Externalities, solutions and other market failure

Todays presentation
What is market failure?

Externalities

Solutions

Other kinds of market failure

What is market failure?

This definition comes up regularly!

It pays to define this term whenever it appears in the

question (just like other definitions)

Externalities

What they
are

Solutions

Things
you need
to know
What
makes
them
large/small

Positive
and
negative

The
diagrams

What are externalities?

Positive externalities

Negative externalities

The costs or benefit

received by a third party
to an economic
transaction outside of the
market mechanism; i.e.

the spillover effects of an

economic activity.

What things go in externality diagrams?

MSC, MPC, MSB,

MPB

Private =

DWL

Social optimum

Under/overproduction

Externality 1: a negative externality

Price

MSC
Deadweight welfare loss

MPC

1. MSC, MPC, MSB, MPB

2. Private =

Social optimum

P2

3. Social optimum
Private equilibrium

P1

4. DWL
5. Under/overproduction

Overproduction

Q2

Q1

MPB = MSB
Quantity

Price

Externality 1: a positive externality

Deadweight welfare loss

MPC = MSC
1. MSC, MPC, MSB, MPB
2. Private =

Social optimum

P2

3. Social optimum
4. DWL

P1
Private equilibrium

5. Under/overproduction
MSB
Underproduction

Q1

MPB
Q2

Quantity

How big is the externality?

Ways to think
about size of
externality eval
Short run vs
long run
Long run impact
may be greater
since

Ceteris
paribus?
Government
intervention?
New tech?

Magnitude of
impact link to
data
UK is very
reliant on GM
since

Do some
external benefits
outweigh costs?
External benefits
in improved
health

Category

Types

Cost/ revenue to
government?
Government
failure?

Are solutions
good/ bad?

Effectiveness and
enforcement?
Impact on firms and
UK economy

Fairness?

Solution 1: taxation
A pigouvian tax is set to shift the MPC
curve towards the MSC curve
In theory the level of the tax per unit
should be exactly equal to the marginal
external cost
This internalises the externality

Example

Diagram
Price

Explanation

Original
Reduced DWL
DWL

MSC MPC TAX

Unit
tax

MPC

Social
P2 optimum
P3
P1

Private equilibrium

Overproduction

Q2Q3

MPB =
MSB
Q1

Quantity

Are solutions
good/ bad?

Cost/ revenue to
government?

Governments
make revenue
from taxes

Government failure?

Information
problem

Effectiveness and
enforcement?

Risk of
smuggling and
black markets

Impact on firms and UK

economy

International
competitiveness

Fairness?

Producer pays!

Solution 2: extending property rights

Through the extension of property rights
companies and consumers are able to seek
compensation from companies and individuals
which pollute.
This raises costs for firms
This is a means by which the problem of the
externality is internalised, and so eliminating
the problem by bringing it back into the market
mechanism.

Example

Diagram
Price

Explanation

Original
Reduced DWL
DWL

MSC MPC 2
Unit
tax

MPC

Social
P2 optimum
P3
P1

Private equilibrium

Extended property ownership over

bodies of water, or even the air above
your house
Overproduction

Q2Q3

MPB =
MSB
Q1

Quantity

Are solutions good/

bad?

Cost/ revenue to government?

Very low (ignoring court costs)

Government failure?

Lack of financial support for the

scheme?

Effectiveness and
enforcement?

1) Information problem
2) Other countries?

Impact on firms and UK

economy

International competitiveness

Fairness?

1) Costs to seek claim. Favours

the rich
2) BUT those harmed get the
compensation.

Solution 3: regulation
Explanation

Example

Minimum standards can be put Examples include:

in place that force firms to only
1. Setting minimum standards for
pollute below a certain amount
health and safety at the workplace

This solution is very simply it 2. Penalties for firms who pollute too
much
simple caps the amount of
pollution the firm can produce
3. Banning cigarette advertising and
making workplaces no-smoking
environments

Are solutions good/

bad?

