) in any way
Examples of goods/services without externalities (Note: Pretty much anything, including these examples, could be argued to have externalities!)
Buying a song on iTunes
Buying a 4th pair of shoes
Hiring someone to help move furniture into an apartment

5. What is an externality? (More complete answer)
An externality is the failure of the market to achieve a ___________ optimum where ______ = ______.
MSB = MPB + MEB
MSC = MPC + MEC
MB = MARGINAL BENEFIT, MC = MARGINAL COST
(S = Social, P = Private, E = External)
When negative externalities exist, MSC ___ MSB
When positive externalities exist, MSC ___ MSB
SOCIAL
MSB
MSC
>
<

6. EXTERNALITY: 3rd party being affected

7. DEMERIT V. MERIT GOODS external costs external benefits
DEMERIT GOODS - Goods whose consumption creates _____________.
MERIT GOODS - Goods whose consumption creates _______________.
external costs
external benefits

8. Examples of Various Externalities
Positive Production
Firms provide training on skills that employees take beyond that job
(cost to one firm benefits a 3rd party.
3rd party = the new firm…that firm gets more benefits b/c no new training costs)
Positive Consumption
Health & Education
(healthier people pass along less illnesses to others…those others become
more productive)
Negative Production
Factories that pollute air/water/land
(the goods that factories produce don’t necessarily harm…but the production of those goods
creates harm)
Negative Consumption
Smoking in public places
(manufacturing of cigarettes doesn’t necessarily pollute…but 2nd hand smoke can lead to many health problems)
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.
No (or very little) externalities:
A teacher’s haircut
This rarely bring positives or negatives to a 3rd party

9. Recap: What do you remember from the previous slide?!!!
Positive Production
Example: ???
(Extra info???)
Positive Consumption
Negative Production )
Negative Consumption
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.
No (or very little) externalities:
A teacher’s haircut
This rarely bring positives or negatives to a 3rd party

10. PRODUCTION EXTERNALITIES: Marginal Social Cost (MSC)
What is Marginal Social Cost? (MSC)
MSC = MPC + MEC
MPC = Cost of firm to produce
MEC = Cost to 3rd parties (“society”) b/c something is produced

11. 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 MSC = MSB. Because of this, the market has failed. 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..

12. Graphing Negative Externalities of Production
Another way to look at it

13. Graphing Negative Externalities of Production
Why is Q1 free market equilibrium?
Q demanded/supplied without gov’t intervention
Why is Q2 the socially optimal output?
The cost to society is equal to the benefit to society (MSC = MSB)
Why is demand = MPB = MSB?
Consumption of the good produced in the factory (e.g. t-shirts) doesn’t harm 3rd parties, but the production of the good harms them
Why is the area in red “deadweight welfare loss?”
B/c at Q1, too much is being produced. (Cost to society is greater than that level of output) @Q2, there is no welfare loss b/c society is optimal Q
What are 3 ways governments can try to move society from Q1 to (the socially optimal) Q2?
1. Tax pollution. 2. Regulation (ban/restrict output). 3. Create market for externality rights.

14. Solutions to Correct Market Failure
What are ways gov’ts can DISCOURAGE NEGATIVE PRODUCTION EXTERNALITIES? (Examples in black)
Taxes on producers
(taxing output): Tax on # of cars Toyota produces
(taxing emissions): Tax on amount of CO2 Toyota emits
Tradable permits (externality rights)
Cap & trade for the amount of carbon companies can emit
Government regulations (laws limiting activity)
Requiring all cars to have fuel efficiency of 8 kms/liter
How could these solutions be considered market-based?
Afterwards, consider how are they not completely free market solutions?
Market-based: When producers/consumers have the ability to decide how much to sell/buy. Pure market-based solution would not need government intervention ***Taxing output is not near as effective as taxing emissions b/c there are greater incentives to change if emissions are taxed instead of simply outputs

15. Is it easy to set a correct “cap” on the amount of
Another Way Govts Can Get Involved: Market for Externality Rights (permits)
Also called
“Cap & Trade”
Is it easy to set a correct “cap” on the amount of
pollution?
Close to a
free-market
solution.
Why?
Why free market & why not free market?

