YEW CHUNG INTERNATIONAL SCHOOL HONK KONG

YEAR 12 ECONOMICS 2014 – 2015 STANDARD LEVELTOPIC 1.4 MARKET FAILURE

THE MEANING OF MARKET FAILURE

TYPES OF MARKET FAILURE:

- THE MEANING OF EXTERNALITIES

- NEGATIVE EXTERNALITIES OF PRODUCTION AND CONSUMPTION

- POSITIVE EXTERNALITIES OF PRODUCTION AND CONSUMPTION

- LACK OF PUBLIC GOODS

- COMMON ACCESS RESOURCES AND THE THREAT TO

SUSTAINABILITY

TOPIC ONE PART 1.4: MARKET FAILURE

1. Explain market failure in terms of- economic efficiency (allocative efficiency)- technical efficiency (technical efficiency)

2. Explain market failure in terms of• Positive and negative externalities, with appropriate diagrams• Short-term and long-term environmental concerns, with reference to sustainable development• Lack of public goods• Under-provision of merit goods• Over-provision of demerit goods• Abuse of monopoly power

3. Explain possible government responses to market failure in terms of• Legislation• Direct provision of merit and public goods• Taxation• Subsidies• Tradable permits• Extension of property rights• Advertising to encourage or discourage consumption• International cooperation among governments

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THE MEANING OF MARKET FAILURE:

Analyse the concept of market failure as a failure of the market to achieve allocative efficiency, resulting in an over or under allocation of resources (i.e. an over or under provision of a good).

Market Forces

Definition: Market forces are the forces of demand and supply that interact to determine the market equilibrium price and quantity.In a perfectly competitive market there exists:

- consumer sovereignty- perfect information- perfect mobility of resources- no exogenous forces.

Consumer sovereignty

This is the principle that consumers are free to make their own decisions about which goods and services best satisfy their needs and wants. Consumers’ choices determine what is produced as consumer choice will impact on market forces which affect market price. Producers will respond to price signals, allocating resources to the production of goods and services which are relatively mor4e profitable, i.e. which consumers desire.PRIVATE PREFERENCES:Private preferences efers to what goods/services consumers want. They do not take into account social benefits and costs, i.e. externalities

Perfect information

This is the idea that all producers and consumers have total knowledge about the market which enables them to make sensible decisions about the use of resources or purchases. In reality this does not happen, e.g. a consumer may be unaware of the pollutants discharged in the production of bleached paper tissues.

Perfect mobility

This is the idea that resources, regardless of geographical or occupational location, are free to move (be allocated) to the production where they are most efficiently used. In reality this does not happen, e.g. not all workers can relocate to places offering employment.

Exogenous force

These are forces OUTSIDE the market (buyers and sellers) that affect market price and/or market quantity, e.g. government intervening in the market

Allocative (economic) efficiency

Definitions:1. The output combination where it is not possible to make someone better off without making

someone else worse off.2. The output combination consumers desire produced at the lowest possible cost (as shown on a

production possibility curve).3. The combination of goods and services which maximises society’s well being.Allocative efficiency in the market for a single, private good occurs at equilibrium, i.e. where the sum of the producer and consumer surpluses is maximised. N.B. ‘produced at the lowest possible cost’ means it is productively efficient: all available resources are being fully utilised, given the current state of technology.

Market failure Definition: Market failure occurs when the conditions for the market system to work perfectly are

not met so the price system will NOT achieve allocative (economic) efficiency: more (or less) is sold at a lower (or higher) price than is allocatively efficient/ socially desirable.Resources are being allocated inefficiently: they are either over or under allocated by the private market.With market failure there is a loss of net welfare, i.e. a dead weight loss at private market equilibrium.Market failure arises with: Externalities Merit and demerit goods (under-provision of Merit goods; over-provision of Demerit goods)

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Public goods (lack of provision of public goods)TYPES OF MARKET FAILURE:- THE MEANING OF EXTERNALITIES- NEGATIVE EXTERNALITIES OF PRODUCTION AND CONSUMPTION- POSITIVE EXTERNALITIES OF PRODUCTION AND CONSUMPTION- LACK OF PUBLIC GOODS- COMMON ACCESS RESOURCES AND THE THREAT TO SUSTAINABILITY

Marginal private benefit [MPB or MB]

Definition: This is the extra benefit to the individual consumer of consuming one extra unit of a good.It is the change in total benefit when another unit of a good is consumed.

