Market Failures and Government Policy Market Failures Externalities

Market Failures and Government Policy

Market Failures: Externalities and Public Goods • Society's microeconomic objectives – equity – social efficiency • marginal social benefits and costs • production where MSB = MSC

Market Failures: Externalities and Public Goods • Externalities • External costs of production – MSC > MC

External costs in production Costs and benefits MC = S P D O Q 1 Quantity

External costs in production Costs and benefits MSC P MC = S D External cost O Q 2 Social optimum Quantity Q 1

Market Failures: Externalities and Public Goods • Externalities – External costs of production • MSC > MC – External benefits of production • MSC < MC

External benefits in production Costs and benefits MC = S P O D Q 1 Quantity

External benefits in production Costs and benefits MC = S MSC External benefit P O D Q 1 Quantity Q 2 Social optimum

External costs and benefits in production D P External cost O Q 2 Q 1 Quantity (a ) External costs MC = S MSC Costs and benefits (£) MSC MC = S External benefit P O D Q 1 Q 2 Quantity (b) External benefits

Market Failures: Externalities and Public Goods • Externalities – External costs of production • MSC > MC – External benefits of production • MSC < MC – External costs of consumption

Market Failures: Externalities and Public Goods • Externalities – External costs of production • MSC > MC – External benefits of production • MSC < MC – External costs of consumption • MSB < MB

Costs and benefits External costs in consumption P D (MB) MU = D O Q 1 Quantity

Costs and benefits External costs in consumption External cost P D (MB) MU = D MSB O Social optimum Q 2 Q 1 Quantity

Market Failures: Externalities and Public Goods • Externalities – External costs of production • MSC > MC – External benefits of production • MSC < MC – External costs of consumption • MSB < MB – External benefits of consumption

Market Failures: Externalities and Public Goods • Externalities – External costs of production • MSC > MC – External benefits of production • MSC < MC – External costs of consumption • MSB < MB – External benefits of consumption • MSB > MB

Costs and benefits External benefits in consumption P D (MB) MU = D O Q 1 Quantity

External benefits in consumption Costs and benefits External benefit P D MSB (MB) MU = D O Q 1 Quantity Q 2 Social optimum

External cost P P Costs and benefits (£) External costs and benefits in consumption External benefit P P MSB MB MB MSB O Q 2 Q 1 Car miles (a ) External costs O Q 1 Q 2 Rail miles (b) External benefits

Market Failures: Externalities and Public Goods • Externalities – External costs of production • MSC > MC – External benefits of production • MSC < MC – External costs of consumption • MSB < MB – External benefits of consumption • MSB > MB • Public goods

Market Failures: Externalities and Public Goods • Externalities – External costs of production • MSC > MC – External benefits of production • MSC < MC – External costs of consumption • MSB < MB – External benefits of consumption • MSB > MB • Public goods – non rivalry

Market Failures: Externalities and Public Goods • Externalities – External costs of production • MSC > MC – External benefits of production • MSC < MC – External costs of consumption • MSB < MB – External benefits of consumption • MSB > MB • Public goods – non rivalry – non-excludability

Market Failures: Monopoly Power • The demand curve under monopoly – production at less than the social optimum

A monopolist producing less than the social optimum £ MC P 1 MC 1 MR O Monopoly output Q 1 AR Q

A monopolist producing less than the social optimum £ MC = MSC P 1 P 2 = MSB = MSC MC 1 MR O Monopoly output Q 1 Q 2 AR = MSB Q Perfectly competitive output

Market Failures: Monopoly Power • The demand curve under monopoly – production at less than the social optimum • Deadweight loss under monopoly – consumer and producer surplus • consumer surplus

Market Failures: Monopoly Power • The demand curve under monopoly – production at less than the social optimum • Deadweight loss under monopoly – consumer and producer surplus • consumer surplus • producer surplus

Market Failures: Monopoly Power • The demand curve under monopoly – production at less than the social optimum • Deadweight loss under monopoly – consumer and producer surplus • consumer surplus • producer surplus • total surplus

Deadweight loss under monopoly MC £ (= S under perfect competition) Consumer surplus Ppc a Producer surplus AR = D O Qpc Q (a) Industry equilibrium under perfect competition

Market Failures: Monopoly Power • The demand curve under monopoly – production at less than the social optimum • Deadweight loss under monopoly – consumer and producer surplus • consumer surplus • producer surplus • total surplus – the effect of monopoly on total surplus

Deadweight loss under monopoly MC £ (= S under perfect competition) Pm Ppc O Consumer surplus b Deadweight welfare loss a Producer surplus AR = D MR Qpc (b) Industry equilibrium under monopoly Q

Deadweight loss under monopoly MC £ (= S under perfect competition) Perfect competition Consumer surplus Ppc a Producer surplus AR = D O Qpc Q (a) Industry equilibrium under perfect competition

Deadweight loss under monopoly MC £ (= S under perfect competition) Monopoly Pm Ppc O Consumer surplus b Deadweight welfare loss a Producer surplus AR = D MR Qpc (b) Industry equilibrium under monopoly Q

Market Failures: Monopoly Power • The demand curve under monopoly – production at less than the social optimum • Deadweight loss under monopoly – consumer and producer surplus • consumer surplus • producer surplus • total surplus – the effect of monopoly on total surplus • Other problems with monopoly

Market Failures: Monopoly Power • The demand curve under monopoly – production at less than the social optimum • Deadweight loss under monopoly – consumer and producer surplus • consumer surplus • producer surplus • total surplus – the effect of monopoly on total surplus • Other problems with monopoly • Possible advantages from monopoly

