Market Failure: Externality and Information Asymmetry: BITS Pilani

Market Failure: Externality and
Information Asymmetry
BITS Pilani
Pilani Campus
Outline
➢ What is an externality, and why does it cause a market

failure?
Externality & Market Failure
➢ When can the private market solve the problem of

externalities?
➢ What are possible public-sector solutions to the problem of
externalities, and what are the advantages and disadvantages
of each?
➢ What is Information Asymmetry?
@ Grubder, J. Public Finance and Policy: Musgrave and

Musgrave-Public Finance: Theory and Policy
What is Market Failure?
Market failure: A problem that causes the market economy to deliver an
outcome that does not maximize efficiency.
Market failure-1 Market failure-2

Externalities: ➢Asymmetric information
➢Externality Theory: Negative & ➢Moral Hazard
Positive-Production and ➢Adverse selection
Consumption externality

Externalities: Problems and Solutions
Externality: Externalities arise Information asymmetry: The
whenever the actions of one difference in the information that is
party make another party worse
or better off, yet the first party available to sellers and to purchasers in
neither bears the costs nor a market.
receives the benefits of doing so. • In the used cars market, sellers are
much more likely to know about
potential defects than buyers are.
• In the insurance market, buyers may
know more about their insurable
risks than the seller (insurer) does.

Market Failure-1-Externalities: Problems and
Solutions
Market failure: A problem that causes the market economy to
deliver an outcome that does not maximize efficiency.
Externality: Externalities arise whenever the actions of one party

make another party worse or better off, yet the first party neither
bears the costs nor receives the benefits of doing so.
➢Global warming is a classic example of an externality, which is a kind
of market failure.
➢The action of one party impacted the other party in a way for which
the first part does not receive the cost or benefit.

Negative Externalities
• Negative production externality: When a firm’s production reduces the well-being
of others who are not compensated by the firm (production coming from the supply side).
o Pollution from steel production, dumped in a river, hurts fishermen.
o Negative-bad →production- supply side→ externality-cost are borne by another party, not by the
party doing so
• Negative consumption externality: When an individual’s consumption reduces the
well-being of others who are not compensated by the individual.
o Smoking at a restaurant affects the health and enjoyment of others.
o Negative-bad →consumption- demand side→ externality-cost are borne by another party, not by
the party doing so
Private benefit and cost are the benefits and cost borne directly by the actors in the
steel market.
Social benefit and cost are the private benefits and cost plus the benefit and cost to
any other actors outside this steel market.
Private and Social Marginal Cost
•Negative production externalities drive a wedge between private
and social marginal cost.
• Private marginal cost (PMC): The direct cost to producers of
producing an additional unit of a good.

• Social marginal cost (SMC): The private marginal cost to
producers plus any costs associated with the production of the
good that are imposed on others.
• The loss from pollution is a cost of production imposed on
others.

Private and Social Marginal Benefit
•Negative consumption externalities drive a wedge between private and
social marginal benefit.
• Private marginal benefit (PMB): The direct benefit to consumers of
consuming an additional unit of a good by the consumer.

• Social marginal benefit (SMB): The private marginal benefit to
consumers minus any costs associated with the consumption of the good
that are imposed on others.
• The loss of health or dining pleasure is a cost of smoking imposed on
others.
• Your consumption of cigarettes at a restaurant may have a negative
effect on my enjoyment of a meal.

Externalities and Efficiency
How do externalities affect efficiency?
• Efficiency requires that SMC = SMB.
• The market sets PMC = PMB.

• When PMC = SMC and PMB = SMB, the market is efficient.
• Production or consumption externalities lead to inefficiency because PMC ≠
SMC and/or PMB ≠ SMB

Economics of Negative Production Externalities:
Steel Production

Externalities and Efficiency
•With a negative production externality
• SMC = PMC + MD
o MD is the marginal damage done to others from each unit of

production.
•With a negative consumption externality
• SMB = PMB – MD
o MD is the marginal damage done to others by your consumption of
that unit.