Marginal private benefit relates to private preferences for individual consumers.

MARGINAL SOCIAL BENEFIT [MSB]

Explain the concepts of marginal private benefits (MPB); marginal social benefits (MSB)

Definition: This is the private benefit to the individual PLUS the spill-over benefit to third parties (people who are not part of the action) of consuming one extra unit.

MSB = MPB + (positive/negative externality of consumption) to society

MPB/ MSB $ Positive externality of consumption MPB MSB

Negative externality of consumption MSB

QuantityThis graph shows that if there are externalities of consumption the MB curve will shift. For positive externalities of consumption the MB curve shifts to the right: For negative externalities of consumption the MB curve shifts to the left.MSB = MPB + externality per unit

Marginal private cost [MPC or MC]

Definition: This is the marginal (extra) costs of production to firms of producing one extra unit.It is the change in firms’ total cost when another unit of a good is produced.

MARGINAL SOCIAL COST [MSC]

Explain the concepts of marginal private costs (MPC) and marginal social costs (MSC)

Definition: This is the marginal costs of production PLUS spillover costs to third parties (society) of producing one extra unit.

MSC = MPC + (positive/negative externality of production) to society

MPC/ MSC $ Positive externality of production MPC MSC Negative externality of production MPC MSC

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DESCRIBE THE MEANING OF EXTERNALITIES AS A FAILURE OF THE MARKET TO ACHIEVE THE SOCIAL OPTIMUM WHERE MSB = MSC.

Quantity

This graph shows that if there are externalities of production the MC curve will shift. For positive externalities of production the MC curve shifts to the right: For negative externalities of production the MC curve shifts to the left.MSC = MPC + externality per unit

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Social OptimumMSB = MSC

Describe the menaing of externalities as the failure of the market to achieve the social optimum where MSB = MSC

Definition: This is the socially optimum market situation that takes into account the social benefits and costs to society so that MSB = MSC. The market reflects the socially desirable price and quantity.

The above graphs show that at the private equilibrium (where MPC = MPB) the price is PP

and the quantity QP. If there is a positive externality, e.g. of consumption, society will want us to consume more (QS) at a lower price (PS). If the externality is negative society will want us to consume less (QS) at a higher price (PS).

Net Welfare Loss

Definitions: This is a loss in net welfare/allocative efficiency resulting from operating at the free market

(private) equilibrium rather than the social equilibrium.

MARKET FAILURE:NEGATIVE EXTERNALITIES OF PRODUCTION AND CONSUMPTIONi. Examplesii.Diagramsiii. Welfare lossiv. Demerit goodsv. Evaluate policy responses to the problem of negative externalities.

EXTERNALITY

= SPILLOVER EFFECT

= UNINTENDED SIDE EFFECT

Definition: This is an unintended side effect that results from production or consumption of a good, affecting some party other than the consumer and/or producer of that good.They can be- positive (beneficial effect to the unintended party) or - negative (harmful effect to the unintended party).

They can arise from- Consumption- Production

The free market does not take into account externalities so where there are externalities the free market will not achieve allocative efficiency, i.e. will not achieve the socially desirable price and quantity, economic efficiency. There will be market failure.

(Too much/little of a good will be produced/consumed at a higher/lower price than is socially desirable. Resources are either under or over allocated by the private market.

Internalising an externality

Definition: This involves a government action to achieve the socially desirable equilibrium. When externalities are internalised the market reflects the SOCIAL PREFERENCES, i.e. the SOCIAL BENEFITS and SOCIAL COSTS of production and/or consumption.Government intervenes in the free market to internalise externalitiesby:either - making those responsible for creating negative externalities responsible for the costs

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or - compensating those responsible for creating positive external benefits.

