Lecture 10

Market Failure

1

In a market: Demand characterizes •individual consumers’ behavior

•personal (private) evaluation of the output’s worth
•the benefits consumers receive from consuming the good Supply characterizes •individual producers’ behavior

•firms’ (private) evaluation of the resources used in production
•the cost of producing the good
2

In a market equilibrium P S P0 D Q0 Q 3 .

MB =MC can be a “market success” because value of last (marginal) unit of output produced = value of resources used to produce it P S = MC D = MB Q 4 .

MB =MC can be a “market failure” market failure: the private market produces an outcome that is not best when considered from society’s viewpoint. Market failure: • happens when private market evaluation of costs or benefits differ from society's evaluation • results in a misallocation of resources • occurs when there are externalities 5 .

Positive Externality P Q 6 .Externality: cost or benefit of a private market activity that spills-over onto a third party.

P MBS MB Q 7 .3. The private market allocates too few resources to the production of the good.

society pays part of the cost of production because society enjoys some of the 8 benefits. .4. Internalize by P MC P0 MBS MB Q0 Qs Q • the socially efficient quantity of output (Qs) is produced •consumers pay a lower price •since the subsidy is paid via taxation.

P MBS MC MB Q Qs •Society pays the entire cost because the benefit is so significant.5. •Providing the product or service free maximizes consumption. 9 . Sometimes the external benefit is so great the product or service is made available for free.

a cost spills over from a consumption or production activity.Negative Externality 1. the private market supply (MC) understates the cost to society (MCS) P Q 10 . 2.

P MCS MC Q 11 . The private market allocates too many resources to the production of the good.3.

4. Internalize by taxing consumption or production P MCS MC P0 MB Qs Q0 Q • the socially efficient quantity of output (Qs) is produced • consumers pay a higher price • taxation is a method of pricing the externality 12 .

Controlling Pollution Price Pollution Incentive to Clean-up Generate Revenues for Clean-up Incentive to Improve Technology Clean-up at Lowest Cost to Society Yes Yes Regulate Polluters No No Assign Property Rights (Coase Rule) Yes Yes Yes No Yes Yes No Yes 13 .

Pricing Pollution Who benefits from pollution? MBpollution = Who bears the costs of pollution? MCpollution = Ppollution Qpollution 14 .

the optimal level of pollution (Q*) is not zero. The price (P*) at which MBpollution = MCpollution is the size of the tax needed to internalize the externality. Often. 2.Ppollution Qpollution Conclusions 1. 15 .

the optimal level of pollution is zero.Conclusions 3. In some instances. Ppollution Qpollution 16 .

Coase Rule: Assigning property rights to the environment results in a level of pollution that is optimal. Assign rights to non-polluters Ppollution MCnon-polluters Assign rights to polluters Ppollution MCnon-polluters MBpolluters MBpolluters 17 Qpollution Qpollution .

2. 3. 18 .Public Good: products and services that are consumed jointly Characteristics of public goods 1. No effective way to restrict the benefits to those who directly pay for the good. The market fails because society’s benefit (MBS) far exceed the cost of production (MC). society pays the entire cost because the benefit is so significant.. Consumption of the good by one party does not reduce the availability to others. 4. The government produces most public goods because i.e.

Joint consumption means the market demand is the vertically sum of all individuals’ demand. P D1 = D2 Q 19 .

P ? D = MBS D = MB Q 20 .Under certain circumstances the private market will produce some public goods but fails to produce the socially efficient quantity .

P ? D = MBS D = MB Q 21 .In most circumstances the private market fails to produce any public goods and government production is necessary to achieve the socially efficient quantity .

3.EOP Assignment 1. 6. Explain why the market outcome of MB=MC is an efficient allocation of resources. 7. What is market failure? What is an externality? What is the reasoning behind subsidizing a product or service that creates a positive externality? What is the reasoning behind taxing a product or service that creates a negative externality? What is a public good? Why does the government produce most public goods? 22 5. 2. . 4.