16. Negative Externalities – Tradeable Emission Permits’ (Freeish) Market Operation
If a firm pollutes at a higher level that its permit allows, it will need to buy permits from other firms. This will raise its costs.
If a firm pollutes less than they are allowed, then they can sell their permit. This will create additional revenue.
In the USA, the emission of chloroflurocarbons (CFCSs) is controlled by the use of tradable emission permits.

17. Example of Tradable Permits: The Kyoto Protocol (est. 1997)
Many developed countries committed to reducing emissions of greenhouse gases such as CO2 (carbon dioxide) over 15 years to slow down problems of global warming & climate change
This agreement was made under the United Nations Framework Convention on Climate Change.
Used market for externality rights
(i.e. tradable permits, cap & trade)
Some problems: (1) Many agreed that the changes were too small, (2) the US and several developing countries did not join

18. Example of Tradable Permits: EU ETS (Est. 2005)
European Union Emissions Trading System (EU ETS)
Focuses on these sectors:
Power & heat generation
Oil refineries
Metals
Pulp & paper
Energy intensive industries (airlines, etc.)
Cap and trade scheme largely seen as successful.
(also, meeting these targets mostly means meeting all targets for the Kyoto Protocol)

19. Tradable Permits: QUANTITY in the EU ETS
As economies have grown, has the EU ETS allowed for a higher or lower cap on output each year?
Why is it lower?
(Remember the goal!)

20. Tradable Permits: PRICE in the EU ETS
If the Q allowed (cap) has decreased, then it makes sense that the P should have increased.
However, it has not. Why might that be?
Think supply & demand!
The demand must have decreased more than the supply did. How?
Perhaps through the development of alternative means of production that are “cleaner” (use less CO2)
Y axis = price in Euros, X axis = years ( )

21. Problems of Correcting Negative Production Externalities by Restricting Emissions and/or Output
Ban or restriction could:
1. Lead to job losses
2. Lead to people not consuming less of what is actually a potentially valuable product (e.g. a polluting factory that produces eyeglass lenses)
3. Lead to gov’t spending more $$$ on (a) setting and (b) policing/enforcing. The cost of doing this may exceed the social cost of the pollution.

22. Carbon tax Another solution:
A tax per unit of carbon emissions of fossil fuels
Negative production externality solution sounds great:
POLLUTER PAYS “CARBON TAXES
But…it’s actually not that simple! Why?

23. CAP & TRADE v. CARBON TAX WHICH IS BETTER?
BENEFITS THEY BOTH HAVE
Somewhat market-based solutions
Internalizes, instead of externalizes, costs (producers pay costs internally instead of society paying externally)
Provide incentives to firms to change production methods to produce less

24. CAP & TRADE v. CARBON TAX WHICH IS BETTER?
PROBLEMS THEY BOTH HAVE
Hard to accurately measure total level of pollution.
(What production methods produce pollutants?)
(Which pollutants are harmful?)
Hard to accurately measure $$$ value of pollution. (How much is X amount of carbon discharge really worth?)
(It’s hard to find where MSC = MSB!)
Hard to accurately measure which firms are responsible for how much pollution.
Taxes/cap may be set too low/high.
Taxes too low = Society hurt. Taxes too high = Producers hurt
Cap too low = Producers hurt. Cap too high = Society hurt