Cost/ revenue to government?

High supervision and

enforcement costs

Government failure?

1) Information problem
2) Risk of regulatory capture and
weak regulators

Effectiveness and
enforcement?

Possibility of evading regulation

Impact on firms and UK economy

Impact of red tape and

bureaucracy on costs
Inefficient distribution

Fairness?

Does not necessarily raise costs for

polluter or compensate consumer

Solution 4: tradable permits

Explanation

The regulation solution was

inefficient as it did not distribute
the costs of reducing
emissions well
Tradable permits try and do this
A firm that finds it difficult to cut
down emissions can buy from a
firm that finds it much easier.
That way the reduction in
pollution is done at minimum cost

Tonnes
of
Carbon

Firm A cost to
remove

Firm B cost to
remove

12,500

17,000

12,000

16,000

11,500

15,000

11,000

14,000

10,500

13,000

10,000

12,000

9,500

11,050

9,000

10,000

8,500

9,000

10

8,000

8,000

Are solutions
good/ bad?

Cost/ revenue to
government?

High supervision and

enforcement costs

Government failure?

Number of permits

Effectiveness and
enforcement?

Possibility of evading
regulation

Impact on firms and

UK economy

Possibility of monopoly
power

Fairness?

How to fairly distribute

permits? Given away?

Solving positive externalities 1: subsidies

A pigouvian tax is set to shift the MPC
curve towards the MSC curve
In theory the level of the tax per unit
should be exactly equal to the marginal
external cost

Diagram
Price

Explanation

Original DWL
Reduced
DWL

MPC=MSC
Unit
subsidy

MPC 2
P2

SO

This internalises the externality

Example

PE
P1
P3

MSB
Underproduction

Q1 Q3 Q2

MPB
Quantity

Are solutions
good/ bad?

Cost/ revenue to
government?

High cost

Government
failure?

Political self-interest
too large?

Effectiveness and
enforcement?

Is the subsidy well

targeted and used?

Impact on firms and

UK economy

Create inefficiency?

Fairness?

Consumers benefit
from lower prices

Solving positive externalities 2 direct

provision
Explanation

In some cases governments

chose to directly provide the
goods themselves

Example

Examples include:
1. Provision of healthcare

This is more often used in

cases such as public goods, but 2. Provision of education
can also be used for
externalities (especially positive 3. In the case of public
ones)
goods, street lighting and

national defence

Are solutions
good/ bad?

Cost/ revenue to
government?

High cost will often require

increased taxes

Government failure?

Problems of self-interest and

myopia

Effectiveness and
enforcement?

Lack of efficiency in the

public sector
Potential over-consumption

Impact on firms and UK

economy

Reduce size of private sector

- potential SS impact

Fairness?

Equitable distribution

Other market failure

Unstable prices

Causes
Inelastic supply

Inelastic
demand

Regular and
unpredictable
supply/demand
shocks

Price

S1

P2

BIG
Change
In
Price
P1

D
Q2 Q1

Quantity

Problems
Sudden loss of revenue and profit

Inefficiency hard to know what to grow

Firms
Unpredictability leading to under-investment

Good firms can go bankrupt

Problems for

Lack of security

Consumers

Inability to plan effectively

Potential impact on inflation

Buffer stock schemes

Price

In good years
S
Spending on scheme

Ptarget

P1

D
Q2

Q1

Q3

Quantity

In bad years
Price

Ptarget

P1

D
Profit from scheme
Q2

Q1

Q3

Quantity

Will they work?

Can the good
be stored?
Is successful
cooperation
likely?

Is the scheme
open to
government
failure?

Can the costs

of storage be
paid?

Will it
work?

Is there
enough
finance for
the scheme?

Public goods

Evaluating public goods

Non-rival?
Parks

Nonexcludable?
Non-rival?

TV signals

Music
downloads

Nonexcludable?

Non-rival?
Nonexcludable?

Other areas to look at