Market Failure Solutions A review of various approaches to address imperfections of the free market system

Market Failure Market Failure SolutionsSolutionsA review of various A review of various

approaches to address approaches to address imperfections of the free imperfections of the free

market systemmarket system

ObjectivesObjectives

The learner will be able to:The learner will be able to:

1.1. List the different approaches List the different approaches available to address externalities.available to address externalities.

2.2. Define the Coase Theorem.Define the Coase Theorem.

3.3. Explain the efficiency challenge of Explain the efficiency challenge of direct control policies.direct control policies.

4.4. Identify, explain and provide Identify, explain and provide examples of market based solutions.examples of market based solutions.

The IssueThe Issue

Demerit goods are goods that generate Demerit goods are goods that generate negative externalities – costs not borne negative externalities – costs not borne by the producer or provider of a by the producer or provider of a product or service.product or service.

All costs to society are not factored into All costs to society are not factored into the output decisionthe output decision

Leads to overallocation of resources Leads to overallocation of resources and excess production.and excess production.

How can we move the allocation of How can we move the allocation of resources closer to the social optimum?resources closer to the social optimum?

Possible RemediesPossible Remedies

1.1. Private solutionsPrivate solutions

2.2. Direct controls (regulation)Direct controls (regulation)

3.3. Market based policiesMarket based policies

Private SolutionsPrivate Solutions

Social sanctions and moral codeSocial sanctions and moral code Generally accepted sense of what is right Generally accepted sense of what is right

or proper behavior within a given societyor proper behavior within a given society Individual sense of right and wrong is a Individual sense of right and wrong is a

way of internalizing negative social way of internalizing negative social externalitiesexternalities

Examples:Examples: Playing loud musicPlaying loud music LitteringLittering

CharitiesCharities

Non-profit organizations and charities Non-profit organizations and charities are often established to deal with are often established to deal with positive and negative externalities.positive and negative externalities.

Examples:Examples: Sierra Club and other environmental Sierra Club and other environmental

groupsgroups Colleges and universitiesColleges and universities United WayUnited Way Local : Arts & Science CampaignLocal : Arts & Science Campaign

Direct Private Direct Private NegotiationNegotiation

Belief that if private parties can bargain Belief that if private parties can bargain without cost over the allocation of without cost over the allocation of resources, they should be able to solve resources, they should be able to solve the problem of externalities on their the problem of externalities on their own.own.

This is known as the Coase TheoremThis is known as the Coase Theorem People impacted should be able to reach People impacted should be able to reach

an agreement based on the value of the an agreement based on the value of the benefit or harm borne by each party.benefit or harm borne by each party.

A simple example … A simple example …

Coase Theorem (Cont’d)Coase Theorem (Cont’d) In the real world, this sort of bargaining In the real world, this sort of bargaining

does not always work – Why?does not always work – Why? Transaction costsTransaction costs Transaction costs usually = legal costsTransaction costs usually = legal costs Local ordinances and property rights often Local ordinances and property rights often

make the issue more about legal claims make the issue more about legal claims versus theoretical value of harm or benefit. versus theoretical value of harm or benefit.

Rarely as simple as a one on one negotiation Rarely as simple as a one on one negotiation (although class action lawsuits can reduce (although class action lawsuits can reduce the number of players involved)the number of players involved)

Direct ControlsDirect Controls

Otherwise known as “command and Otherwise known as “command and control” policiescontrol” policies

Governments can prohibit or restrict Governments can prohibit or restrict certain actions, or mandate certain certain actions, or mandate certain actions (i.e. use of technology)actions (i.e. use of technology)

Often difficult or impossible to impose Often difficult or impossible to impose an outright ban (consider pollution)an outright ban (consider pollution)

Society must weight the costs and Society must weight the costs and benefits of these restrictionsbenefits of these restrictions

Direct Controls (Cont’d)Direct Controls (Cont’d)

Direct controls can be very effective, Direct controls can be very effective, especially in the case of limiting or especially in the case of limiting or eliminating actions that are deemed eliminating actions that are deemed extremely costly (or dangerous) to extremely costly (or dangerous) to society.society.

But are these command and control But are these command and control policies efficient?policies efficient?

Is there a more efficient way to Is there a more efficient way to achieve the same (or better) results?achieve the same (or better) results?

Market Based SolutionsMarket Based Solutions

Remember, the basic problem with Remember, the basic problem with demerit goods is that full costs to demerit goods is that full costs to society are not factored into the society are not factored into the output decision.output decision.MSC

MPC

MPB

Market Based SolutionsMarket Based Solutions

Instead of directly regulating Instead of directly regulating behavior, governments can use behavior, governments can use market based policies to more market based policies to more closely align private incentives with closely align private incentives with social objectives.social objectives.

