Lecture 10

Market Failure

In a market: Demand characterizes individual consumers behavior

personal (private) evaluation of the outputs 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

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

MB =MC can be a market failure

market failure: the private market produces an outcome that is not best when considered from societys 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

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

Q
6

3. The private market allocates too few resources to the production of the good.

MBS MB

Q
7

4. Internalize by

P
MC

P0 MBS MB Q0 Qs

the socially efficient quantity of output (Qs) is produced consumers pay a lower price since the subsidy is paid via taxation, society pays part of the cost of production because society enjoys some of the 8 benefits.

5. Sometimes the external benefit is so great the product or service is made available for free.

P
MBS MC MB

Q
Qs

Society pays the entire cost because the benefit is so significant. Providing the product or service free maximizes consumption.
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Negative Externality 1. a cost spills over from a consumption or production activity.

2. the private market supply (MC) understates the cost to society (MCS)

Q
10

3. The private market allocates too many resources to the production of the good.

MCS MC

Q
11

4. Internalize by taxing consumption or production

MCS MC

P0 MB Qs Q0

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

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Pricing Pollution Who benefits from pollution?

MBpollution =

Who bears the costs of pollution? MCpollution =

Ppollution

Qpollution

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Ppollution

Qpollution

Conclusions 1. The price (P*) at which MBpollution = MCpollution is the size of the tax needed to internalize the externality. 2. Often, the optimal level of pollution (Q*) is not zero.
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Conclusions 3. In some instances, the optimal level of pollution is zero.

Ppollution

Qpollution
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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

Public Good: products and services that are consumed jointly

Characteristics of public goods 1. Consumption of the good by one party does not reduce the availability to others. 2. No effective way to restrict the benefits to those who directly pay for the good. 3. The market fails because societys benefit (MBS) far exceed the cost of production (MC).

4. The government produces most public goods because i.e., society pays the entire cost because the benefit is so significant.
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Joint consumption means the market demand is the vertically sum of all individuals demand.

D1 = D2

Q
19

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
20

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

D = MB

Q
21

EOP Assignment
1. 2. 3. 4. Explain why the market outcome of MB=MC is an efficient allocation of resources. 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. 6. 7.