When

markets fail
When markets fail
We have so far talked about instances when allowing
competitive markets to function leads to efficiency and social
welfare – and government intervention (well-meaning or not)
leads to inefficiency and net welfare losses.
Now we shall talk about cases when markets fail to function
properly, or are absent – and government or some nonmarket
institutions can play a positive role.
3. Externalities
Externalities
An externality arises when a person engages in an activity that
influences the well-being of a bystander, yet neither pays nor
receives compensation for that effect.
A negative externality if the impact on bystander is adverse.
car-exhaust fumes, smoking, noisy late-night parties, failing to get
TB treatment
A positive externality if the impact on bystander is beneficial
scientific research, maintaining historic buildings, cleaning one’s
surroundings, replanting forests for the future
Externalities: the problem
Buyers and sellers in a market pay attention only to their
own well-being and neglect the external effects of their
decisions regarding how much to consume or produce.
As a result, the market equilibrium is not efficient in the
presence of externalities, i.e., it does not maximise
society’s welfare. Latent benefits or latent costs are
involved that are not included in the price of the good or
activity.
Pollution as negative externality
Social cost
Price
S (private cost)

Extra social cost of

pollution

D (private value)

QS QM
Quantity
Curiosity-driven research as
positive externality
Price Extra value to
society
S

Social value

D (private value)

QM QS
Quantity
Solutions to externalities
1. Public solutions to externalities
•regulation and prohibition
• problem is the “one size fits all” nature
• same regulation affects industries differently
•taxes and subsidies
• tax or subsidy is based on the amount of externality emitted,
rather than a common imposed limit
• allows private actors to calibrate their actions and respond to
the tax
Solutions to externalities
Pigovian taxes and subsidies (unlike usual ones) A.C. Pigou
move the economy towards the optimum rather than
away from it.
The Pigovian tax (subsidy) reflects the extra cost (value)
to society of the production activity or consumption
and therefore offsets the externality.
Pigovian tax
SS
Price

SP (private cost)
PT
T*
Tax revenue Pigovian tax

PM Impose a tax equal to the divergence

between social and private cost.

D (private value)

QS QM
Quantity
Pigovian tax: welfare analysis
SS
Price
Reduced
damage SP (private cost)
Govt Net social
revenue gain

Pre-tax Pigovian tax

damage

Net private D (private value)

losses

QS QM Quantity
Pigovian tax: welfare analysis
The social gain is net of all private gains and losses.
The result of the tax is almost never a complete elimination or
prohibition of the activity or production of the good.
The subsequent use of the government revenue earned is of
secondary importance to the fact that the activity is reduced.
Revenues may of course be offset some of the private losses from
the tax. But these will never be enough to offset the private
losses of direct consumers and producers of the good. (If so
desired, other sources of revenue may be used.)
 Pigovian subsidy: welfare Current
Price social gains
Potential
Net social gains
social gains
S
Pigovian
Sellers receive a higher price PP subsidy
Subsidy Producer gain Deadweight loss from
expense subsidy
Consumer gain
Buyers pay a lower price PB
D Social value

D (private value)

QM QS Quantity
Pigovian subsidy: welfare analysis
The subsidy results in higher output, a lower consumer price and a
higher producer price; both consumers and producers benefit.
As in any subsidy, a private deadweight loss ensues because supply
is pushed beyond what buyers are willing to pay.
The expense of the subsidy is offset by the benefits to consumers,
to producers, and pays for the deadweight loss.
However, the social gain from the higher beneficial output or
activity offsets the deadweight loss and constitutes a net social
gain, making the expence worthwhile.
Regulation/prohibition versus taxation
Prohibition/regulation assumes one needs to impose a
common limit to the externality for all. Essentially a quantity
restriction.
In contrast, taxes are based on the extent or quantity of the
externality emitted by individual firms or persons, rather
than a common imposed limit.
Regulation/prohibition versus taxation
Taxation is generally preferred to regulation or prohibition.
Why? It is more sensitive to the circumstances of individual
firms (or persons) and gives firms a choice between, say,
polluting more and paying a higher tax and polluting less
paying less tax.
This disrupts production less and encourages technological
innovation.
Regulation/prohibition versus taxation
Example:
The cement industry is highly energy-intensive and currently has
few technological alternatives to fossil fuel (solar power can only
replace 9-12% of its power needs*)
In contrast, auto manufacturing can almost completely replace its
diesel-powered machinery with electricity from solar power.
If the government set a uniform regulatory limit to fossil-fuel
pollution, the cement industry would be at a disadvantage and its
production would be severely affected.
*https://ornatesolar.com/blog/how-solar-energy-can-support-the-cement-industry-energy-demand
Regulation/prohibition versus taxation
Benefit to firm per Demand curves (reservation prices) for
additional unit of pollution pollution by cement (C) and
Regulation
C automotive (A) industries.
Each unit of pollution is worth more
to the cement industry than to
A the automotive industry.
Without intervention, each industry
produces 150 units of pollution:
Tax
total 300.

