Externalities and Market Inefficiencies

1. Externalities and Market Inefficiencies A LOT of content courtesy of http://welkerswikinomics.com/blog/ww-study-guides-3/

2. Externalities and Market Inefficiencies • Recall: Adam Smith’s “invisible hand” of the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society can derive from a market. But market failures can still happen.

3. Market Failure: The market has failed when it results in either an over or an under-allocation of resources towards a particular product. • Examples of markets failing: • · The market has failed because too many cigarettes are being produced and consumed in the world today. • · The market has failed because without state funded public schools, not enough educational institutions would be available for the nation's youth. • · The market has failed because without the government providing an Army, Navy and Air Force, not enough national defense would be provided for the country's citizens. • · The market has failed because too many people have driven SUVs for too long, resulting in greenhouse gasses to concentrate in the earth's atmosphere, contributing to global warming.

4. Sometimes markets fail by... • Not providing ANYof a particular good or service that benefits society, • i.e. national defense, street lights, paved roads, park benches, city parks, etc. • These things are called… Public goods: goods and services that will not be provided by the free market. Government must provide public goods.

5. Sometimes markets fail by... • Not providing ENOUGHof a particular good or service that benefits society, i.e. education, health care, sporting events, scientific research, museums, rail transportation, airports, art, etc. These things are called... • Merit goods: goods and services that are under-provided by the free market. Government may choose to help subsidize or provide merit goods.

6. Sometimes markets fail by... • Providing TOO MUCH of a particular good or service that harms others in society, i.e. tobacco, heroine, child pornogrophy, coal-generated electricity, greenhouse gas-intensive industry, alcohol, etc. These things are called... • Demerit goods: goods and services that are over-provided by the free market. Government is needed to regulate the production and consumption of these goods, either through taxes, direct controls, bans, etc...

7. Market Failure and Externalities... • Positive Externalities: When the production or consumption of a product creates external benefits for a third party not involved in the market transaction, or for society as a whole. • Merit goods create positive externalities of consumption.

8. Negative Externalitites: When the production or consumption of a product places external costs on a third party not involved in the market transaction, or society as a whole. • Demerit goods create negative externalities of consumption or production. • Cause of negative externalities: Over-allocation of resources towards products that have spillover costs associated with either their production or consumption.

9. Where are the Spillover Effects Felts by Society? Consumption: Uncertain? Production: water pollution over-fishing cigarette smoke air pollution body odor drunk driving acid rain fast food global warming nuclear waste

10. EXTERNALITIES AND MARKET INEFFICIENCY • An externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander. • Externalities cause markets to be inefficient, and thus fail to maximize total surplus.

11. EXTERNALITIES AND MARKET INEFFICIENCY • How is the global financial crisis a result of a market failure? • Information Asymmetry: When the consumers or producers of a particular good or service, (or financial asset) make their decisions based on imperfect information.

12. How is the global financial crisis a result of a market failure? • Americans bought homes in growing numbers in the '90s and early 2000s under the assumption that house prices would always rise. Banks made loans to Americans who normally wouldn't qualify for loans under the same assumption. • Banks "bundled" these loans into securities that they sold to investors all over the world, who assumed that the lending banks were correct in their assumption that house prices would continue to rise. • Developers built houses in record numbers based on the assumption that they'd be able to sell them at higher and higher prices. • Supply of houses grew faster than demand, and eventually house prices began to fall.

13. How is the global financial crisis a result of a market failure? • · Borrowers found they could not make their monthly payments because their loans were "adjustable rate“ meaning they required higher payments over time, causing foreclosures to increase and the supply of houses for sale to grow even more, forcing prices down even more. • · Now investors and banks all over the world hold securities made up of bad loans to Americans that were made based on the incorrect assumption that house prices would always rise. With bad assets on their "balance sheets" banks are unable to make new loans to consumers and firms, so spending in the economy has slowed, meaning recession and high unemployment. • Imperfect information about the true value of houses led to an overallocation of the world's financial resources towards the US housing market!