Externality & Market Failure Negative consumption externality

CHAPTER 5: EXTERNALITIES: PROBLEMS AND SOLUTIONS
APPLICATION: The Externality of SUVs
•The consumption of large cars such as SUVs produces three types

of negative externalities:
1. Environmental externalities: In 2020, compact cars get 32.0
miles/gallon, but SUVs get only 23.9.
2. Wear and tear on roads: Larger cars wear down the roads more.
3. Safety externalities: For a car of average weight, the odds of having a
fatal accident quadruple if the accident is with a typical SUV and not
with a car of the same size.
Positive Externalities
•Externalities can be positive as well as negative.

• Positive production externality: When a firm’s production increases
the well-being of others but the firm is not compensated by those others.
• Positive consumption externality: When an individual’s consumption

increases the well-being of others but the individual is not compensated
by those others.

Externality & Market Failure Economics of Positive Production Externalities

Quick Hint
•One confusing aspect of the graphical analysis of externalities is knowing which curve to
shift and in which direction. There are four possibilities:
• Negative production externality: SMC curve lies above PMC curve.
• Positive production externality: SMC curve lies below PMC curve.
• Negative consumption externality: SMB curve lies below PMB curve.
• Positive consumption externality: SMB curve lies above PMB curve.
•Armed with these facts, the key is to assess which category a particular example fits into.

Private-Sector Solutions to Negative Externalities:
The Solution
• In microeconomics, the market is innocent until proven guilty.

• An excellent application of this principle can be found in a classic work by
Coase, who asked in the 1960s, why won’t the market simply compensate
the affected parties for externality?
• Externalities undermine efficiency because one party does not pay the costs
or get all the (net) benefits of its actions.
• The solution to this, therefore, is to internalize the externality.
• Internalizing the externality: When either private negotiations or
government action led the party to fully reflect the external costs or benefits
of that party’s actions.
o The fishermen could pay the steel producer to reduce production.
The Solution: The Coase Theorem
The Coase theorem says that private parties will be able to solve the problem of
externalities. This is accomplished by internalizing the externality.
There no longer over production because the social marginal cost and benefit of each
unit of production are internalized.

• Coase theorem (Part I): When there are well-defined property rights and costless
bargaining, then negotiations between the party creating the externality and the party
affected by the externality can bring about the socially optimal market quantity.
• This theorem states that externalities do not necessarily create market failure,
because negotiations between the parties can lead the offending producers or
consumers to internalize the externality or account for the external effect of their
production or consumption.
• Coase theorem (Part II): The efficient solution to an externality does not depend
on which party is assigned the property rights as long as someone is assigned those
rights. Musgrave-Public Finance: Theory and Policy
The Solution: Coasian Payments

The Problems with Coasian Solutions 1
There are difficulties with Coasian solutions, making them less

likely to arise as more people become involved.

• The assignment problem: The first problem is assigning blame.
Does the fisherman pay the steel plant for not polluting? Or does
the steel plant pay for polluting?
• The holdout problem: Shared ownership of property rights
gives each owner power over all the others. Each person has veto
power and so may demand enormous payments.

The Problems with Coasian Solutions 2
• The free-rider problem: When an investment has a personal cost but a

common benefit, individuals will underinvest. Individuals may not want

to pay enough to reduce pollution.
• Transaction costs and negotiating problems: It is hard to negotiate
when there are large numbers of individuals on one or both sides of the
negotiation.
o This problem is amplified for an externality such as global warming,
where the potentially divergent interests of billions of parties on one
side must be somehow aggregated for a negotiation.

Bottom Line
• Ronald Coase’s insight that externalities can sometimes be

internalized was a brilliant one.

• It provides the competitive market model with a defense
against the onslaught of market failures.
• It is also an excellent reason to suspect that the market may be
able to internalize some small-scale, localized externalities.
• It won’t help with large-scale, global externalities.

Public-Sector Remedies for Externalities
Public policy makers employ three types of remedies to resolve the

problems associated with negative externalities:

1.Corrective taxation to discourage use
2.Subsidies to encourage use
3.Regulation to directly change use

Corrective Taxation and Subsidies
•Taxes and subsidies change the private marginal cost or marginal benefit
without affecting the social marginal cost or benefit.
•They can therefore be used to internalize the externality.

