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