Government can do this through:- indirect taxes- establishing property rights- subsidies- regulation (laws)- public provision- publicity statements, campaigns (e.g. press releases; speeches)

NEGATIVE EXTERNALITY OF PRODUCTION

Explain, using diagrams and examples, the concepts of negative externalities of production, and the welfare loss associated with the production of the good/service

Definition: This is an unintended negative/harmful side effect to others/society that occurs due to production by a firm.These are also called – Spill-over costs or Social costs or External costs of production Examples: climate change brought about by the emission of green house gases from production damage to health caused by air pollution from factories Soil depletion and erosion caused by deforestation Species extinction due to over fishing by commercial fishing firmsThe free (private MPB=MPC) market will not achieve allocative efficiency. In the free market more of these goods will be produced at a lower price than is socially desirable.The Marginal Social Cost (MSC) curve is to the left of the MarginalPrivate Cost curve (MPC).The vertical distance between the MSC and the MPC is equal to theexternality per unit. Market:

Private price = Pp Private quantity = QpSocially desirable price = Ps Socially desirable quantity = Qs = pareto quantityNegative externality per unit = vertical distance between MPC and MSCLoss of welfare benefit (dead-weight loss) in the private market= area shaded(The private market is not allocatively efficient)This graph shows that with a negative externality of production the MSC at each unit of output is more than the MPC. The private market does not reflect the negative externality. The MSC is to the left of the MPC. The socially desirable price Ps is higher than the private price Pp. At the social equilibrium less is produced (Qp moves to Qs) at a higher price.

NEGATIVE EXTERNALITY OF

Definition: This is a harmful side effect to others/society that occurs due to consumption by an individual.These are also called – Spillover benefits or Social benefits of consumption -

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CONSUMPTION

Explain, using diagrams and examples, the concepts of negative externalities of consumption, and the welfare loss associated with the consumption of the good/service

Examples: Health problems caused by the inhaling of second-hand cigarette smoke Traffic congestion at peak hour caused by people driving their private vehicles to work Injury and deaths caused by driving too fast and dangerouslyThe free market (private market MPC=MPB)will not achieve allocative efficiency. In the free market more of these goods will be consumed at a lower price than is socially desirable, i.e. resources will be over allocated.The Marginal Social Benefit (MSB) curve is to the left of the Marginal Private Benefit curve(MPB). The vertical distance between the MSB and the MPB is equal to theexternality per unit. Market:

Private price = Private quantity = Socially desirable price = Socially desirable quantity = Negative externality per unit = = pareto quantityLoss of welfare benefit (dead-weight loss) in the private market= (The private market is not allocatively efficient)This graph shows that with a negative externality of consumption the MSB at each unit of output is less than the MPB. The MSB is to the left of the MPB. The socially desirable price Ps is higher than the private price Pp. At the social equilibrium less is produced (Qp moves to Qs) at a higher price.

DEMERIT GOOD

Explain that demerit goods are goods whose consumption creates external costs (i.e. a negative externality of consumption )

Definition: This is good that society/ government considers harmful for us to consume and will discourage the consumption of this good. Demerit goods usually have negative externalities of consumption.Examples: Smoking (consuming) cigarettes Dangerous weapons, e.g. pistols; automatic guns ‘Hard’ drugs e.g. cocaine Fast and dangerous driving; drunk drivingDemerit goods are likely to be OVER-PROVIDED by the free market system, i.e. the socially desirable optimum is not equal to the private market equilibrium. Therefore, demerit goods are an example of market failure.Methods Government uses to decrease production and discourage consumption of demerit goods: Indirect taxes (e.g. on cigarettes and alcohol) Regulations and laws (e.g. speed limits and blood/alcohol limits when driving;) Publicity campaigns/advertising

INDIRECT TAX

Definition: this is a tax on goods/services (tax on spending), collected by firms and passed on to Government. This increases the costs that firms have to meet so decreases supply (less is supplied at each

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Evaluate, using diagrams, the use of policy responses, including market based policies of taxation, to the problem of negative externalities of production and consumption.

INDIRECT TAX

price level). The market price rises and the market quantity falls.An indirect tax is a market-based policy that can be used to internalize negative externalities of both production and consumption.Once the externality is internalised the market equilibrium will reflect the socially desirable price and quantity. Economic efficiency will be achieved.

