9
MARKET FAILURE AND EXTERNALITIES
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I. Market Failure
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Market Failure
◦ Market models lose their value….
◦ … when making predictions if we have imperfect information
and irrational behaviour.
◦ …because individuals and firms have different levels of power
and influence in markets.
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II. Externalities
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Belief Systems
The intellectual basis for the market system …
◦ … individuals being left to their own devices without
government interference motivated by self-interest.
Critics of this belief system argue that…
◦ … individuals make decisions without fully understanding the
costs and benefits and lead to inefficiencies which the market
system on its own does not solve.
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Belief Systems
An externality is an uncompensated impact of one person’s
actions on the well-being of a bystander.
o Externalities cause markets to be inefficient, and so fail to
maximize total surplus.
o An externality arises...
. . . when a person engages in an activity that affects the well-being
of a bystander and yet neither pays nor receives any compensation
for that effect.
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Belief Systems
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.
◦ In either situation, decision makers fail to take account of the external
effects of their behaviour.
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The Social Costs and Social Benefits of
Decision Making
Market decisions are be based on weighing up private costs and
private benefits.
Social costs and social benefits are lost or gained by those not
party to the initial decision.
Market decisions may not take account of the social costs and
benefits of their actions.
The market equilibrium is not efficient when there are
externalities.
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Types of externalities
Negative Externalities
◦ Car exhaust fumes
◦ Cigarette smoking
◦ Barking dogs (loud pets)
◦ Loud stereos in an apartment building
Positive Externalities
◦ Immunizations
◦ Restored historic buildings
◦ Research into new technologies
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III. Externalities And Market
Inefficiency
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Welfare Economics: A Recap
Negative externalities lead markets to produce a larger quantity
than is socially desirable.
Positive externalities lead markets to produce a larger quantity
than is socially desirable.
◦ Look at the market for aluminium (figure 1)
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Welfare Economics: A Recap
Figure 1. The Market for Aluminium
Price of
Aluminum Supply
(private cost)
Equilibrium
Demand
(private value)
0 QMARKET Quantity of
Aluminum
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Negative Externalities
The Market for aluminum
◦ The quantity produced and consumed in the market equilibrium is
efficient in the sense that it maximizes the sum of producer and
consumer surplus.
◦ If the aluminum factories emit pollution (a negative externality), then
the cost to society of producing aluminum is larger than the cost to
aluminum producers.
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Negative Externalities
The Market for aluminum
◦ For each unit of aluminum produced, the social cost includes the
private costs of the producers plus the cost to those bystanders
adversely affected by the pollution.
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Negative Externalities
Figure 2 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
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Negative Externalities
The intersection of the demand curve and the social-
cost curve determines the optimal output level.
• The socially optimal output level is less than the market
equilibrium quantity.
Internalizing an externality involves altering incentives
so that people take account of the external effects of
their actions.
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Negative Externalities
Achieving the Socially Optimal Output
◦ The government can internalize an externality by imposing a tax on
the producer to reduce the equilibrium quantity to the socially desirable
quantity.
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Positive Externalities
A positive externality exists when an externality
benefits the bystanders.
◦ The social value of the good exceeds the private value.
◦ Example: Education yields positive externalities.
◦ A better-educated population leads to improved productivity
and economic growth. The economic growth is the positive
externality as it benefits everyone.
The marginal social benefit (MSB) is the private value
plus the external benefit to society at each price.
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Figure 3. Education and the Social Optimum
Price of
Education
Supply
(private cost)
MSB
or
Social
value
Demand
(private value)
0 QMARKET QOPTIMUM Quantity of
Education
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Positive Externalities
The intersection of the supply curve and the social
value curve determines the optimal output level.
◦ The optimal output level is more than the equilibrium quantity.
◦ The market produces a smaller quantity than is socially
desirable.
◦ The social value of the good exceeds the private value of the
good.
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Positional Externalities
A positional externality is a situation which exists when
the payoff to one individual is dependent on their
relative performance to others.
A positional arms race is a situation where individuals
invest in a series of measures designed to gain them
an advantage, but which simply offset each other.
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IV. Private Solutions To
Externalities
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Types of Private Solutions
Government action is not always needed to solve the
problem of externalities.
Social norms and Moral Behaviour
◦ Do unto others as you would have them do unto you.
Charities that deal with externalities.
◦ E.g. Greenpeace.
Self-interest
◦ Where two firms gain from each other’s presence
Social Contracts
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The 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.
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Why Private Solutions Do Not Always Work
Transactions Costs
o Transaction costs are incurred in the process of agreeing to and
following through on a bargain.
o Sometimes the private solution approach fails because
transaction costs can be so high that private agreement is not
possible.
Bargaining Problems
o Each party tries to hold out for a better deal.
Difficult to Coordinate the interested parties.
Asymmetric Information and Irrational Behaviour.
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V. Public Policies Toward
Externalities
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Command and Control: Regulation
Command-and-Control Policies
◦ Usually take the form of regulations:
◦ Forbid certain behaviours.
◦ Require certain behaviours.
◦ Examples:
◦ Requirements that all students be immunized.
◦ Stipulations on pollution emission levels set by the
government.
◦ Needs good information
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Market based policies: Corrective Taxes
and Subsidies
Pigovian taxes are taxes enacted to correct the effects
of a negative externality.
