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Efficiency and Non-Market Forces
• Going ga-ga about markets– Review of Market Efficiency
• Government’s Role in Economic Efficiency– Provides infrastructure for economic activity
• Market Failures– 4 reasons markets break down / do not exist
• Public Goods– What are they? How best to manage them?
Revisiting Some Economic Concepts
• Value of Free Markets (bidding mechanism)– Maximize (total social benefit - cost)
• Pareto Efficient– Competition drives societies to PPF– Pareto Improvements
• Sharing the Economic Pie– Efficiency, Growth, Better Living Standards
• Markets work under some assumptions
The Government: not there just to take your money!
• Physical Infrastructure– Networks, Lifelines
• Institutional Infrastructure– Legal System– Regulation
• Security– Internal; External; Preserves conditions for trade.
• Taxation– Pays for public goods; helps redistribute econ growth– Can increase efficiency & help create markets
Legal System
• Criminal
• Property
• Contract
• Tort
• Antitrust Law– Price fixing; Monopoly; Mergers
Reasons for Market Failure
Why do markets fail in general?• Economic: Wealth Effect /Market Power• Externalities
– Negative – Positive
• Public Goods and Common Property Resources• Asymmetric Information
– Adverse selection (market for lemons)– Moral Hazard (risk insurance problem)
Unintended costs or benefits that are imposed on unsuspecting people and that result from the economic activity of others
– Subsidize the production of an environmentally friendly good making it less expensive
Externality
Price per Gallon
Gasoline (Gallons)
1.00 A
S
Qineff
D
Qeff
MSC = S + tax
B1.30
0.80
$1.50
Negative Externality – graph
Price
Number of Bachelor’s
Degrees
50,000A
S
Q
D
MSB = D + SubsidyB
$65,000
Positive Externality - graph
A market left on its own will not address the problem of negative externalities
What is Market Failure
Some Environmental Terms related to Market Failure
• Social Cost– This cost includes both the private costs of production
and the externalities cost generated by its production
• Free Rider– Someone who consumes a good or service without
paying for it
• Property Rights– The right to own a good or service and the right to
receive the benefits of the goods or service
• Goods whose benefits are not diminished even when additional people consume it and no one is excluded from its benefits– Roads– National defense– Lighthouse
Public Goods
Private / Mixed / Pure Public Goods
Can limit target market. Cannot prevent anyone from consuming it.
Non ExcludableExcludable
Private / Mixed / Pure Public Goods
One’s consumption
deprives another
Benefits of joint consumption
Rival
Non Rival
Private / Mixed / Pure Public Goods
Private Good
Hot Dogs, Cars,
Houses
Mixed Good
Fishing lakes,
Grazing lands
Mixed Good
Freeway, Bridge
City Parks
Pure Public Good
Defense
Public Radio / TV
Non ExcludableExcludable
Rival
Non Rival
• The failure of the government to buy the quantity of public goods that generates maximum efficiency
Government Failure
Solutions to the Externality Problem
• Command & Control• Export (NIMBY)• Convert to private goods (property rights)
– Create new property forms• Internalize the cost
– Impose penalty taxes– Enforce standards
• Modern market based measures– Quantity: quotas / permits– Price: taxes
Examples of Environmental Solutions
• New Property Form– Giving legal title to a public beach
• Pollution Tax– A tax of 5 cents per kilowatt-hour levied on a
firm using coal to generate electricity
• Standard– Mandate the use of scrubbers in smokestacks
Some Cool Environmental Buzzwords!
• Market Failure• Externality• Negative Externality• Socially Optimal
Output• Positive Externality• Internalizing
Externalities• Transaction Costs• Coase Theorem
• Public Good• Rivalry in
Consumption• Nonexcludability• Excludability• Free Rider• Asymmetric
Information• Adverse Selection• Moral Hazard
for
the real nerds
ADDITIONAL MATERIAL
Negative ExternalityNegative
Externality
a
Price and Cost
Quantity0 Q1Q2
S2 = MSC = (MPC + external costs)
D
S1 = MPC
E1
E
External Costs(linked to negativeexternality)
Representative ofMarket Failure
Socially OptimalOutput
MarketOutput
The TriangleThe Triangle
a
Price and Cost
Quantity0 Q1Q2
S2 = MSC
D
S1 = MPC
TheTriangle
SociallyOptimalOutput
MarketOutput
P,C
Q0 Q1Q2
S2 = MSC
D
S1 = MPC
Window - 1 Benefits ofmoving from Q2 to Q1
P,C
Q0 Q1Q2
S2 = MSC
D
S1 = MPC
Window 2 - Costs ofmoving from Q2 to Q1
a
PriceandCost
Quantity0 Q1
S
D1 = MPB
Representative ofMarket Failure
Socially Optimal OutputMarketOutput
Q2
E1
E2
D2 = MSB = (MPB +external benefits)
Positive Externality
Positive Externality
a
Price and Cost
Quantity0 Q1Q2
S2 = MSC
D
S1 = MPC
External Costs
SociallyOptimalOutput
MarketOutput
Q3
Output that resultsbecause of government-imposed corrective tax
S3 = MPC + Tax
A Corrective Tax Gone
Wrong
A Corrective Tax Gone
Wrong
Cost of Reducing Pollution - 3 Firms example
Cost of Reducing Pollution - 3 Firms example
a
Cost of Eliminating:
First unit of pollution
Second unit of pollution
Third unit of pollution
$ 50
75
100
$ 70
85
200
$ 500
1,000
2,000
Firm X Firm Y Firm Z
Asymmetric Information in a Product MarketAsymmetric Information in a Product Market
S1 = MPC
E1
E2
0 Q2 Q1 Quantity
D2 = MPB2 (symmetric info.)
D1 = MPB1 (asymmetric info.)
Price andCost
Output withSymmetric info.
Output withAsymmetric Info.
Asymmetric Information in a Factor MarketAsymmetric Information in a Factor Market
S1= MPC1 (asymmetric info.)
E1
E2
0 Q2 Q1 Quantity of Labor
D1 = MPB
Wage Rate
Quantity of Laborwith Symmetric info.
Quantity of Laborwith Asymmetric Info.
Wage withSymmetric info.
Wage withAsymmetric Info.
S2= MPC2 (symmetric info.)
W2
W1