Market Failures and Collective

Action
 Market Equilibrium
• Equilibrium in the market results in maximum
benefits, and therefore maximum total
welfare for both the consumers and the
producers of the product.
 Welfare of Consumer and Producer

• Consumer surplus measures economic welfare

from the buyer’s side.
• Producer surplus measures economic welfare
from the seller’s side.
• Consumer Surplus
– Willingness to pay is the maximum amount that a
buyer will pay for a good.
– It measures how much the buyer values the good
or service
– Consumer surplus is the buyer’s willingness to pay
for a good minus the amount the buyer actually
pays for it.
Consumer Surplus

(a) Consumer Surplus at Price P

Price
A

Consumer
surplus
P1
B C

Demand

0 Q1 Quantity

Copyright©2003 Southwestern/Thomson Learning

• Producer Surplus
– Producer surplus is the amount a seller is paid for
a good minus the seller’s cost.
– It measures the benefit to sellers participating in a
market.
Producer Surplus

(a) Producer Surplus at Price P

Price
Supply

B
P1
C
Producer
surplus

0 Q1 Quantity
Copyright©2003 Southwestern/Thomson Learning
 MARKET EFFICIENCY
• Efficiency is the property of a resource
allocation of maximizing the total surplus
received by all members of society.
 MARKET EFFICIENCY
Consumer Surplus
= Value to buyers – Amount paid by buyers

and

Producer Surplus
= Amount received by sellers – Cost to sellers
 MARKET EFFICIENCY
Total surplus
= Consumer surplus + Producer surplus

or

Total surplus
= Value to buyers – Cost to sellers
 MARKET EFFICIENCY
• In addition to market efficiency, a social
planner might also care about equity – the
fairness of the distribution of well-being
among the various buyers and sellers.
 Consumer and Producer Surplus in the Market Equilibrium

Price A

D
Supply

Consumer
surplus

Equilibrium E
price
Producer
surplus

Demand
B

0 Equilibrium Quantity
quantity
Copyright©2003 Southwestern/Thomson Learning
 MARKET EFFICIENCY
• Three Insights Concerning Market Outcomes
– Free markets allocate the supply of goods to the
buyers who value them most highly, as measured
by their willingness to pay.
– Free markets allocate the demand for goods to the
sellers who can produce them at least cost.
– Free markets produce the quantity of goods that
maximizes the sum of consumer and producer
surplus.
The Efficiency of the Equilibrium Quantity

Price
Supply

Value Cost
to to
buyers sellers

Cost Value
to to
sellers buyers Demand

0 Equilibrium Quantity
quantity

Value to buyers is greater Value to buyers is less

than cost to sellers. than cost to sellers.

Copyright©2003 Southwestern/Thomson Learning

 Grains from Cooperative
Domestic supply curve

price
A
Total Supply curve
(Domestic s + Foreign)

due to cooperative
Fall in cost of production
Exploitative price offered

Domestic Supply curve

after cooperative
by private trader

P1
C

B
D1 Q1 quantity

P1, Q1 is initial equilibrium price and quantity

D1 is initial amount of milk purchased from domestic producers
Producer Surplus (PS) lost due to exploitative pricing of domestic milk
PS obtained by domestic milk producers when price is exploitative
ABC is the Total Surplus (TS) after cooperative is formed
TS increased after cooperative
Both consumer surplus and PS increase after cooperative
Evaluating the Market Equilibrium

• Collective Action increases Economic

Efficiency
• Free market alone is less efficient
Evaluating the Market Equilibrium

• Market Power
– If a market system is not perfectly competitive,
market power may result.
• Market power is the ability to influence prices.
• Market power can cause markets to be inefficient
because it keeps price and quantity from the
equilibrium of supply and demand.
 Externalities
• Externalities
– created when a market outcome affects
individuals other than buyers and sellers in that
market.
– Welfare more than just the value to the buyers
and cost to the sellers.
• When buyers and sellers do not take
externalities into account when deciding how
much to consume and produce, the
equilibrium in the market can be inefficient.
 Market Failures
• Market fails to produce the right amount
of the product
• Resources may be
• Over-allocated
• Under-allocated

LO1 5-19
• Recall: Adam Smith’s “invisible hand” of the
marketplace leads self-interested buyers and
sellers in a market to maximize the total
benefit that society can derive from a market.

But market failures can still happen.