1.Negative Externality of Production

Private price = Indirect Tax per unit =Private quantity = Gain in welfare benefit = Socially desirable price = Socially desirable quantity = Negative externality per unit = = pareto quantity

This graph shows that if an indirect tax equal to the negative externality is imposed in a market with negative externality of production, the market price will rise and the market quantity will fall. Less will be produced/consumed at a higher price. Producers will receive a lower price (Pp to P2) as they now need to pay the tax (Ps – P2) to the government.2. Negative Externality of Consumption

Private price = Negative externality per unit =Private quantity = Indirect tax per unit =Socially desirable price = Gain in welfare benefit = Socially desirable quantity = This graph shows that if an indirect tax equal to the negative externality per unit is imposed in a market with negative externality of consumption, the market price will rise (Pp to Ps) and the market quantity will fall (Qp to Qs). Less will be produced/consumed at a higher price. Producers will receive a lower price (Pp to P2) as they now need to pay the tax (Ps – P2) to the government.

Evaluating the use of an indirect tax to internalise externalities

Advantages: Consumers consumed less at a higher price The net welfare benefit increases Resources are allocated more efficiently – the market moves closer to the output

combination society desires (i.e. allocative efficiency) Government receives taxation revenue that can be used to reduce the harmful side

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effects of production/consumption

Disadvantages: Measuring the harmful effect (externality) is difficult in reality: the tax per unit might be

more or less than the actual externality per unit. Hence there may still be a loss of net welfare benefit due to over or under taxation per unit.

It is difficult with some externalities to identify which firms/consumers are causing the harmful effect (e.g. some cars emit more pollutants than other more efficient, ‘clean’ cars) - it is difficult to assess the extent of responsibility to firms’ consumers

Taxes themselves may not stop consumption significantly (e.g. if there is inelastic PED)

Evaluating the use of regulation to internalise externalities

Evaluate, using diagrams, the use of policy responses, regulation, to the problem of negative externalities of production and consumption.

Definition: These are laws that government uses to control (reduces) the production and consumption of goods with negative externalities.Examples: Impose a law making discharging of chemical waste into waterways (rivers; sea) illegal Impose a law making illegal to sell cigarettes to minors Impose a law making firms that emit GHG plant a set number of trees to absorb CO2.

Advantages of regulations:In order to comply with the law, firms will have to increase costs of production. This will reduce their supply and increase the market price.Government may gain some revenue from fines where the law is infringed upon.Disadvantages of regulations: Government will have to police these laws – this will increase government expenditure The laws may be politically unpopular so governments may be reluctant to

impose/enforce them

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Tradeable permits:Issuing property rights to internalise externalities

Evaluate, using diagrams, the use of policy responses, including market based policies of tradeable permits, to the problem of negative externalities of production and consumption

Government may sell to firms the rights to e.g. pollute. The rights would set out the quantity, type and time period of pollution. The owner of these rights can sell them, the price being set by the forces of demand/supply for these rights.These rights are purchased and give certain entitlements to the purchaser.Tradeable rights are initially purchased from the governing authority and can then be sold by the legal owner of the rights.Examples: ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________

Advantages of using property rights to internalise a negative externality of production: the owner has the incentive to limit their pollution to within these limits (else they face

government sanctions or will have to purchase more rights, incyurring higher costs). the owner has the incentive to ensure that others who have not paid for these rights do not

pollute. the owner can sell these rights, i.e. they are an asset. Government gains revenue from the sale of property rightsDisadvantages of using property rights to internalise a negative externality of production:__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

POSITIVE EXTERNALITIES OF PRODUCTION AND CONSUMPTIONi. Examplesii. Diagramsiii. Welfare lossiv. Merit goodsv. Evaluate policy responses to the problem of negative externalities.