•Taxes that correct externalities are called “Pigouvian taxation,” after A. C.
Pigou.
•Corrective tax caused the firm to internalize the externality.
•A corrective subsidy of an amount gets firms to internalize the externality
•A tax can play a positive role because a tax can correct the market failure

Corrective Taxation
Figure 5-6
This tax internalizes the externality and removes the inefficiency of the negative
externality.
APPLICATION: Congestion Pricing

•Traffic jams lead to huge time and environmental costs to the US economy.
They are also a classic externality: each driver does not account for the fact
that adding their car to the road increases costs on others.
• Economists recommend corrective taxation to solve such externalities, in this
context, congestion pricing.
• London first created congestion tax in 2003. This was a flat tax of $21.00 for entrance into city
center on weekdays. Decreased cars on streets by 39%
• In Stockholm, variable congestion fee used. Price depends on length of time driving in city.
Decreased health impacts of pollution.
• Plans for congestion tax in New York City abandoned after Covid-19 lockdown.
Corrective Subsidies
Figure 5-7
The quantity produced rises from Q1 to Q2, the socially optimal level of production.

APPLICATION: Operation Warp Speed

•Vaccination classic positive externality: private benefits of vaccination are
less than social benefits. Private benefits do not take into account the health
improvements of others by ones’ own vaccination.
• The U.S. Government’s “Operation Warp Speed” provided both “push” and “pull”
incentives to speed rapid development of Covid-19 vaccines.
• Push incentives were large grants to firms, and pull incentives were large purchase guarantees.
• This ensured that vaccines would be developed quickly, and would be distributed quickly once
made.
• Was huge success: instead of typical timeline of 10 to 15 years for vaccine development, Covid-
19 vaccine created in just seven months with efficacy of over 90%.
Regulation
• In an ideal world, Pigouvian taxation and regulation

would be identical.
• Regulation has been the traditional choice for
addressing environmental externalities in the United
States and around the world.
• In practice, there are complications that may make
taxes a more effective means of addressing
externalities.

Price and Quantity approach
The goal in comparing these approaches is to find the most efficient path to
environmental targets.
Price-taxation, quantity-regulation approach to addressing externality.
For any reduction in pollution, the goal is to find the least-cost means of
achieving that reduction.
Market for steel to market for pollution reduction.
PMB zero- there is no gain to the plant’s private interest from reducing
dumping.
Govt set a tax $100 on each unit of pollution. If there is any pollution
reduction that the plant can do that cost less than $100 , it will be cost-
effective to make that reduction.
Distinctions Between Price and Quantity Approaches to
Addressing Externalities: Basic Model
Figure 5-8
Cost of pollu.
Reduction to
the plant or
benefit to the
society
The optimal level of pollution reduction is R*, the point at which these curves intersect.
Because pollution is the complement of reduction, the optimal amount of pollution is P*.
Price Regulation (Taxes) Versus Quantity
Regulation in This Model
• The efficient solution is for SMB = SMC and SMC = PMC.

o Finding efficient quantity requires knowing the whole
SMC curve.
• If MD is constant, setting a tax is easier than setting a
regulation since there is no need to know the shape of the
MC curve.
o But if marginal damage were unknown or not constant,
the government would need to know the shapes of both
MC and MD curves in order to set either the optimal tax
or the optimal regulation.

Externality & Market Failure Multiple Plants with Different Reduction Costs 1
• Two steel plants doing the dumping 200 units of sludge into the river each
day, but now technology is available to reduce sludge associated with the
production but technology is different.

Multiple Plants with Different Reduction Costs 1
Figure 5-9
The efficient solution is one where, for each plant, the marginal cost of reducing pollution is set equal
to the social marginal benefit of that reduction, that is, where each plant’s marginal cost curve
intersects with the marginal benefit curve.

Three possible policies here are:

1.Quantity regulation: For each plant, the marginal cost of reducing pollution
is set equal to the social marginal benefit of that reduction.
2.Corrective tax: Pigouvian taxes cause efficient production by raising the
cost of the input by the size of its external damage.
3.Quantity regulation with tradable permits: Trading allows the market to
incorporate differences in the cost of pollution reduction across firms.
Internalized the externality by providing property right to pollution

How do price regulation (taxes) and quantity regulation differ?

