1. PART 10 Market Failures
Markets may fail to generate efficient results due to
Monopoly
Externalities
Public Goods
Open Access
Markets may also have informational problems—adverse selection and moral hazard

2. Externalities
An externality is a cost or a benefit that is not reflected in market demand or supply curves
An effect external to the market
Environmental pollution, congestion in cities, etc
MSC $
S (MC)
D (MB) Q* Q’
Output

3. Pollution and Abatement
Pollution imposes costs
Abatement of pollution is also costly
“Optimal” amount of pollution is where MC of pollution is equal to its MB
Marginal benefit of pollution is the abatement cost saved
Can also think of this as the MC and MB of abatement

4. Pollution and Abatement
Optimal quantity of pollution $ MC MB P* P’
Pollution
If the affected parties cannot negotiate
the market will produce P’ pollution

5. Pollution and Abatement
Optimal quantity of abatement $ MC MB A*
Abatement
If the affected parties cannot negotiate
the market would produce no abatement.

6. Externalities and Transactions Costs
Externalities can be thought of a being caused by a lack of property rights or high transactions costs (costs of negotiation or litigation)
The Coase Theorem
Important point is that the world is a world of positive transactions costs, so that externalities are common

7. Externalities and Transactions Costs
Example: A lake which can be used for recreation (by a fishing club) or waste discharge by a firm
We can think of the costs and benefits of the abatement of pollution
The costs are the costs of reducing waste discharge, the benefits are the better fishing

8. Externalities and Transactions Costs$ MC MB A* A’
Abatement
0 = no abatement
A’ = complete abatement
A* = optimal level of abatement

9. Externalities and Transactions Costs
If the firm and the fishing club could negotiate without cost then regardless of who has the property right they would negotiate to A*
If there are high costs to negotiating and the fishing club has the property right end up at A’ (MC>MB of abatement)
If there are high costs to negotiating and the firm has the property right end up at 0 (MB>MC of abatement)
Transactions costs are usually high, so the market results in inefficient allocation of resources

10. Policy Towards Externalities
Regulation by standards
If the standard to be achieved is the same for all firms this can result in inefficiency $
MB2
MB1
Pollution
Standard

11. Policy Toward Externalities
Charges – Polluter pays a per unit charge $
MB2
MB1
Unit
charge
Pollution

12. Policy Toward Externalities
Tradable Permits: Set total pollution level and let firms trade $ P
MB1+MB2
Pollution $ $ P
MB2
MB1
Pollution 1
Pollution 2

13. Policy Toward Externalities
Optimal (Pigovian) Taxes
Set tax equal to excess of the marginal social cost over the marginal private cost $
MSC
MC+ Tax MC MB Q Q*

14. Public Goods
A public good is a good that has to be provided to everyone or to no one
National defense, clean air, lighthouses, public health
Pure public goods characterized by non-rival consumption and non-excludable use

15. Public Goods Rivalry and excludability Rival Non-rival Artificially
scarce goods
Excludable
Most goods
Non-
excludable
Open access
Public goods
Artificially scarce goods often have close to
zero MC of production. Private producers have
to find ways of limiting distribution to those
who pay. Examples include computer software,
downloadable music, pay per view TV. Some
inefficiency in private provision.

16. Public Goods Public goods and the free rider problem
If provided the good will be provided even to those who do not pay
Lack of incentive to pay—people will try to free ride
Provision by voluntary contribution
Provision by government

17. Benefits of a Public Good
One person’s consumption of a unit of a public good does not exclude others
Marginal willingness to pay (MB) for the first unit of a public good is the vertical sum of the marginal willingness to pay of all individuals
If I am willing to pay $100 for a one unit improvement in air quality and you are willing to pay $50 for a one unit improvement in air quality the MB of that improvement is $150

18. Optimal Provision of a Public Good
The optimal level of provision for a public good is where MB=MC (economic efficiency)
If left to the market the good will be under-provided (cannot capture people’s willingness to pay)
Public provision—will government provide the optimal amounts of a public good?

19. Open Access Common property resources
Problem of free entry and overuse of the resource
“Tragedy of the Commons”
Regulation, tax, assign some form of property right to individuals or groups
System of tradable licenses
Example of fisheries

20. Open Access Optimal level of effort Yield TC TR Effort Open access
Max sustainable yield
Max Econ Yield