1. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 1

2. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 2 Market Failures CHAPTER 14

3. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 3 DEFINITION OF EXTERNALITIES Cost of benefit arising from any activity which does not accrue to the person or organization carrying the activity. Two types – External costs – External benefits

4. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 4 EXTERNAL COSTS Damage to other people or the environment, for example, by radiation, river or air pollution, or noise, which does not have to be paid by those carrying on the activity.

5. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 5 EXTERNAL BENEFITS Effects of an activity which are pleasant or profitable for other people who cannot be charged for them, for example, fertilization of fruit trees by bees, or the public enjoyment of views of private buildings or gardens.

6. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 6 CAUSES OF MARKET INEFFICIENCY Externalities cause markets to allocate resources inefficiently. We will examine various ways in which private individuals and government may diagnose this type of market failure.

7. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 7 POSITIVE EXTERNALITIES Benefits to society more than the provider. For example, education. When population is educated, it leads to more productive workers, lower crime rates, encourage developments and dissemination of technology, higher productivity and wages for everyone.

8. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 8 Education and Social Optimum POSITIVE EXTERNALITIES (CONT)

9. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 9 POSITIVE EXTERNALITIES OF EDUCATION AND SOCIAL OPTIMUM The demand curve does not reflect the social value of the good due to the fact that the social value is greater than the private value. The social value curve lies above the demand curve. The optimal quantity: The social value curve and the supply curve (which represents cost) intersect.

10. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 10 Hence, the social optimal is greater than the quantity determined by the private market. In case of market failure, the government can correct the market failure by inducing market participants to internalize the externality. Market equilibrium move closer to the social optimum, a positive externality requires subsidies from government. EDUCATION AND SOCIAL OPTIMUM EXPLANATION

11. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 11 NEGATIVE EXTERNALITIES Costs to society is larger than cost of production. For example, rubber factories emit pollution. For each unit of processed rubber produced, a certain amount of smoke enters the atmosphere. This smoke creates health problems for those who breathe the air.

12. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 12 Social Cost of Producing Rubber NEGATIVE EXTERNALITIES (CONT)

13. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 13 SOCIAL COST OF PRODUCING RUBBER The equilibrium quantity of rubber is larger than the social optimal quantity. This inefficiency is due to the fact that the market equilibrium reflects only the private costs of production.

14. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 14 In this market equilibrium, the marginal consumer values aluminum at less than the social cost of producing it. So at Q Market, the demand curve lies below the social-cost curve. As a result, reducing rubber production and consumption below the market equilibrium level raise total economic well-being. SOCIAL COST OF PRODUCING RUBBER (CONT)

15. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 15 SOLUTIONS TO EXTERNALITIES Government actions are always the best to solve externalities and to achieve the allocation of resources closer to social optimum.

16. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 16 OTHER TYPES OF SOLUTIONS 1.Moral codes and social sanctions: To take account of how our actions affect other people. For example, why most people litter, although there are laws against littering, but these laws are not fully enforced. 2.Charities: Colleges and universities receive gifts from corporations, alumni and foundations to internalize externalities.

17. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 17 OTHER TYPES OF SOLUTIONS (CONT) 3. Self-interest of the relevant parties: For example, a corn grower and a housekeeper are located next to each other. Both parties confer positive externalities on each other. 4. Enter into contract: A contract between two parties in the form of integrating different types of businesses.

18. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 18 HOW EFFECTIVE IS THE PRIVATE MARKET IN DEALING WITH EXTERNALITIES? A famous economist, Ronald Coase came up with a theory called Coase Theorem which suggests that if the private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.

19. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 19 WHY PRIVATE SOLUTIONS DO NOT ALWAYS WORK? The Coase Theorem is only workable if both parties have no trouble coming with and enforcing on the agreement. The transaction cost incurred during the process of agreeing and following through on a bargain. Sometimes bargaining can simply break due to labour strikes, war and natural disaster.

20. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 20 PUBLIC POLICIES TOWARD EXTERNALITIES In order to solve the inefficient allocation of resources in the market, government can respond in two ways: Command and control policies Regulations that prohibits certain act altogether such as dumping poisonous chemicals into the water supply.

21. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 21 Pigovian taxes and subsidies: Taxes enacted to correct the effects of negative externalities through monitoring level of pollution and tax incentives. Market-based policies Tradable pollution permits: Agreeing to reduce its emission by certain level. PUBLIC POLICIES TOWARD EXTERNALITIES (CONT)

22. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 22 DIFFERENT KINDS OF GOODS Excludable: Can people be prevented from using the good? Rival in consumption: Does one persons use of the good reduce another persons ability to use it?

23. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 23 FOUR CATEGORIES OF GOODS Private goods: Both excludable and rival in consumption. For example, a burger is excludable because it is possible to prevent someone from eating the burgeryou just do not give it to him. Public goods: Neither excludable nor rival in consumption. For example, tsunami alert system.

24. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 24 Common resources: Rival in consumption but not excludable. For example, fish in the ocean. Natural monopolies: Excludable good but not rival. For example, ambulance service. FOUR CATEGORIES OF GOODS (CONT)

25. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 25 Public Goods Tsunami siren National defence Common Resources Fish in the ocean Environment Natural Monopolies Cable TV Fire protection Private Goods Burger Shirts YES NO RIVAL EXCLUDABLE YES NO EXAMPLES OF GOODS IN EACH CATEGORY

26. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 26 PUBLIC GOODS Not excludable. For example, big screen cinema: It is possible to prevent someone from seeing the screen, and it is not rival in consumption because one persons enjoyment of watching the movie does not reduce anyone elses enjoyment of watching the movie.

27. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 27 PUBLIC GOODS (CONT) Because certain goods are not excludable, people have an incentive to be free riders. A free rider: A person who receives the benefit of a good but does not pay for it.

28. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 14– 28 National It is neither excludable nor rival in consumption. Basic Research One persons use of theory does not prevent any other person from using the theory. IMPORTANT PUBLIC GOODS