• Quantity regulation ignores the fact that the plants have different marginal
costs of pollution reduction.
• Pigouvian taxes cause efficient production by raising the cost of the input
by the size of its external damage, thereby raising private marginal costs to
social marginal costs.
• Taxes are preferred to quantity regulation, with an equal distribution of
reductions across the plants, because taxes give plants more flexibility in
choosing their optimal amount of reduction, allowing them to choose the
efficient level.

In conclusion:
• The main benefit of taxation over regulation arises when plants differ in
their cost of reducing pollution.
• How to determine how much each plant should produce?
• Regulation often requires each plant to reduce usage by the same amount,
but it would be more efficient to have the low-cost plants reduce use by
more.
• Pigouvian corrective taxes set equal to the marginal damage are more
efficient.

Externality & Market Failure Uncertainty About Costs of Reduction
How does uncertainty about costs of reduction affect corrective strategies?

• If costs are high, then regulation could be expensive since plants are forced
to comply.
• Using a price mechanism avoids this problem since firms will adjust until
cost of adjustment = tax.
• But if costs are uncertain, then so is the amount of pollution reduction that a
tax achieves.

Uncertainty About Costs of Reduction:
Case 1: Flat MD Curve (Global Warming)
Figure 5-10a
If costs are uncertain, then taxation at level t = C2 can lead to a much lower deadweight loss
(DBE) than does regulation of R1 (ABC).
Case 2: Steep MD Curve (Nuclear leakage)
Figure 5-10b
If costs are uncertain, then taxation can lead to a much larger deadweight loss (DBE) than
does regulation (ABC).

Implications for Instrument Choice 1
• Using taxes leads to lower costs but less control over the
amount of pollution reduction.
• The instrument choice depends on whether the government
wants to get the amount of pollution reduction right or
whether it wants to minimize costs.

Externality & Market Failure Conclusion 1
• Externalities arise when one party’s actions affect another party, and the
first party doesn’t fully compensate (or get compensated by) the other for
this effect.
• Externalities are the classic answer to the “when” question of public
finance: if externalities are present, then the market has failed, and
intervention is potentially justified.

Conclusion 2
• This naturally leads to the “how” question of public finance.

Two solutions:
1. Price-based measures (taxes and subsidies)
2. Quantity-based measures (regulation)
• Which of these methods will lead to the most efficient
regulatory outcome depends on factors such as the
heterogeneity of the firms being regulated, the flexibility
embedded in quantity regulation, and the uncertainty over
the costs of externality reduction.

Market Failure-2-Information Asymmetry
The difference in information that is available to sellers and to

purchasers in the market.

• Imperfect competition as a market failure

• Externality as a market failure
• Information asymmetry as a market failure

Why Have Social Insurance? Asymmetric Information
Why should the government provide insurance?

• Information asymmetry can lead to a key market failure called adverse

selection.
o Information asymmetry: The difference in the information that is
available to sellers and to purchasers in a market.
• In the used cars market, sellers are much more likely to know about
potential defects than buyers are.
• In the insurance market, buyers may know more about their insurable
risks than the seller (insurer) does.

• "Asymmetric information" is a term that refers to when one party in a
transaction is in possession of more information than the other.
• In certain transactions, sellers can take advantage of buyers because
asymmetric information exists whereby the seller has more knowledge of

the good being sold than the buyer.
• The difference in information that is available to sellers and to
purchasers in the market.

Why there exist social insurance and why we have it?
• It is government provided insurance programme, which is one of the
largest expenditure of government in the US today.
• We have all these because of the presence of uncertainty and why people
dislike uncertainty.
• What wrong with private market, why there is presence of market
failure? Why government should intervene in this case?