14. What are three goods or services from which you have benefited in the last year that were provided by the free market? Three goods that were not? Public Goods Private goods: ________________ ________________ ________________ ________________ ________________ · ________________ Private goods are: · Rivalrous in consumption: When I purchase and use an iPod, it is not available for another person's purchase and consumption. · Excludable by seller: Apple can keep people who do not pay for an iPod from obtaining its benefits. Only people who are willing to pay for an iPod can enjoy its benefits. Because of their rivalry and excludability, firms in a free market find it profitable to produce and sell private goods.

15. Private goods are: • Rivalrous in consumption: • When I purchase and use an iPod, it is not available for another person's purchase and consumption.

16. Private goods are: • Excludable by seller: • Apple can keep people who do not pay for an iPod from obtaining its benefits. Only people who are willing to pay for an iPod can enjoy its benefits. • Because of their rivalry and excludability, firms in a free market find it profitable to produce and sell private goods.

17. Public Goods are: • Nonrivalrous in Consumption: • One person's consumption of a good does not prevent others from consuming it too.

18. Public Goods are: • Nonexcludable by the Seller: • Once the good comes into existence (it is produced), it is impossible from excluding certain individuals from benefiting from it.

19. Public Goods are: • These characteristics create the free-rider problem. No one will voluntarily pay for a product or service they could just as easily consume without paying for. • Since firms cannot effectively "tap the market demand", they will simply not produce public goods. • Resources are reallocated from private to public use by levying taxes on households and businesses government uses tax revenue to provide the public goods, correcting the market failure.

20. Below are a selection of goods or services you may have "consumed" recently. · Which are "private goods", i.e. rivalrous and excludable? · Which are "public goods", i.e. nonrivalrous and nonexcludable? Purely Private Goods Quasi-Public Purely Public Goods Rivalrous/ExcludableNon-Rivalrous/Non-Excludable Groceries Recreational facilities Radio Park benches Electric power Health care National rail line Elementary schooling National Defense Professional sports events College education Water Police protection Garbage collection Interstate highway facilities

21. EXTERNALITIES AND MARKET INEFFICIENCY • Negative Externalities • Automobile exhaust • Cigarette smoking • Barking dogs (loud pets) • Loud stereos in an apartment building

22. EXTERNALITIES AND MARKET INEFFICIENCY • Positive Externalities • Immunizations • Restored historic buildings • Research into new technologies

23. Negative Externalies

24. Market for ___________ MPC = Marginal PRIVATE COST. This is the cost of Using societies resources To produce this particular Good. IT ONLY INCLUDES The EXPLICIT COSTS associated With producing this good. It does not include ANY external costs or benefits that this good may impose on society. Price Of ___ S*(MPC) Pe MSB= Marginal SOCIAL BENEFIT. The benefit Society receivea from each unit of the good as the price decreases (the benefit is that they get to “enjoy’ more of the good). Society ONLY pays the for the EXPLICIT COSTS of production. The price they pay does not include ANY External cost or benefits this good may impose on society. D*(MSB) QMKT Quantity of ______

25. Market for ___________ Price Of ___ S*(MPC) If this Market is producing NEGATIVE EXTERNATLITIES, This means the PRIVATE MARKET Is producing too much of this good. In order to reduce the market quantity Thereby reducing the availability of this Good that imposes costs on others, the Govt could impose a tax and/or Regulations on the SUPPLIER. The net Effect would be to increase the cost of Producing which would DECREASE supply Pe D*(MSB) QMKT Quantity of ______

26. Market for ___________ Price Of ___ S*(MPC) Assume the Govt. imposes a Tax or regulations that increase The cost of producing by TAX*. At QMKT the supplier will supply that Amount at Pe + TAX* TAX* Pe D*(MSB) QMKT Quantity of ______

27. Market for ___________ S1 = MSC Price Of ___ S*(MPC) The Supply Curve shifts to the LEFT Indicating a DECREASE in supply. TAX* TAX* Pe D*(MSB) QMKT Quantity of ______