No regulation

60 80 100 150 Pollution emitted/output produced

Regulation/prohibition versus taxation
Without intervention both industries push pollution to the limit.
Quantity regulation makes both industries cut back on pollution to the
same extent (from 150 to 80, total 160).
But this hurts cement more: its valuation of pollution becomes higher
than automotive, meaning it would be more profitable for this industry
to expand its output – as well as pollution.
Taxation again equalizes the returns to both industries: cement produces
more, pollutes and pays more. Automotive produces less, pollutes less,
and pays less. Same total pollution can be achieved: 60+100 = 160.
Solutions to externalities
2. Private solutions
• moral codes and social sanctions can promote positive
externalities or minimise negative ones (e.g., hiya, desire for
approval by others)
• charity and philanthropy
• private business organization: integration of activities with
positive externalities
• buy-outs and compensation through private bargaining
“Coase Theorem”
(after Ronald Coase, 1960):
Private economic actors can solve the problem of externalities
among themselves. Whatever the initial distribution of rights, the
interested parties can always reach a bargain where everyone is
better off and the outcome is efficient.
Coase Theorem: example
Jay’s residence doubles as a workshop and his van is always parked
before his house on a narrow street. This is not illegal. Aye lives
across and has a hard time backing out of the driveway in the
morning because of Jay’s van.
If the difficulty of backing-out is worth ₱200/month to Aye, and
the trouble of finding another parking spot is worth ₱150/month
to Jay, then Aye can buy out Jay’s right to park his van.
 Right is more valuable to Aye
Jay’s payoff Aye’s payoff Social gain or
loss

Jay has the right 150 – 150 = 0 200 – 150 = 50 50

Aye has the right – 150 200 50

If rights are assigned to Jay, then Aye pays him 150 to induce him to park
elsewhere.
If the rights are given to Aye, then she does not have to pay anything; it is
Jay who must adjust and suffer the inconvenience. Either way, the social
gain is +50.
Right is more valuable to Jay
Jay’s payoff Aye’s payoff Social gain or
loss

Jay’s rights 300 –200 100

Aye’s rights 300 – 200 = 100 200 – 200 = 0 100

If rights are assigned to Jay, then he does not have to do

anything. He gains 300 and Aye loses 200 by suffering the
inconvenience. (She cannot buy him out.) If the rights are given
to Aye, then Jay can compensate her for her loss. Either way, the
social gain is 100.
Coase Theorem
The result is that the externality is removed. Society gets an extra
₱50 in benefits per month.
Now suppose the trouble of finding another parking spot is
₱300/month to Jay. Then he would not accept Aye’s offer, and he
has to live with the current situation. But then this too would
also be the best solution.
Note: it will not matter who has the “right”, either way.
Coase Theorem
But the Coase Theorem does not always work because of
transactions costs, i.e., costs of trying to reach agreement and
enforcing (i.e., following through on) a bargain.
In the example, suppose for example, that Jay’s and Eye’s
schedules are so different they do not even have a common time
to meet to discuss the matter. Or they may speak different
languages. Then bargaining cannot even begin or is bound to be
difficult.
Coase Theorem: an example of
transaction costs
Many small fisherfolk are harmed by pollution created by a mining firm.
The sum of the fishers’ losses is greater than the cost of the mining firm
installing an effective antipollution device.
The Coase Theorem says that if the right is assigned to the firm, the fishers
can pay it to install the antipollution device. But because they are many and
hard to organise, the fishers cannot come up with a coherent offer. As a
result, the externality is unmitigated and society suffers a net loss.
[N.B. What if the right were assigned to the fishers instead? Does it
matter?]
Coase Theorem
According to Coase himself, the existence of transactions costs means
government intervention is necessary. E.g., the government may act in
behalf of the fisherfolk.
In particular, transactions costs make a wise application of the law
necessary.
a. Where transactions costs are low, design the law to facilitate
voluntary trade.
b. Where rights are ambiguous and where transactions costs are
high, Coase suggested the rights should be assigned to the party who
values the asset/activity the most. (Ask yourselves why.)