“Lemons Problem”- Nobel prize winning economist Akerlof (1970)
(Lemon is something which is a poorly performing product)
• Look at the market for used cars- Someone selling a car knows what’s
wrong with it whereas the person buying the car doesn’t.
• Seller of the car are selling them because they are not good
• Lemon- In this case the car that gets something wrong with it

• Market failure arises whenever the private market does not deliver all transition that
makes buyers and sellers better off.
• Suppose, I have a 12 year old car and kept in a good shape and I am interested to
selling this car. I am interested to sell this car, lets say X wants to buy this car in a
good shape and ready to pay.
• Sell-₹12lk-WTS (willingness to sell)
• Buy-₹ 14lk-WTP (willingness to pay)
• This is a transaction that should happen and it would be welfare maximizing.
• Lets say most of the 12 year old cars are not in a good shape, so you have to invest
something more on this car.
• So in reality X is willing to pay around 10lk but not 14lk.

• Due to this the transaction has not occurred which could have welfare
maximised.
• A transaction where there was full information, we can get the entire
information.
• Transaction dint not happen because of imperfect information
• The buyer was perfectly happy to buy , because one party has
information but the other part does not , due to which the other party was
suspicious as a result the transaction dint not happen.

CHAPTER 12: SOCIAL INSURANCE: THE NEW FUNCTION OF GOVERNMENT
Social Insurance: The New Function of

Government 2
• Government spending now focuses heavily on social insurance programs.
o Social insurance programs: Government interventions in the provision of insurance
against adverse events.
• For most programs, eligibility is not means-tested.
o Means-tested: Refers to programs in which eligibility depends on the level of one’s
current income or assets.
What Is Insurance?
• Insurance is a promise to make some payment in case of a
particular event, in exchange for a payment, called a premium.
• Insurance premiums: Money that is paid to an insurer so that an
individual will be insured against adverse events.
• Insurance products in the United States include health insurance,
auto insurance, life insurance, and casualty and property
insurance.
Why Do Individuals Value Insurance?

•Insurance is valuable because it helps individuals’ insurance consumption across states of the world.
• Consumption smoothing: The transfer of consumption from periods when consumption is high, and
thus has low marginal utility, to periods when consumption is low, and thus has high marginal
utility.
• States of the world: The set of outcomes that are possible in an uncertain future.
The Role of Risk Aversion
• Risk aversion: The extent to which individuals are willing

to bear risk.
• Risk-averse people may still want to buy some

insurance even if it is not actuarially fair.
• People may differ in their risk aversion, and if insurance
premiums are extremely unfair, then only the most risk
averse will want it.

• In a market condition the given facts of health and sick people ratio is 90healthy: 10Sick
• Thus 100%=10% sick+90% healthy
Let say,
• In a market for healthy people: the probability of getting sick of a heathy person is 10%
• 10% sick share ‘10,000’costs and 90% heathy share ‘0’ costs
• Cost per head of healthy getting sick=10,000*10%=1000
Let say,
• In a market for sick people: the probability of getting sick of a sick person is 50%
• 50% share ‘10,000’costs and 50% share ‘0’ costs
• Cost per head of sick=10,000*50%=5000
• Total estimated cost= 0.9*1000+0.1*5000
=900+500
=1400

Given cost, insurance company incurs insurance of 1500 per head
• But, in reality, 60 out of 100 purchase insurance,

• Estimated revenue=60*1500=90,000
• Out of 60, 50 healthy and 10 sick (60=50 H+10S)
• Estimated Cost= 50H*1000+10S*5000
=50,000+50,000
=1,00,000
10,000 extra cost is the cost of adverse selection for which govt intervention required

The Problem of Adverse Selection
• Adverse selection: The fact that insured individuals know more

about their risk level than does the insurer might cause those most
likely to have the adverse outcome to select insurance, leading
insurers to lose money if they offer insurance.
• Selling to both requires that low-risk people subsidize high-risk
people.
• Low-risk people may not want to do this.
• Sometimes, only high-risk people end up with insurance.