25. CAP & TRADE v. CARBON TAX WHICH IS BETTER?
CARBON TAX Pros (compared to Cap & Trade)
Easier to design, implement, & enforce (less monitoring)
Energy prices are made more predictable (important in helping businesses plan their costs ahead of time)
Can be applied to all users of fossil fuels (not just certain industries)
Do not have to worry about a fair way to distribute permits
Less room for manipulation by interest groups, governments, etc.
Cap & Trade schemes face strong political pressures to set a high cap
Less likely to restrict competition between firms
CARBON TAX Cons (compared to Cap & Trade)
Taxes just discourage action instead of stopping it.
They cannot target a specific level of carbon reduction
Higher taxes = more incentive to break the law
Taxes are regressive (hurts companies that earn less income)
Taxes must be adjusted for inflation

27. Solutions to Correct Market Failure
What are ways gov’ts can DISCOURAGE NEGATIVE CONSUMPTION EXTERNALITIES? (Examples in black)
Excise taxes (indirect tax when purchase is made)
Taxes on purchasing sodas, cigarettes, etc.
Government regulations and/or banning
Reducing #s of places people can smoke
Requiring (a) health warnings and/or (b) plain (non-branded) packaging on cigarette packs
Requiring minimum age for consumption
Not allowing marketing towards teenagers/children
Creating advertisements/providing education
Showing “public service announcements” about how sugar and/or smoking is bad for people
Anti-smoking and/or fast food campaigns in schools
Market-based: When producers/consumers have the ability to decide how much to sell/buy. Pure market-based solution would not need government intervention.

28. Plain packaging w/graphic labeling (UK will implement this type of label in May 2016)

29. Problems of Correcting Shortage of Negative Consumption Externalities by Taxing Consumers
Indirect taxes on smoking might:
1. not reduce smoking as much as desired (b/c of its inelasticity)
2. lead to smokers buying from other countries
Legally: Austrian smokers buy in Slovakia
Illegally: Via a black market

30. Problems of Correcting Shortage of Negative Consumption Externalities by Banning
Banning smoking completely (gov’t regulation) should:
1. Lead to high costs by gov’t for enforcing ban
2. Lead to unemployment and lost $ for shareholders in tobacco industry
3. Lead to sharp reduction in tax revenue from cigarettes
4. Lead to black market for cigarettes
Having said that, many cities/states/provinces have banned smoking inside public buildings.

31. Reducing Neg. Exter. of Consumption Via an Indirect Tax
PQ = ?
Q* = ?
P* = ?
P2 = ?
(P2 – P*) X Q* = ?
Why is the incidence for the tax greater for consumers?

32. Reducing Neg. Exter. of Consumption Via an Indirect Tax
“Solution” could be labeled “indirect tax”
Reducing Neg. Exter. of Consumption Via an Indirect Tax
PQ = ? Equilibrium Q (amount S & D by market before tax)
Q* = ? Socially optimal Q
P* = ? Price producers receive after tax
P2 = ? Price consumers pay after tax
(P2 – P*) X Q* = ? Government Revenue
Why is the incidence for the tax greater for consumers? PED far more inelastic than PES (Think about why!)

33. What is the free market Q? What is the socially optimal Q?
Reducing Neg. Exter. of Consumption Via Negative Advertising
What is the free market Q?
What is the socially optimal Q?

34. POSITIVE EXTERNALITIES!
Enough of the discouraging negative externalities…
let’s get to
Encouraging
POSITIVE EXTERNALITIES!

35. Solutions to Correct Market Failure
What are ways gov’ts can ENCOURAGE POSITIVE Production &/or Consumption EXTERNALITIES?
C: Subsidizing consumers (buyers)
Vaccines now only $5 (rebate offered for $10 of original $15 price)
P: Subsidizing producers (sellers) *more common than subsidizing buyers*
Vaccines now only $5 (gov’t pays producers subsidies to supply more at a lower price to the consumer. Producer earns more than price consumers pay. )
C: Advertising to influence behavior
“Do you want a long, healthy life? Get vaccinated today for only $15!”
C: Legislation
All citizens are required to get a vaccine.
C: Direct provision
Government provides all vaccines to citizens for free
Market-based: When producers/consumers have the ability to decide how much to sell/buy. Pure market-based solution would not need government intervention.