Two basic approaches:Two basic approaches:1.1. Corrective taxes and subsidiesCorrective taxes and subsidies

2.2. Tradeable Pollution permitsTradeable Pollution permits

Corrective Corrective Taxes/SubsidiesTaxes/Subsidies

Tax activities with negative externalitiesTax activities with negative externalities Known as a Pigovian TaxKnown as a Pigovian Tax Ideal tax would equal the external cost to Ideal tax would equal the external cost to

society from an activitysociety from an activity Subsidize activities with positive Subsidize activities with positive

externalitiesexternalities Ideal subsidy would equal the external Ideal subsidy would equal the external

benefit from an activitybenefit from an activity Both of these policies would narrow the Both of these policies would narrow the

spillover gap from externalitiesspillover gap from externalities

A Graphical LookA Graphical Look

MSC

MPC1

MPB

Qp1Qp2Qs

MPC2

Pigovian TaxesPigovian Taxes

Economists prefer taxes over regulation as Economists prefer taxes over regulation as remedies for negative externalities – Why?remedies for negative externalities – Why?

Regulations require everyone to behave Regulations require everyone to behave the same (reduce pollution by the same the same (reduce pollution by the same amount), regardless of their cost amount), regardless of their cost structure.structure.

Corrective taxes place a price on the right Corrective taxes place a price on the right to pollute and allow producers to to pollute and allow producers to efficiently factor this cost into their output efficiently factor this cost into their output decisions.decisions.

Pigovian Taxes (Cont’d)Pigovian Taxes (Cont’d)

Without diving deeply into taxation Without diving deeply into taxation policy ...policy ...

Note that the impact of a corrective tax is Note that the impact of a corrective tax is to move the allocation of resources closer to move the allocation of resources closer to the social optimum point.to the social optimum point.

This makes Pigovian Taxes (which deal This makes Pigovian Taxes (which deal with externalities) very different from with externalities) very different from “normal” taxes, which have a net negative “normal” taxes, which have a net negative economic impact – otherwise known as a economic impact – otherwise known as a deadweight loss.deadweight loss.

Tradeable Pollution Tradeable Pollution PermitsPermits

This approach starts with the This approach starts with the creation of a new scarce resource – creation of a new scarce resource – pollution permits (rights to pollute)pollution permits (rights to pollute)

If these rights are transferable a If these rights are transferable a market will developmarket will develop

The forces of supply and demand The forces of supply and demand will determine the pricing and will determine the pricing and allocation of these permitsallocation of these permits


By definition, these permits will be owned By definition, these permits will be owned (acquired) by firms that value these permits (acquired) by firms that value these permits most highly – based on their willingness to most highly – based on their willingness to paypay

Willingness to pay will be determined by a Willingness to pay will be determined by a firm’s cost of reducing pollutionfirm’s cost of reducing pollution

Result is an efficient allocation of permits Result is an efficient allocation of permits among firms based on their cost of reducing among firms based on their cost of reducing pollutionpollution

Also provides a market incentive to reduce Also provides a market incentive to reduce pollution below “target” levelspollution below “target” levels


So, could this market based system So, could this market based system actually work in practice?actually work in practice?

A few real world examples:A few real world examples:1.1. Acid Rain Program (SOAcid Rain Program (SO22))

2.2. Northeastern NOx marketNortheastern NOx market

3.3. EU Carbon Trading SchemeEU Carbon Trading Scheme


What are some of the objections to these What are some of the objections to these programs?programs?

Philosophical problem with “licenses to Philosophical problem with “licenses to pollute”pollute”

Standards based approaches tend to hide Standards based approaches tend to hide the costs of pollution control, versus market the costs of pollution control, versus market based systems which make the costs explicitbased systems which make the costs explicit

The political process is dominated by The political process is dominated by lawyers – and lawyers prefer legal solutionslawyers – and lawyers prefer legal solutions

Direct controls appear more certainDirect controls appear more certain

A Market Based Approach A Market Based Approach to a Different Problemto a Different Problem

Read the article “Stockholm’s Read the article “Stockholm’s Syndrome”Syndrome”

1.1. What are the externalities that are What are the externalities that are being addressed?being addressed?

2.2. What new “markets” are being created?What new “markets” are being created?

3.3. How do you expect driver “buying” How do you expect driver “buying” patterns will change?patterns will change?

4.4. Do you think this new system will be Do you think this new system will be effective?effective?

Documents

Market Failure Solutions A review of various approaches to address imperfections of the free market system