• You cant simply increase the money because if you will do that you are
going to lose money-death spiral-as you raise the price you chase out the
healthier people-
• A insurance market can make people better-off, but it fails
• Market failure does not mean market collapse- it means a reduction in

welfare
• Private insurance market is not going to function well. Setting one price
for multiple products

• What are some potential government solutions?
• 1-subsidization (subsidize while purchasing health insurance)
• Let’s say Govt of India says , It will give you 50000 worth of tax credit
if you will buy the health insurance, Tax subsidy to employer sponsored
insurance. Spend lot of money
• 2- Mandate-passed a law that everyone has to buy a health insurance
(many people don’t want, or they don’t have money for this)- healthy
people bears the cost- workers comp insurance- on the job injury
insurance
• 3-Provide the insurance facilities (social security facilities for the elderly
insurance, unemployment, disability insurance)

Formalizing This Intuition: Expected Utility Model

• We formalize these ideas in the expected utility model.
• Expected utility model: The weighted sum of utilities across states of
the world, where the weights are the probabilities of each state
occurring.
• Suppose an adverse event occurs with probability 𝑝. Expected utility
(EU) is
𝐸𝑈 = 1 − 𝑝 × 𝑈 + 𝑝 × 𝑈 ∗
• where p is the probability of an adverse event, U is utility with

no adverse event, and U* is utility with an adverse event.
The Expected Utility Model: Health insurance

• 1% chance that Mimi gets hit by a car, resulting in $30,000 in medical
expenses.
• Insurance costs m for each dollar of coverage.
o If Mimi buys $b of coverage, her premium is $mb.
o If she fully insures the risk, she pays $m × 30,000.
• To analyze Mimi’s choice, assume 𝑈 = 𝐶 and that premiums are

actuarially fair.
o Actuarially fair premium: An insurance premium that is set equal to the insurer’s
expected payout.
o In this case, the expected payout is 0.01 × 30,000 = $300.
Full Insurance Is Optimal
Table 12-1
If Mimi... And Mimi is . . . Consumptio n (C ) Utility C Expected Utility
Not hit by a car (p = 99% ) $30,000 173.2
Doesn' t buy insurance 0.99  173.2 + 0.01  0 = 171.5
Hit by a car (p = 1% ) 0 0
Buys full insurance Not hit by a car (p = 99% ) $29,700 172.34
0.99  172.34 + 0.01  172.34 = 172.34
(for $300 ) Hit by a car (p = 1% ) $29,700 172.34
Buys partial insurance Not hit by a car (p = 99% ) $29,850 172.77
0.99  172.77 + 0.01  121.86 = 172.26
(for $150 ) Hit by a car (p = 1% ) $14,850 121.86
Examples with Full or Asymmetric Information
• Two kinds of people:

o Careless people have a 5% chance of being in a car

accident (half the population).
o Careful people have a 0.5% chance (half the
population).
• If the insurance company knows each person’s type, it can
charge them separate prices.
• If the insurance company doesn’t know their type, it could
try charging a price that is fair on average or try charging
separate prices.
Does Asymmetric Information Necessarily Lead to
Market Failure?
If low-risk people have a high enough risk premium, they will

subsidize high-risk people in a pooling equilibrium.
• Risk premium: The amount that risk-averse individuals will

pay for insurance above and beyond the actuarially fair
price.
• Pooling equilibrium: A market equilibrium in which all
types of people buy full insurance even though it is not
fairly priced to all individuals.
• Separating equilibrium: A market equilibrium in which
different types of people buy different kinds of insurance
products designed to reveal their true types.
How Does the Government Address Adverse Selection?
Adverse selection leads to market failure since healthy people

may not be willing to buy insurance.

• The government can address adverse selection and
improve market efficiency in a number of ways . . .
• but they involve redistribution from the healthy to the sick,
which may be quite unpopular.

Other Reasons for Government Intervention in
Insurance Markets
• Externalities: Vaccines have positive spillovers, car crashes
negative ones.
• Administrative costs: Government-run Medicare has much

lower administrative costs than private insurance.
• Redistribution: Governments may want to redistribute
from the healthy to the sick.
• Paternalism: Governments may feel that people would
choose to buy too little insurance for themselves.

The Problem with Insurance: Moral Hazard
A cost of insurance is moral hazard.

• Moral hazard: Adverse actions taken by individuals or

producers in response to insurance against adverse
outcomes.
o “Nothing emboldens sin so much as mercy.”
• The existence of moral hazard means that it may not be
optimal for the government to provide the full insurance
that is demanded by risk-averse consumers.

Externality & Market Failure What Determines Moral Hazard?
• How easy it is to observe whether the adverse event has

happened.
• How easy it is to change behavior in order to establish the
adverse event.