36. Solutions to Correct Market Failure
Encouraging POSITIVE CONSUMPTION EXTERNALITIES in Education
Legislation
School is compulsory for all citizens until a certain age (This increases the amount consumed!)
Direct provision
Government provides education for free to all citizens (This also increases the amount consumed!)
Market-based: When producers/consumers have the ability to decide how much to sell/buy. Pure market-based solution would not need government intervention.

37. Which one CANNOT be considered a market-based solution?
How were most of the solutions to expand positive externalities partially (but not fully) market-based?
Which one CANNOT be considered a market-based solution?
Direct provision cannot be considered. Legislation that requires all citizens likely isn’t as well. In the other examples, there is some choice by individual producers and consumers on how much to supply and/or consume.

38. Problems of Correcting Shortage of Positive Production Externalities by Assisting Firms
Providing vocational training by setting up training centres for workers in certain industries should:
1. Lead to high costs for the gov’t
2. Lead to problems in determining which industries/locations/individuals do or do not get the training
3. Lead to problems in finding quality trainers for the expertise needed by certain firms
4. Dissuade firms from offering their own training

39. Asymmetric Information! Now for something different…
An example of market failure that does not involve externalities

40. The Information Problem
In a perfect market…
BOTH consumers AND producers have a perfect knowledge of the market
But often in the real world…
One party in an economic transaction (either the buyer or the seller) possesses more information than the other party.
The seller more often is the one who knows more!
This is asymmetric
information!

41. Examples of Asymmetric Information: SELLERS knowing more
1. Used car salesman
Used car salesman knowing the car he/she is selling is worth far less than the sticker price
2. Possible dangers known only to sellers
Food served that is more unsafe than advertised
Medicine sold that is actually unsafe
3. Real-Life Example: 2015 VW Scandal
By 2015, Volkswagen had sold 11 million cars in the US that were rigged to cheat the emissions tests (tests on how much a car pollutes)
The cars actually polluted much worse than the owners/US gov’t knew.

42. Examples of Asymmetric Information: BUYERS knowing more
1. Insurance
Buyer of health insurance is more sick than the providers (of that insurance) are aware of
2. Labour market (employers knowing more)
Note:
Employers “buy” the services of their employees
Employees “sell” their services to their employers
Job not as safe, fair, or as well-paying as employee thought it was going to be
3. Insider trading
Person buys a stock with inside information that a company announcement is going to increase the stock’s price
Note: This ‘insider trading’ is illegal

43. How might governments respond to problems of asymmetric information?
The #1 way: Legislating & Regulating
Example: Food
Gov’t requiring all ingredients in food to be on the label
Gov’t requiring fast food restaurants to publish the amount of calories in each dish
Example: Doctors & lawyers & teachers (etc.)
Gov’t requiring all doctors & lawyers & teachers to have a certain license and/or amount of training
Example: Banks
Gov’t requiring banks to disclose the annual % interest rates on loans they give to consumers
Example: Taxis
Gov’t requiring taxis and taxi drivers to be licensed
Gov’t setting the price of taxis from airports to various parts of a city

44. How might governments respond to problems of asymmetric information?
Another way: Directly Providing Information
Examples:
Gov’t posting health care statistics of different providers
Gov’t advertising about health hazards related to various activities
Gov’t creating a map of crime rates in various neighbourhoods

45. Other than enormous (1) financial and (2) opportunity costs governments spend in combatting asymmetric information, what are some problems with these ‘solutions?’
1. It is extremely difficult to:
regulate accurately (gather all the correct information)
regulate fairly (not favor one company over another)
regulate quickly (help consumers before it is too late)
communicate effectively (ensure the proper info reaches all consumers)
2. It limits free trade (this is a libertarian argument)
Why? Supply is decreased, prices are raised
Argument: People should choose what they want to choose. The market will naturally build in safeguards. (In other words, if the gov’t doesn’t regulate, people will start to self-regulate.)
Example: More new medicines could possibly help patients NOW instead of patients waiting years for a gov’t to test their safety & then approve them

