Chapter
LECTURE 11:
THE MARKET FAILURES
Chapter
10
Externalities
Externalities
• Externality
– The uncompensated impact of one person’s
actions on the well-being of a bystander
– Market failure: allocate resources inefficiently
– Negative externality
• Impact on the bystander is adverse
– Positive externality
• Impact on the bystander is beneficial
3
Externalities
• Examples of negative externalities:
• Examples of positive externalities:
• Decision maker - fails to account for
externalities
4
• Government: protect the interests of bystanders
Externalities and Market Inefficiency
• Externalities
• Cause markets to allocate resources inefficiently
• Welfare economics: a recap
– Demand curve – value to consumers
• Prices they are willing to pay
– Supply curve – cost to suppliers
– Equilibrium quantity and price
• Efficient
– Maximizes sum of producer & consumer surplus
5
Externalities and Market Inefficiency
• Negative externalities
– Pollution
– Cost to society (of producing aluminum)
• Larger than the cost to the aluminum producers
– Social cost - supply
• Private costs of the producers
• Plus the costs to those bystanders affected
adversely by the negative externality
– Social cost curve – above the supply curve
6
Figure 2
Pollution and the social optimum
Price of
Aluminum Social cost (private cost
and external cost)
External
Cost Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0 QOPTIMUM QMARKET Quantity of
Aluminum
In the presence of a negative externality, such as pollution, the social cost of the good
exceeds the private cost. The optimal quantity, QOPTIMUM, is therefore smaller than the
equilibrium quantity, QMARKET.
7
Externalities and Market Inefficiency
• Negative externalities
– Optimum quantity produced
• Maximize total welfare
• Smaller than market equilibrium quantity
• Government – correct market failure
– Internalizing the externality
• Altering incentives so that people take account of
the external effects of their actions
• E.g.: tax producers
– Shift supply upward – by the size of the tax
– Tax – value of negative externality 8
Externalities and Market Inefficiency
• Positive externalities
– Education
• Benefit of education – private
• Externalities: better government, lower crime
rate, higher productivity and wages
– Social value – demand
• Higher than private value
– Social value curve
• Above demand curve
9
Figure 3
Education and the social optimum
Price of
Aluminum
Supply
(private cost)
Optimum
External
Equilibrium Benefit
Social value
(private value
and external benefit)
Demand
(private value)
0 QMARKET QOPTIMUM Quantity of
Aluminum
In the presence of a positive externality, the social value of the good exceeds the private
value. The optimal quantity, QOPTIMUM, is therefore larger than the equilibrium quantity,
QMARKET.
10
Externalities and Market Inefficiency
• Positive externalities
– Socially optimal quantity
• Greater than market equilibrium quantity
– Government – correct market failure
• Internalize the externality
• Subsidy
11
Externalities and Market Inefficiency
• Negative externalities
– Markets - produce a larger quantity than is
socially desirable
• Positive externalities
– Markets - produce a smaller quantity than is
socially desirable
• Government: internalize the externality
– Taxing goods that have negative externalities
– Subsidizing goods that have positive
externalities 12
Public Policies Toward Externalities
• Command-and-control policies: regulation
– Regulate behavior directly
2. Tradable pollution permits
13
Figure 4
The equivalence of corrective taxes & pollution permits
(a) Corrective tax (b) Pollution permits
Price of Price of
pollution pollution
1. A corrective tax sets Supply of
the price of pollution . . . pollution permits
1. Pollution
Corrective tax permits set
P P the quantity
of pollution . . .
Demand for
2. . . . which, together pollution rights 2. . . . which, together
with the demand curve, with the demand curve,
determines the quantity determines the price Demand for
of pollution. of pollution.
pollution rights
0 Q Quantity of 0 Q Quantity of
pollution pollution
In panel (a), the EPA sets a price on pollution by levying a corrective tax, and the demand curve
determines the quantity of pollution. In panel (b), the EPA limits the quantity of pollution by
limiting the number of pollution permits, and the demand curve determines the price of pollution.
The price and quantity of pollution are the same in the two cases. 14
Public Policies Toward Externalities
• People face trade-offs
– Eliminating all pollution is impossible
– Clean water and clean air – opportunity cost
• Lower standard of living
15
Private Solutions to Externalities
• The types of private solutions
– Moral codes and social sanctions
– Charities
– Self-interest of the relevant parties
• Integrating different types of businesses
– Interested parties – enter a contract
16
Private Solutions to Externalities
• Why private solutions do not always work
– High transaction costs
• Costs that parties incur in the process of agreeing
to and following through on a bargain
– Bargaining simply breaks down
– Large number of interested parties
17
11
Public Goods and Common
Resources
The Different Kinds of Goods
• Excludability
– Property of a good
– A person can be prevented from using it
• Rivalry in consumption
– Property of a good
– One person’s use diminishes other people’s
use
19
1
Four types of goods
Rival in consumption?