Externality & Market Failure The Consequences of Moral Hazard
Moral hazard is costly for two reasons.

• The adverse behavior encouraged by insurance lowers
social efficiency because it reduces the provisions of a
socially efficient labor supply.
• When social insurance encourages adverse events, which
raise the cost of the social insurance program, it
increases taxes and lowers social efficiency further.

Conclusion
• Asymmetric information in insurance markets has two

important implications:
o It can cause adverse selection.
o It can cause moral hazard.
• The ironic feature of asymmetric information, therefore, is
that it simultaneously motivates and undercuts the
rationale for government intervention through social
insurance.

Thank You…
These information has been collected for

educational purpose only


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Market Failure: Externality and

➢ What is an externality, and why does it cause a market

➢ When can the private market solve the problem of

@ Grubder, J. Public Finance and Policy: Musgrave and

Market failure-1 Market failure-2

@ Grubder, J. Public Finance and Policy: Musgrave and

@ Grubder, J. Public Finance and Policy: Musgrave and

Externality: Externalities arise whenever the actions of one party

@ Grubder, J. Public Finance and Policy: Musgrave and

producing an additional unit of a good.

@ Grubder, J. Public Finance and Policy: Musgrave and

consuming an additional unit of a good by the consumer.

@ Grubder, J. Public Finance and Policy: Musgrave and

• The market sets PMC = PMB.

@ Grubder, J. Public Finance and Policy: Musgrave and

@ Grubder, J. Public Finance and Policy: Musgrave and

o MD is the marginal damage done to others from each unit of

@ Grubder, J. Public Finance and Policy: Musgrave and

@ Grubder, J. Public Finance and Policy: Musgrave and

APPLICATION: The Externality of SUVs

•The consumption of large cars such as SUVs produces three types

•Externalities can be positive as well as negative.

• Positive consumption externality: When an individual’s consumption

@ Grubder, J. Public Finance and Policy: Musgrave and

@ Grubder, J. Public Finance and Policy: Musgrave and

• Negative production externality: SMC curve lies above PMC curve.

• Positive production externality: SMC curve lies below PMC curve.

• Negative consumption externality: SMB curve lies below PMB curve.

• Positive consumption externality: SMB curve lies above PMB curve.

@ Grubder, J. Public Finance and Policy: Musgrave and

• In microeconomics, the market is innocent until proven guilty.

unit of production are internalized.

@ Grubder, J. Public Finance and Policy: Musgrave and

There are difficulties with Coasian solutions, making them less

likely to arise as more people become involved.

@ Grubder, J. Public Finance and Policy: Musgrave and

• The free-rider problem: When an investment has a personal cost but a

common benefit, individuals will underinvest. Individuals may not want

@ Grubder, J. Public Finance and Policy: Musgrave and

• Ronald Coase’s insight that externalities can sometimes be

internalized was a brilliant one.

@ Grubder, J. Public Finance and Policy: Musgrave and

Public policy makers employ three types of remedies to resolve the

problems associated with negative externalities:

@ Grubder, J. Public Finance and Policy: Musgrave and

•They can therefore be used to internalize the externality.

@ Grubder, J. Public Finance and Policy: Musgrave and

APPLICATION: Congestion Pricing

@ Grubder, J. Public Finance and Policy: Musgrave and

APPLICATION: Operation Warp Speed

• In an ideal world, Pigouvian taxation and regulation

@ Grubder, J. Public Finance and Policy: Musgrave and

• The efficient solution is for SMB = SMC and SMC = PMC.

@ Grubder, J. Public Finance and Policy: Musgrave and

@ Grubder, J. Public Finance and Policy: Musgrave and

@ Grubder, J. Public Finance and Policy: Musgrave and

Three possible policies here are:

@ Grubder, J. Public Finance and Policy: Musgrave and

How do price regulation (taxes) and quantity regulation differ?

@ Grubder, J. Public Finance and Policy: Musgrave and

@ Grubder, J. Public Finance and Policy: Musgrave and

How does uncertainty about costs of reduction affect corrective strategies?

• Estimated Cost= 50H1000+10S5000