EXTERNALITIES AND MARKET INEFFICIENCY

• An externality refers to the uncompensated

impact of one person’s actions on the well-
being of a bystander.
• Externalities cause markets to be inefficient,
and thus fail to maximize total surplus.
EXTERNALITIES AND MARKET INEFFICIENCY

• An externality arises...
. . . when a person engages in an activity that
influences the well-being of a bystander and yet
neither pays nor receives any compensation for
that effect.
EXTERNALITIES AND MARKET INEFFICIENCY

• When the impact on the bystander is adverse,

the externality is called a negative externality.
• When the impact on the bystander is
beneficial, the externality is called a positive
externality.
EXTERNALITIES AND MARKET INEFFICIENCY

• Negative Externalities
– Automobile exhaust
– Cigarette smoking
– Barking dogs (loud pets)
– Loud stereos in an apartment building
EXTERNALITIES AND MARKET INEFFICIENCY

• Positive Externalities
– Immunizations
– Restored historic buildings
– Research into new technologies
EXTERNALITIES AND MARKET INEFFICIENCY

• Negative externalities lead markets to

produce a larger quantity than is socially
desirable.
• Positive externalities lead markets to produce
a smaller quantity than is socially desirable.
 Pollution and the Social Optimum

Price of
Social
Aluminum
cost
Cost of
pollution
Supply
(private cost)

Optimum

Equilibrium

Demand
(private value)

0 QOPTIMUM QMARKET Quantity of

Aluminum
 Education and the Social Optimum

Price of
Education
Supply
(private cost)

Social
value
Demand
(private value)

0 QMARKET QOPTIMUM Quantity of

Education

Copyright © 2004 South-Western

 Other Reasons of Market Failure
• Incomplete Information
– Consumers do not have accurate information
about market prices or product quality
– Lack of information may give producers an
incentive to supply too much or too little
– Consumers may not buy product even though it is
beneficial to buy
– Lack of information may prevent some markets to
develop
 Government Intervention
• Tax
– Negative externality
• Subsidy
– Positive externality
PRIVATE SOLUTIONS TO EXTERNALITIES

• Moral codes and social sanctions

• Charitable organizations
• Integrating different types of businesses
• Contracting between parties
 Private Solutions: Coase Theorem

• The Coase Theorem is a proposition that if private parties

can bargain without cost over the allocation of resources,
they can solve the problem of externalities on their own.
• Whatever the initial distribution of rights, the interested
parties can reach a bargain in which everyone is better
off and the outcome is efficient
– distribution of property rights have implications
• Transactions Costs
– Transaction costs are the costs that parties incur in the process
of agreeing to and following through on a bargain.
Why Private Solutions Do Not Always Work

• Sometimes the private solution approach fails

because transaction costs can be so high that
private agreement is not possible.
• Number of individuals involved on both sides
high
• Need to resolve Collective Action Problem
PUBLIC POLICY TOWARD EXTERNALITIES

• When externalities are significant and private

solutions are not found, government may
attempt to solve the problem through . . .
– command-and-control policies.
– market-based policies.
PUBLIC POLICY TOWARD EXTERNALITIES

• Command-and-Control Policies
– Usually take the form of regulations:
• Forbid certain behaviors.
• Require certain behaviors.
– Examples:
• Requirements that all students be immunized.
• Stipulations on pollution emission levels set by the
Environmental Protection Agency (EPA).
PUBLIC POLICY TOWARD EXTERNALITIES

• Market-Based Policies
– Government uses taxes and subsidies to align
private incentives with social efficiency.
– Pigovian taxes are taxes enacted to correct the
effects of a negative externality.
PUBLIC POLICY TOWARD EXTERNALITIES

• Examples of Regulation versus Pigovian Tax

– If the EPA decides it wants to reduce the amount
of pollution coming from a specific plant. The EPA
could…
– tell the firm to reduce its pollution by a specific
amount (i.e. regulation).
– levy a tax of a given amount for each unit of
pollution the firm emits (i.e. Pigovian tax).
PUBLIC POLICY TOWARD EXTERNALITIES