28. Market for ___________ S1 = MSC Price Of ___ S*(MPC) NOTICE: The new Supply Curve is Now labeled MSB (Marginal Social Benefit). This means NOW the Decrease in supply results in a DECREASED Market Quanitity---Qsocially Optimal (Qs.o.) Ps.o. TAX* TAX* Pe D*(MSB) Qs.o. QMKT Quantity of ______

29. Market for ___________ S1 = MSC Price Of ___ S*(MPC) Marginal SOCIAL BENEFIT---means that there is LESS of this good that causes a negative externality. This new market quantity eliminates some (or all) of the good that imposed costs on 3rd parties by making the existing demanders pay a higher price for the good. MSB ≥ MSC Ps.o. Pe D*(MSB) Qs.o. QMKT Quantity of ______

30. Market for ___________ S1 = MSC Price Of ___ S*(MPC) This is gong to result in some loss of Consumer Surplus AND Producer Surplus. The net result will be a Dead Weight Loss of A + B Ps.o. A B Pe D*(MSB) Qs.o. QMKT Quantity of ______

31. POSITIVE Externalies

32. Market for ___________ Price Of ___ S*(MSC) Pe D*(MPB) QMKT Quantity of ______ Now let’s assume that this good provides a POSITIVE EXTERNALITY. This means that the Market is NOTproducing enough of this good. QMKT is too small. Government deems that we should have MORE of this good. The Government will provide a SUBSIDY to the supplier of this good.

33. Market for ___________ Price Of ___ S*(MPC) This Subsidy will REDUCE the cost Of production. The supply curve Will shift to the RIGHT representing An INCREASE in supply Pe D*(MPB) QMKT Quantity of ______ The cost of producing will DECREASE by the amount of the SUBSIDY---SUB*. At QMKT the supplier will supply that Amount at Pe – SUB*

34. Market for ___________ Price Of ___ S*(MPC) S1 (MSB) The Market now produces Qs.o. which is MORE than QMKT. The new Supply Curve, S1, NOW Represents the Marginal Social Benefitthat society gains from the Subsidy (Qs.o. – QMKT) Pe Psub D*(MPB) QMKT Qs.o. Quantity of ______

35. KEY POINT!! • In the case of a NEGATIVE EXTERNALITY, the govt. could INCREASE taxes on the DEMAND side. This would DECREASE DEMAND which would lower the market price AND lower the market quantity • In the case of a POSITIVE EXTERNALITY, the govt could provide the SUBSIDY to the DEMANDER which would INCREASE the market price AND increase market quanitity. • Regardless of who is taxed or subsidized, the goal is to either INCREASE the market quantity in the case of a POSITIVE EXTERNALITY, or DECREASE the market quantity in the case of a NEGATIVE EXTERNALITY.

36. PRIVATE SOLUTIONS TO EXTERNALITIES • Moral codes and social sanctions • Charitable organizations • Integrating different types of businesses • Contracting between parties

37. 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. • Transactions Costs • Transaction costs are the costs that parties incur in the process of agreeing to and following through on a bargain.

38. Why Private Solutions Do Not Always Work • Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible.

39. PUBLIC POLICY TOWARD EXTERNALITIES • When externalities are significant and private solutions are not found, government may attempt to solve the problem through . . . • command-and-control policies. • market-based policies.

40. PUBLIC POLICY TOWARD EXTERNALITIES • Command-and-Control Policies • Usually take the form of regulations: • Forbid certain behaviors. • Require certain behaviors. • Examples: • Requirements that all students be immunized. • Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA).

41. PUBLIC POLICY TOWARD EXTERNALITIES • Market-Based Policies • Government uses taxes and subsidies to align private incentives with social efficiency. • Pigovian taxes are taxes enacted to correct the effects of a negative externality.

42. PUBLIC POLICY TOWARD EXTERNALITIES • Examples of Regulation versus Pigovian Tax • If the EPA decides it wants to reduce the amount of pollution coming from a specific plant. The EPA 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).

43. PUBLIC POLICY TOWARD EXTERNALITIES • Market-Based Policies • Tradable pollution permitsallow thevoluntary 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.