Other Market Failures • Ignorance and uncertainty • Immobility of factors and time lags • Protecting people's interests – dependants – the principal–agent problem • the problem of asymmetric information • the need for monitoring – poor economic decision making by people • merit goods • Macroeconomic goals • Economists and policy advice

Government Intervention: Taxes and Subsidies • The use of taxes and subsidies to correct externalities – the optimum size of a tax

Using taxes to correct a market distortion Costs and benefits MC = S P D O Q 1 Quantity

Using taxes to correct a market distortion Costs and benefits MSC P MC = S D External cost O Q 2 Social optimum Quantity Q 1

Using taxes to correct a market distortion Costs and benefits MSC MC = S Optimum tax = MSC – MC P D MC O Q 2 Quantity Q 1

Government Intervention: Taxes and Subsidies • The use of taxes and subsidies to correct externalities – the optimum size of a tax – the optimum size of a subsidy

Using subsidies to correct a market distortion Costs and benefits MC = S P O D Q 1 Quantity

Using subsidies to correct a market distortion Costs and benefits MC = S MSC External benefit P O D Q 1 Quantity Q 2 Social optimum

Using subsidies to correct a market distortion MC = S MSC Costs and benefits MC Optimum subsidy = MC – MSC P O D Q 1 Quantity Q 2

Government Intervention: Taxes and Subsidies • The use of taxes and subsidies to correct for monopoly – use of lump-sum taxes • Advantages of taxes and subsidies • Disadvantages of taxes and subsidies – infeasible to use different tax and subsidy rates – lack of knowledge

Government Intervention: Laws and Regulation • The use of laws and regulation • Advantages of legal restrictions – simple to understand – safer when size of problem is potentially great – quick to implement – a good way of dealing with imperfect information • Disadvantages of legal restrictions – a 'blunt weapon'

Government Intervention: Laws and Regulation • Types of regulation • The system of regulation in the UK – UK regulatory bodies – price-cap regulation • the RPI–X formula • Advantages of the UK system – discretionary – flexible – incentive for firms to reduce costs • Disadvantages of the UK system

Other Forms of Government Intervention • Changes in property rights – the problem of limited property rights – extending property rights – limitations of this solution • impractical in many situations • problems of litigation • questions of equity • Provision of information – consumer information – information on jobs – information to firms

Other Forms of Government Intervention • Direct provision of goods and services – the provision of public goods – the need to evaluate costs and benefits of publicly provided goods – the provision of other goods and services by the government • social justice • large positive externalities • dependants • ignorance

More or Less Intervention? • Drawbacks of government intervention – shortages and surpluses – poor information – bureaucracy and inefficiency – lack of market incentives – shifts in government policy – lack of freedom for the individual

More or Less Intervention? • Advantages of the free market – automatic adjustments – dynamic advantages of capitalism – possibly high degree of competition even under monopoly/oligopoly – Judging the arguments • Should there be more or less intervention in the market? – important to consider both costs and benefits of intervention – moral issues – problem of predicting effects of intervention

The Environment: a Case Study • The environmental problem – global and local environmental problems – causes of the problems • Market failures – environment as a common resource – externalities – ignorance – inter-generational problems

The Environment: a Case Study • Policy alternatives – charging for use of the environment • emissions charges

An emissions charge Costs and benefits (£) MSC P 2 MB = MSB P 1 = 0 L 2 Level of emission L 1

The Environment: a Case Study • Policy alternatives – charging for use of the environment • emissions charges • user charges

The Environment: a Case Study • Policy alternatives – charging for use of the environment • emissions charges • user charges • optimum charge = external cost

The Environment: a Case Study • Policy alternatives – charging for use of the environment • emissions charges • user charges • optimum charge = external cost – green taxes and subsidies

The Environment: a Case Study • Policy alternatives – charging for use of the environment • emissions charges • user charges • optimum charge = external cost – green taxes and subsidies • use of such taxes around the world

Green tax revenues as a % of GDP

Green tax revenues as a % of GDP

The Environment: a Case Study • Policy alternatives – charging for use of the environment • emissions charges • user charges • optimum charge = external cost – green taxes and subsidies • use of such taxes around the world – laws and regulations

The Environment: a Case Study • Policy alternatives – charging for use of the environment • emissions charges • user charges • optimum charge = external cost – green taxes and subsidies • use of such taxes around the world – laws and regulations • advantages and disadvantages

The Environment: a Case Study • Policy alternatives – charging for use of the environment • emissions charges • user charges • optimum charge = external cost – green taxes and subsidies • use of such taxes around the world – laws and regulations • advantages and disadvantages – education

The Environment: a Case Study • Policy alternatives – charging for use of the environment • emissions charges • user charges • optimum charge = external cost – green taxes and subsidies • use of such taxes around the world – laws and regulations • advantages and disadvantages – education – tradable permits

The Environment: a Case Study • Policy alternatives – charging for use of the environment • emissions charges • user charges • optimum charge = external cost – green taxes and subsidies • use of such taxes around the world – laws and regulations • advantages and disadvantages – education – tradable permits • advantages and disadvantages

The Environment: a Case Study • How much can we rely on governments? – governments must have the will to protect the environment • depends on attitudes of various interest groups – must be able to identify problems and appropriates solutions – when problems are global: • may require international agreements • governments are likely to be more concerned with their own national interests