46. Moving on...the issue of ‘a lack of public goods’
Be able to do the following (from the IB guide)
1. Using the concept of rivalry and excludability, and providing examples, distinguish between public goods and private goods.
2. Explain, with reference to the free rider problem, how the lack of public goods indicates market failure.
3. Discuss the implications of the direct provision of public goods by government

47. NOTE: MOST GOODS ARE PRIVATE, NOT PUBLIC!
THE MARKET FAILS B/C MORE PUBLIC GOODS SHOULD BE
PRODUCED!

48. #1: Concepts of excludability/rivalry
Excludability: (A public good is non- excludable)
Consumers can be excluded from consuming the product if they are not willing to pay for it
Examples of exclusion:
1) Not allowing a spectator who hasn’t paid inside a football stadium
2) Internet provider turning off one’s wifi who hasn’t paid
Rivalry: (A public good is non-rivalrous)
One person's consumption of a product reduces the amount available for other people to consume –
Example of rivalrous: If I eat a cookie, you can’t eat the same cookie. My consumption reduces the total amt of cookies
from tutor2u.net

49. #1: Examples of rivalry/excludability
Why are a t-shirt AND broccoli both rivalrous AND excludable?
Why are a lighthouse at sea AND a public fireworks display
non-rivalrous AND non-excludable?

50. #1: Examples of rivalry/excludability
Why are common access resources such as fisheries rivalrous but not excludable?
Why is a movie theater non-rivalrous but excludable?

51. COMMON ACCESS RESOURCES: NONEXCLUDABLE (but usually RIVALROUS)
1 Definition:
Resources not owned by anyone, do not have a price, and are available for anyone to use without payment.
Another Definition:
A resource that benefits a groups of people, but which provides diminished benefits to everyone if each individual pursues his or her own self interest.  The value of a common-pool resource can be reduced through overuse because the supply of the resource is not unlimited, and using more than can be replenished can result in scarcity.

52. COMMON ACCESS RESOURCES: NONEXCLUDABLE (but usually RIVALROUS)
Definition:
Resources not owned by anyone, do not have a price, and are available for anyone to use without payment.
Examples:
Clean air
Lakes
Rivers
Fish in open seas
Hunting grounds
Open grazing land
Ozone layer
Biodiversity
Forests
If activities in common access areas (such as polluting air/water or over- fishing/grazing/hunting) affect others’ ability to use that same air/ water/land, then those activities are
RIVALROUS

53. Problem: Economic and Environmental goals often (but not always
Problem: Economic and Environmental goals often (but not always!) are in conflict
Econ goals for firms & govt: Increase Q produced & consumed
Environmental goals: Preserve the environment

54. COMMON ACCESS RESOURCES: NONEXCLUDABLE (but usually RIVALROUS)
Sustainability (definition):
Ability of something (such as the environment or economy) to be maintained or preserved over time.
Important idea w/sustainability
Certain rivalrous resources (e.g. fisheries) can be used as long as it is done at a sustainable level.
In other words, fishing can be sustainable (b/c the fish supply can replace itself) but OVERFISHING cannot be.
In overfishing, the amount of fish left in the oceans will NOT become equal to the amount prior to the overfishing.

55. COMMON ACCESS RESOURCES: NONEXCLUDABLE (but usually RIVALROUS)
Though catching fish and cutting down forests can be sustainable, using fossil fuels cannot be.
Main 3 fossil fuels:
PETROLEUM
NATURAL GAS
COAL
Once used, they cannot be replaced/reused.
(they are also examples of rivalrous goods)

56. This field can handle 20 cows
This field can handle 20 cows. More than 20, and the soil will start to be depleted. B/c this is non-excludable, there is a problem. What is best for an individual (use the land as much as possible) is not best for the group/society/future generations.