• Government uses taxes and subsidies to align private
incentives with social efficiency.
• Factories an incentive to reduce pollution up to a point where
the marginal abatement cost is equal to the tax rate
imposed.
• Firms that can reduce pollution with the least cost are likely
to do so (to avoid the tax) while firms that encounter high
costs when reducing pollution will pay the tax.
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Market based policies: Corrective
Taxes and Subsidies
Regulation Versus PigovianTax.
If the government decides it wants to reduce the
amount of pollution coming from a specific plant, the
government 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).
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Tradable Pollution Permits
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.
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Tradable Pollution Permits
Figure 4a. The Equivalence of Pigovian Taxes and Pollution Permits: Pigovian tax
Price of
Pollution
P Pigovian
tax
1. A Pigovian
tax sets the
price of Demand for
pollution . . . pollution rights
0 Q Quantity of
Pollution
2. . . . which, together
with the demand curve,
determines the quantity
of pollution.
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Tradable Pollution Permits
Figure 4b. The Equivalence of Pigovian Taxes and Pollution Permits: Pollution Permits
Price of Supply of
Pollution pollution permits
Demand for
pollution rights
0 Q Quantity of
Pollution
2. . . . which, together 1. Pollution
with the demand curve, permits set
determines the price the quantity
of pollution. of pollution . . .
VI. Public/Private Policy Toward
Externalities
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Property Rights
o Property rights is the exclusive tight of an individual,
group or organization to determine how a resource
is used.
◦ If I have ownership rights over the air 1 km above my house,
then no one can legally pollute it.
◦ I can negotiate with a firm that wishes to pollute that air and
agree a price for the right to do so.
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Property Rights
o Extending property rights is therefore one area
where externalities can be internalized.
o Arrives at efficient solutions.
o Can be extended to include intellectual property rights.
o However, it is a complex task to establish a system of such
property rights and they may be expensive to enforce.
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Control of Positional Arms Races
o An incentive must exist to prevent the investment in
attempts to gain some benefit which is ultimately
mutually offsetting.
◦ Laws against performance enhancing drugs in sport.
◦ External body overseeing any dispute over the social norms.
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Objections to the Economic Analysis of
Pollution
o Some individuals dislike the idea of allowing
companies to purchase the right to pollute.
• These people fail to understand that an economy has limited
ability to eliminate pollution and such elimination would come
at a high opportunity cost.
• “People face trade-offs” and we must decide how much we
would be willing to give up to have no pollution.
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VII. Government Failure
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The Importance of Power
o Government decision-making is often flawed and not
based on perfect information or rational, positive
analysis.
o The benefits accrue to a small number of people, but the
costs are spread across large sections of the population.
o Government failure a situation where political power and
incentives distort decision making so that decisions are
made which conflict with economic efficiency.
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Public Choice Theory
Governments might intervene in markets as a reaction to
public pressure or moral panic spread by news
organizations.
◦ Public choice theory is the analysis of governmental behaviour,
and the behaviour of individuals who interact with government.
◦ Public interest: making decisions based on a principle where the
maximum benefit is gained by the largest number of people at
minimum cost.
◦ Example of road congestion: Government wants people to pay
for roads, but pressure groups against road pricing win the day.
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The Invisible Hand versus Public Interest
Public choice theory looks at are cases where individual self
interest of voters, politicians, lobbyists or civil servants leads to
decisions and the allocation of resources which may not be the
most efficient allocation.
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Voter, Politician and Bureaucrat Incentives
Rational ignorance
◦ A voter tends not to not seek out information to make an informed
choice in elections since they do not see their individual vote as
making any difference.
Politicians will reflect the interests of the local
communities they are seeking to serve.
◦ They want to be re-elected.
Bureaucrat
◦ Civil servants providing advice have power.
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Other Distorting Behaviour
The special-interest effect may lead to minorities gaining
significant benefits, but the cost is borne by the population as a
whole.
Logrolling is a term used to describe vote trading in government.
Rent seeking is where individuals or groups take actions to
redirect resources to generate income (rents) for themselves or
the group.
Public sector inefficiency.
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Other distorting behaviour
Cronyism (returning favours).
Inefficiency in the Tax System
◦ Individuals and companies using of loopholes in the tax
system to avoid paying tax.
◦ Tax avoidance is legal. Tax evasion is illegal and includes the
informal economy.
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Summary
① When one party’s activity affects another party, the effect
is called an externality.
② Negative externalities cause the socially optimal quantity
in a market to be less than the equilibrium quantity.
③ Positive externalities cause the socially optimal quantity
in a market to be greater than the equilibrium quantity.
④ Those affected by externalities can sometimes solve the
problem privately.
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Summary
⑤ Coase theorem states that if people can bargain without
a cost, they can always reach an agreement in which
resources are allocated efficiently.
⑥ When private parties cannot adequately deal with
externalities, then the government steps in.
⑦ The government can either regulate behaviour or
internalize the externality by:
◦ Using Pigovian taxes or by issuing pollution permits,
◦ It might create property rights so that the private parties may be
able to bargain and reach a satisfactory outcome.
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Summary
⑧ Government intervention to correct market failure might be
subject to its own failures.
◦ Minority groups are able to exercise political power to influence
decision making of politicians and bureaucrats to gain benefits which
might be outweighed by the costs imposed on the majority.
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