Principles of Microeconomics Lecture 15 Market failures University

Principles of Microeconomics Lecture 15: Market failures University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Overview • Introduction • Externalities • Asymmetric information • Low-equilibrium traps Slide 1 The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Introduction • What is market failure? • Why is it important to address? • Efficiency and equity (again!) Slide 2 The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Introduction • A typology to identify products where government intervention may be needed: • Rivalrous: where the consumption of the product by one consumer prevents its consumption by another consumer • Excludable: non-paying consumers can be excluded from consuming the product Slide 3 The University of Papua New Guinea

Lecture 15: Market failures Excludable Rival Private goods Examples: • Hamburgers • Clothes Quasi-public goods Examples: Non-rival • Cable TV • Fire-fighting Michael Cornish Non-excludable Common resources Examples: • Tuna in the ocean • Public parks Public goods Examples: • National defence • Street lighting Are more likely to be subject to market failures Tragedy of the commons: Where (rational) self-interest leads to the depletion of common resources - Solved through cooperation, coupled with enforcement! Slide 4 The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Externalities • An externality is a benefit or cost created by a market that is borne by people outside of the market – I. e. , a benefit or cost external to the market • We can categorise these externalities as: – Positive or negative; – Production or consumption Slide 5 The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Externalities Negative externalities: • Production: – Classic example? Pollution • Consumption: – Classic example? Passive-smoking • How should we address negative externalities? – One approach: (Pigouvian) taxes! Slide 6 The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Negative production externality Price of electricity Efficient equilibriu m Deadwei ght loss S 1 = Social cost S 0 = Private cost Cost of pollution PEFFICIENT PMARKET Market equilibrium 0 Slide 7 QEFFICIENT QMARKET Dema ndof electricity Quantity The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Dealing with a negative production externality Price of electricity Price paid by consumers PEFFICIENT Market equilibriu m with tax PMARKET Price received by producer s Slide 8 0 S 2 = Social cost and private cost tax S after = Private 1 cost before tax Cost of pollution = amount of tax imposed by government Market equilibrium without tax QEFFICIENT QMARKET Deman d Quantity of electricity The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Externalities Positive externalities: • Production: – Classic example? Bee-keeping and crop pollination – There are not many great examples! • Consumption – Classic examples? Education, immunisation • How should we address positive externalities? – One approach: (Pigouvian) subsidies! Slide 9 The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Positive consumption externality Price of a university education Positive externality Deadweig ht loss Efficient equilibrium PEFFICIENT PMARKET Market equilibriu m 0 Slide 10 Suppl y QMARKET QEFFICIENT D 1 = Social D 0 = benefit Private benefit Quantity of university education The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Dealing with a positive consumption externality Price of university education Price received by producers PEFFICIENT PMARKET Price paid by consumer s 0 Slide 11 Positive externality = amount of subsidy Suppl y Market equilibrium with subsidy = efficient equilibrium D 2 = social benefit and private benefit after subsidy D 1 = private benefit before subsidy Market equilibriu m without subsidy QMARKET QEFFICIENT Quantity of university education The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Externalities Another approach: The Coase Theorem • Private bargaining will result in an efficient solution to the problem of externalities, as long as: – There is perfect information (‘full information’) – Transactions costs are sufficiently low – There are property rights Slide 12 The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Externalities The Coase Theorem (cont. ) • E. g. , a company creating pollution could pay the victims for the right to pollute; or • The victims could pay the polluting company to reduce its pollution Slide 13 The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Externalities Yet another approach: Market-based solutions • Tradeable rights markets – Cap-and-trade (e. g. greenhouse gases) – Entitlements (e. g. Murray River water markets) And (another!) approach: Central planning • Also known as ‘command control’ – Use of quantitative controls Slide 14 The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Asymmetric information • Where a party to a transaction has a different level of information than the other (‘information gaps’) – E. g. the second-hand car market, university education – Leads to inefficient distortions in the market Slide 15 The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Asymmetric information • Adverse selection is where a party takes advantage of this asymmetric information – Leads to even more inefficient distortions in the market! Slide 16 The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Asymmetric information can also lead to… • Moral hazard: – Where one person takes more risks because they know that the burden of those risks is borne by another party – E. g. subprime mortgage crisis (the GFC!) Slide 17 The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Asymmetric information can also lead to… • Principal-agent problem: – Where an agent’s self-interest conflicts with that of their client – E. g. real estate agents Slide 18 The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Low-equilibrium traps • Occurs where decisions by multiple parties are required simultaneously in order to achieve a more desirable outcome – E. g. creating a manufacturing sector in a poor developing country where none currently exists • Instead, economic decision-makers (such as major investors) remain inactive until all the conditions for them to invest are fulfilled Slide 19 The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Multiple Equilibria Lowequilibrium trap Slide 20 The University of Papua New Guinea

Lecture 15: Market failures Michael Cornish Case Study: Latin American Time Slide 21 The University of Papua New Guinea