57. COMMON ACCESS RESOURCES: THE PROBLEMS AREN’T JUST LOCAL!
Polluting air (not just health effects of local population)
Health effects; contributing to global warming (which leads to many other problems in agriculture, health, econosystems)
Overfishing (not just reduction of fish)
Possibility of disrupting entire marine ecosystem
Clearing of forests (not just fewer # of trees)
Loss of biodiversity, threats to ozone layer, threats to types of wildlif
Overgrazing of land (not just poorer soil)
Arable land lost due to erosion & salinisation, wildlife endangered

58. NO PRICE MECHANISM: This is a problem that exists because there is
If people had to pay for the use of these goods, (whether as capital goods for producers or as consumer goods for individuals)
there would be fewer problems with sustainability!
It’s a big problem! Governments have to try and intervene b/c the market has failed. While some public goods are underutilized, these public goods are overproduced.

59. Pollution in developed countries v. Pollution in developing countries!
Wrapping this sub-section up…
Pollution in developed countries v.
Pollution in developing countries!
It’s a big problem! Governments have to try and intervene b/c the market has failed. While some public goods are underutilized, these public goods are overproduced.

60. POLLUTION (NOTE: NOT ALWAYS TRUE FOR EACH!)
DEVELOPED COUNTRIES
DEVELOPING COUNTRIES
Biggest problem: More CO2 emissions per capita
More laws/regulations & enforcement (of those laws)
More R & D spent on sustainable practices such as developing clean technologies
POVERTY is “the most important cause of environmental destruction”
WHY? Overexploitation of land by scarce resources.
Soil depletion from overuse and/or unavailability of inputs that preserve soil’s fertility
High birth rates/population growth creates more pressure for finding/using arable land
Lack of finances (loans) prevents improvements in sanitation, irrigation, & other inputs
Lack of alternatives for environmentally sustainable jobs due to poor economy/education
Lack of gov’t regulation/enforcement
arguably

61. Evaluating Legislation (Laws/Regulations) in Responding to Threats of Sustainability
Examples
Restricting emissions standards on cars
Restricting emissions from factories
Banning the use of harmful substances (e.g. asbestos) in production
Creating protected areas (no construction, etc.)
Logging quotas
Hunting (and fishing) licenses/quotas/seasons
Licenses: Only allowing certain people to hunt/fish
Quotas: B/c most hunters prefer killing male deer (bucks) largely b/c of their antlers, only 2 can be killed per season
Seasons: Only allowing hunting to take place at certain times of the year

62. Deer Hunting Regulations Tennessee (USA)

63. Evaluating Legislation (Laws/Regulations) in Responding to Threats of Sustainability
Pros of Legislation
Relatively simple to set up & implement compared to carbon taxes/market for externality rights
Often effective
Avoids problems that market-based solutions often have (not specifically limiting unsustainable acts)
Cons of Legislation
Costs $$$ (financial & opportunity) to monitor/enforce
Very difficult to avoid under- or over-regulating
(It’s hard to find where MSC = MSB!)

64. Evaluating Funding of Clean Technologies in Responding to Threats of Sustainability
Definition
“Technology that uses less material and/or energy, generates less waste, and causes less environmental damage than the alternatives.”
Examples
#1 Example: RENEWABLE ENERGIES
Wind power, solar power, hydropower, biomass/biofuels, etc.
Other Examples
Geothermal energy
Nuclear power
Energy storage (e.g. development of fuel cells)
Fuel efficiency (ei.e. less waste in use of energy)
Recycling

65. Evaluating Funding of Clean Technologies in Responding to Threats of Sustainability
Pros of Funding Clean Technologies
The current model of carbon emissions is unsustainable. It is important/urgent to have a paradigm shift.
Cons of Funding Clean Technologies
Without stronger regulations of fossil fuels, there are low incentives for governments and private firms to invest in clean technologies.
(Opportunity costs: Why spend $$$ right now on developing solar power when coal works fine?)
(Opportunity costs: Why spend $$$ helping develop clean technologies to reduce carbon emissions for the world when people in my country need education, health care, retirement benefits, national defense, etc.?)
Developing countries often still subsidize fossil fuel companies & spend little on clean technologies