Yes No
Private goods Natural monopolies
Yes - Ice-cream cones - Fire protection
- Clothing - Cable TV
Excludable? - Congested toll roads - Uncongested toll roads
Common resources Public goods
No - Fish in the ocean - Tornado system
- The environment - National defense
- Congested nontoll roads - Uncongested nontoll roads
Goods can be grouped into four categories according to two characteristics:
(1) A good is excludable if people can be prevented from using it.
(2) A good is rival in consumption if one person’s use of the good diminishes other
people’s use of it.
This diagram gives examples of goods in each category.
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The Different Kinds of Goods
• Public goods & Common resources
– Not excludable
– People cannot be prevented from using them
– No price attached to it
– Positive externalities
– Negative externalities
21
Public Goods
• The free-rider problem
– Free rider
– Person who receives the benefit of a good but avoids
paying for it
– Public goods – not excludable
• Free-rider problem prevents the private market
from supplying the goods
• Government - can remedy the problem
– If total benefits of a public good > its costs
– Provide the public good
– Pay for it with tax revenue
– Make everyone better off 22
Public Goods
• Some important public goods
– National defense
• Very expensive public good
– Basic research
• General knowledge
– Fighting poverty
• Welfare system
• Food stamps
23
Are lighthouses public goods?
• Lighthouses
– Mark specific locations so that passing ships can
avoid treacherous waters
• Benefit - to the ship captain
– Not excludable, not rival in consumption
• Incentive – free ride without paying
– Most - operated by the government
• In some cases
– Lighthouses - closer to private goods
• Coast of England, 19th century
– Lighthouses – privately owned and operated
– The owner - charged the owner of the nearby port
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• Decide whether something is a public good
– Determine who the beneficiaries are
– Determine whether the beneficiaries can be
excluded from using the good
• A free-rider problem
– When the number of beneficiaries is large
– Exclusion of any one of them is impossible
26
Public Goods
• The difficult job of cost–benefit analysis
– Government
• Decide what public goods to provide
• In what quantities
– Cost–benefit analysis
• Compare the costs and benefits to society of
providing a public good
• Doesn’t have any price signals to observe
• Government findings on the costs and benefits
– Rough approximations at best
27
How much is a life worth?
• Cost: $10,000 – new traffic light
• Benefit: increased safety
– Risk of a fatal traffic accident
• Drops from 1.6% to 1.1 %
• Obstacle
– Measure costs and benefits in the same units
• Put a dollar value on a human life
– Priceless = infinite dollar value
29
• Put a dollar value on a human life
– Implicit dollar value
• Courts - award damages in wrongful-death suits
– Ignores other opportunity costs of losing one’s life
• Risks - people are voluntarily willing to take
– Value of human life = $10 million
• Cost-benefit analysis
• Traffic light
– Reduces risk of fatality by 0.5 percentage points
• Expected benefit = 0.005 × $10 million = $50,000
• Cost ($10,000) < Benefit ($50,000)
• Approve the traffic light
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Common Resources
• Common resources
– Not excludable
– Rival in consumption
• The tragedy of the commons
– Parable - why common resources are used
more than desirable
• From society’s standpoint
– Social and private incentives differ
– Arises because of a negative externality
31
Common Resources
• The tragedy of the commons
– Negative externality
• One person uses a common resource
– Diminishes other people’s enjoyment of it
• Common resources tend to be used excessively
– Government - can solve the problem
• Regulation or taxes
– Reduce consumption of the common resource
• Turn the common resource into a private good
32
Common Resources
• Some important common resources
– Clean air and water
– Congested roads
– Fish, whales, and other wildlife
33
Why the cow is not extinct
• Species of animals
– Commercial value - threatened with extinction
• Buffalo
– North America
– Hunting - 19th century
• Elephants
– African countries
– Hunting – today
• The cow
– Commercial value
– Species - continue to thrive
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• Elephant - common resource
– No owners
– Poachers - numerous
• Strong incentive to kill them
• Slight incentive to preserve them
• Cows - private good
– Ranches - privately owned
– Ranchers
• Great effort to maintain the cattle population on his ranch
• Reaps the benefit
36
• Government intervention – help elephant
population
– Kenya, Tanzania, and Uganda
• Illegal to kill elephants; Illegal to sell ivory
• Hard to enforce
• Elephant population – still diminishing
– Botswana, Malawi, Namibia, and Zimbabwe
• Elephants – private good
• Allow people to kill elephants
– Only those on their own property
• Landowners - incentive to preserve elephants
• Elephant population – started to rise
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