• Market-Based Policies
• Tradable pollution permits allow the voluntary
transfer of the right to pollute from one firm
to another.
– A market for these permits will eventually
develop.
– A firm that can reduce pollution at a low cost may
prefer to sell its permit to a firm that can reduce
pollution only at a high cost.
Climate change – the biggest market failure the
world has ever seen?
 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.
 Carbon Trading
• Carbon Trading is market-based mechanism to
incentivise reduction of greenhouse gas emissions in
a cost-effective and economically-efficient manner
• Under Carbon trading, a country having more
emissions of carbon is able to purchase the right to
emit more and the country having less emission
trades the right to emit carbon to other countries.
More carbon emitting countries, by this way try to
keep the limit of carbon emission specified to them
 Carbon Markets
• EU Emissions Trading System (EU-ETS) 
– Operates in the 28 EU countries and the three EEA-
EFTA states (Iceland, Liechtenstein and Norway)
– covers more than 11,000 power stations and
industrial plants
• Clean Development Mechanism (CDM) 
– emission-reduction projects in developing countries
can earn certified emission reduction credits.
– These saleable credits can be used by industrialized
countries to meet a part of their emission
reduction targets under the Kyoto Protocol
 Carbon Credits
• A carbon credit is a generic term for any tradable certificate or permit
representing the right to emit one tonne of carbon dioxide or the mass of
another greenhouse gas with a carbon dioxide equivalent
• Carbon Credits are the production cost, for which, ultimately the consumer
pay
• Cap and trade (or emission trading) – compliance market
– a limit (or "cap") on certain types of emissions or pollutions is set, and
companies are permitted to sell (or "trade") the unused portion of their
limits to other companies that are struggling to comply.
• Offset trading (trading in project based carbon credit) – voluntary market
– restore forests, update power plants and factories or increase the energy
efficiency of buildings and transportation
– UN's Clean Development Mechanism (CDM) is the largest offsetting
scheme with almost 3,000 registered projects in the global South as of
April 2011
– Offsetting does not reduce emissions, but allows companies and
governments in the North that have the historical responsibility to clean
up the atmosphere to buy credits from projects in the South.
 CDM in India
• ONGC has 6 CDM projects registered with UNFCCC
(United Nations Framework Convention on Climate
Change) and is the only PSU to achieve this feat.
• Carbon Trading in Ankleshwar
– A sulphuric acid treatment plant, using technology
imported from Canada, and a pharmaceutical company
wanting new technology to help cut nitrogen dioxide
emissions are among those seeking revenue from
carbon credits
• NGOs and MFIs
– SEWA and Grameen Shakti for solar lighting
– CTRAN, A BASIX group company for solar water heaters
 Carbon Market Failures
• No legally binding agreement to reduce emission
• More credits allocated than needed
– Low price of carbon
– No incentive for carbon saving
• "total lack of environmental integrity“ of CDM
• High transaction cost on the process for applying for
mitigation and adapting financing
• Need International Collective action
– Provision of global public good
– The transparency and comparability of national action across a
range of dimensions of effort are key to mutual understanding
and recognition of what others are doing, as well as ensuring
public accountability
 Efforts
• Kyoto Protocol – 1997
– Binding international action and agreed specific
commitments from 2008 to 2012
– Entered into force 2005 and ratified by 162 countries
– "common but differentiated responsibilities.“
– Market based mechanisms (Carbon market)
– US and Australia declined to join the Protocol
• Post-Koyoto: China, India, and the United States
have all signaled that they will not ratify any
treaty that will commit them legally to reduce
CO2 emissions
 United Nations Framework Convention on
Climate Change
• UNFCCC is an international environmental
treaty negotiated at the Earth Summit in Rio
de Janeiro in 1992
• Outlines how specific international treaties
(called "protocols" or "Agreements") may be
negotiated to set binding limits on greenhouse
gases.
• Conference of Parties
– The COP is the supreme decision-making body of the
Convention (UNFCCC )
–  COP is to review the national communications and
emission inventories submitted by Parties. Based on this
information, the COP assesses the effects of the measures
taken by Parties and the progress made in achieving the
ultimate objective of the Convention. 
– COP serve as the meeting of the Parties to the Kyoto
Protocol (CMP)
• Collection Action
 COP 21 or CMP 11 - 2015
Paris Agreement
• Holding the increase in the global average
temperature to well below 2°C above pre-industrial
levels and pursuing efforts to limit the temperature
increase to 1.5°C above pre-industrial levels
• Making finance flows consistent with a pathway
towards low greenhouse gas emissions and climate-
resilient development
• reflect equity and the principle of common but
differentiated responsibilities and respective
capabilities, in the light of different national
circumstances.
 Ratification
• reflect equity and the principle of common but
differentiated responsibilities and respective capabilities,
in the light of different national circumstances.
– USA ??? China ????
• Each country that ratifies the agreement will be required
to set a target for emission reduction or limitation, called
a "nationally determined contribution," or "NDC," but the
amount will be voluntary
• Name and shame
• No binding constraint
• 2017 USA withdrew from Paris Agreement (four-year exit
process)