66. Back to ‘a lack of public goods’
Be able to do the following (from the IB guide)
1. Using the concept of rivalry and excludability, and providing examples, distinguish between public goods and private goods.
2. Explain, with reference to the free rider problem, how the lack of public goods indicates market failure.
3. Discuss the implications of the direct provision of public goods by government

67. Because of this, the MARKET HAS FAILED!!!
#2: Explain, with reference to the free rider problem, how the lack of public goods indicates market failure.
If someone can consume or benefit from a good without making a payment, what is he/she?
A FREE RIDER!!!
A free rider benefits more from which one of the 2 characteristics of a public good?
NON-EXCLUDABLE!!!
Because free riders cannot be excluded from consumption, private firms lack an __________ to produce that public good/service.
INCENTIVE!!!
Because of this, the MARKET HAS FAILED!!!

68. Good Q…perhaps they shouldn’t!
In other words…
Why should a private company sell a product they can’t prevent people who haven’t paid from using?
Good Q…perhaps they shouldn’t!

69. Free Rider Problem
If a private individual erects a flood barrier to protect a house, the other people in the area may gain a benefit even though they have paid nothing.
The flood barrier is a PUBLIC GOOD
Why? (What characteristics make it one?)
The “other people” are FREE RIDERS

70. What happens in the free market?
(How do markets fail?)

71. #3: Discuss the implications of the direct provision of goods by the government
What do governments often directly provide?
HEALTH CARE & EDUCATION!
What are pros/cons of direct provision?
Pros
These merit goods are extremely valuable to society & would be underprovided by the market
(Think about why!)
Cons
Extraordinarily expensive
Governments not often the most efficient providers
Difficult choices on what/how much to produce/spend
Hard to distribute benefits equally/fairly

72. Some important diagrams

73. Diagram Tips #1 Supply (MPC curve) needs shifting to the right?
Positive production externality (Increase Q!)
Supply (MPC curve) needs shifting to the left?
Negative production externality (Decrease Q!)
Demand (MPB curve) needs shifting to the right?
Positive consumption externality (Increase Q!)
Demand (MPB curve) needs shifting to the left?
Negative consumption externality (Decrease Q!)
Note: Indirect tax on consumers will shift both curves to left

74. Diagram Tips #2
(Except for in a subsidy &/or indirect taxation) The biggest part of the Dead Weight Loss (DWL) triangle should be touching the market equilibrium point (w/o gov’t intervention)
Think about it: At market equilibrium, society is further away from the optimal level than it should be after government intervention. Therefore, the most welfare loss should occur BEFORE gov’t intervention
Which type of market failure does this graph show? Why?
Negative ext. of consumption
Because Q is overproduced and the solution is to REDUCE DEMAND (instead of supply) to socially optimal level

75. GRAPHING Various Externalities
Negative Production
Factories that pollute air/water/land
(the goods that factories produce don’t necessarily harm…but the production of those goods
creates harm)
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.

76. 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 _____ (e.g. 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.
In this situation, the costs to
society (i.e. 3rd parties) are greater
than the benefits the individual
producer & consumer receive

77. TAXES TO DECREASE PRODUCTION
TAXING A NEG. EXTERNALITY OF PRODUCTION
Yellow area = ???
Green area ???
Blue area = ???
Price for both P & C w/o tax = ???
Price producers receive (w/tax)= ??
Price consumers pay (w/tax) = ??
If negative externalities did not exist, purple triangle would be welfare loss. Why?
CS = consumer surplus, PS = producer surplus

78. TAXES TO DECREASE PRODUCTION
TAXING A NEG. EXTERNALITY OF PRODUCTION
Yellow area = CS
Green area = PS
Blue area = Tax revenue
Price for both P & C w/o tax = Pe
Price producers receive (w/tax)= Pp
Price consumers pay (w/tax) = Pso
If negative externalities did not exist, purple triangle would be welfare loss. Why? B/c the total amount of surplus lost by the 2 parties involved in the transaction—producer & consumer—is greater than the tax revenue the gov’t receives.
CS = consumer surplus, PS = producer surplus
But since negative externalities exist, the reduced Q is actually the more optimal quantity for society (health improves, etc.). If the gov’t has estimated correctly (which is nearly an impossible task), MPC + tax = MSC. Before, the good was being OVERPRODUCED. Now it is produced at the ideal amount for society.

79. Possible Problem w/TAXING a NEGATIVE EXTERNALITY OF PRODUCTION
The government taxes a paint factory that pollutes.
If the tax is less than the optimal amount, the deadweight loss is REDUCED but NOT ELIMINATED
However, it still is producing at a more optimal amount than it would in the free market

80. Possible Benefit w/ (indirectly) TAXING a
NEGATIVE EXTERNALITY OF PRODUCTION
Higher costs + less revenue might get firms to switch to more environmentally-friendly inputs (perhaps to renewable energy).
When that happens, (1) there are fewer external costs in producing that good, causing (2) the new socially optimal output (Qopt2) to be greater.

81. (Below: 2 ways to show the same diagram)
Another Way Govts Can Get Involved: Market for Externality Rights (permits)
(Below: 2 ways to show the same diagram)

82. GRAPHING Various Externalities
Negative Consumption
Smoking in public places
(manufacturing of cigarettes doesn’t necessarily pollute…but 2nd hand smoke can lead to many health problems)
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.

83. Graphing Negative Externalities of Consumption

84. Graphing Negative Externalities of Consumption

85. Both aim to reduce consumption
2 diagrams in 1:
Indirect tax on cigarettes &
Negative advertising against cigarettes
Both aim to reduce consumption

86. GRAPHING Various Externalities
Positive Production
Firms provide training on skills that employees take beyond that job
(cost to one firm benefits a 3rd party.
3rd party = the new firm…that firm gets more benefits b/c no new training costs)
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.

87. Graphing Positive Externalities of Production

88. Graphing Positive Externalities of Production

89. Graphing Positive Externalities of Production

90. Graphing Positive Ext. of Production or Consumption: Subsidies
Goals
Find where the market (w/o gov’t intervention P & Q would be
Figure out why the top of the red line is the price producers receive
Figure out why the bottom part of the red line is the price consumers pay
Figure out why the pink + yellow areas is the total amount paid by the gov’t for the surplus

91. Graphing Positive Ext. of P or C: Subsidies
A + B + C + F + G
B + C + D + E
-(B+C+E+F+G+H)
(A+B+C+D) - H
If subsidies REDUCE total surplus, then why do
governments use them?
Because the model of surplus (seen above) above assumes NO positive externalities. With positive externalities, total surplus SHOULD actually
increase b/c even though providing the good w/government help is not allocatively efficient, the positive externalities those goods provide help society.

92. GRAPHING Various Externalities
Positive Consumption
Health & Education
(healthier people pass along less illnesses to others…those others become
more productive)
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.

93. Graphing Positive Externalities of Consumption
Legislation or advertising
should lead to HIGHER prices for consumers while direct
gov’t provision & subsidies
lead to LOWER prices

94. Graphing Positive Externalities of Consumption
Why is Q1 free market equilibrium?
Why is Q2 the socially optimal output?
Why is supply = MPC = MSC?
Supply = MPC = MPC because producing/supplying education or medicine doesn’t necessarily bring any benefit or harm to a 3rd party. CONSUMING them does.
Why is the area w/ red lines “potential welfare loss?”
Review Q: What are 3 things governments can do to move society from Q1 to Q2?

95. POSITIVE EXTERNALITY OF CONSUMPTION– 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.

96. 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.