POSITIVE EXTERNALITY OF PRODUCTION

Explain, using examples and diagrams, the concepts of positive externalities of

Definition: This is a beneficial side effect to others/society that occurs due to production by a firm.These are also called – Spillover benefits - Social benefitsExamples: _________________________________________________________________________

_________________________________________________________________________ _________________________________________________________________________

_________________________________________________________________________ _________________________________________________________________________

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production of a good or service

_________________________________________________________________________

The free market will not achieve allocative efficiency. In the free market less of these goods will be produced at a higher price than is socially desirable. Resources will be under-allocated.The Marginal Social Cost (MSC) curve is to the right of the Marginal Private Cost curve (MPC).The vertical distance between the MSC and the MPC is equal to the externality per unit1. Positive Externality of Production

Private price = Externality per unit=Private quantity = Loss in net welfare benefit = Socially desirable price = Socially desirable quantity = Negative externality per unit = = pareto quantityThis graph shows that with a positive externality of production the MSC at each unit of output is less than the MPC. The MSC is to the right of the MPC. The socially desirable price Ps is lower than the private price Pp. At the social equilibrium more is produced (Qp moves to Qs) at a lower price.

POSITIVE EXTERNALITY OF CONSUMPTION

Explain, using examples and diagrams, the concepts of positive externalities of consumption of a good or service

Definition: This is a beneficial side effect to others/society that occurs due to consumption by an individual.These are also called – Spill-over benefits - Social benefitsExamples: Increase in the quality of the future workforce due to education (e.g. better knowledge;

better thinking skills) Beneficial health effects and longer life expectancy of the workforce/population due to

individual’s healthy eating and physical exercise. Reduction in injury and death with road accidents through the wearing of seat beltsThe free market will not achieve allocative efficiency. In the free market less of these goods will be consumed at a higher price than is socially desirable.The Marginal Social Benefit (MSB) curve is to the right ofthe Marginal Private Benefit curve (MPB).The vertical distance between the MSB and the MPB is equal to theexternality per unit2 . Positive Externality of Consumption

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Private price = Private quantity = Private market loss in welfare benefit = Socially desirable price = Socially desirable/pareto quantity = Negative externality per unit =This graph shows that with a positive externality of consumption the MSB at each unit of output is more than the MPB. The MSB is to the right of the MPB. The socially desirable price Ps is lower than the private price Pp. At the social equilibrium less is produced (Qp moves to Qs) at a lower price.

MERIT GOOD

Explain that merit goods are goods whose consumption creates external benefits

Definition: This is good that society/ government considers beneficial for us to consume and will encourage us to have this good. Merit goods usually have positive externalities of consumption,Examples: Wearing seat belts Children immunisation (e.g. polio; rubella; whooping cough; tuberculosis) Physical exercise educationMerit goods are likely to be UNDER-PROVIDED by the free market system, i.e. the socially desirable optimum is not equal to the private market equilibrium. Therefore, merit goods are an example of market failure.Methods Government uses to increase production and encourage consumption of merit goods: _______________________________________________________________________ _______________________________________________________________________ _______________________________________________________________________ _______________________________________________________________________

INTERNALISING A POSITIVE EXTERNALITY

Definition: This involves a government action to achieve the socially desirable equilibrium by compensating those responsible for creating positive external benefits.Government can do this through:

- subsidies- regulation (laws)- public provision

SUBSIDY

Evaluate, using diagrams, the use of policy responses, including subsidies, to the problem of positive externalities of production and consumption.

SUBSIDY

Definition: This is a payment by Government to firms to encourage production by contributing towards the costs of production. Note: subsidies may also be paid to individuals on low incomes to pay for their health care, living expenses etc. A subsidy can be used to internalize positive externalities of both production and consumption. Once the externality is internalised the market equilibrium will reflect the social preferences, i.e. the socially desirable price and quantity. Economic efficiency will be achieved.1.Positive Externality of Production

Private price = Private quantity =

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Socially desirable price = Socially desirable quantity = Positive externality per unit = Subsidy per unit =Price received by producer = Subsidy paid by government = Gain in welfare benefit =This graph shows that if a subsidy is provided the costs of production firms must meet decrease. The supply curve (MPC) shifts to the right (MPC + subsidy = MSC). More is supplied at each price level. The price consumers pay falls (Pp to Ps); the quantity sold/produced increases (Qp to Qs). The price producers receive increases ( to Ps + subsidy per unit).The positive externality is brought into the market (i.e. internalised).2. Positive Externality of Consumption

Private price = Private quantity = Socially desirable price = Socially desirable quantity = Positive externality per unit = Subsidy per unit =Price received by producer = Subsidy paid by government = Gain in welfare benefit =This graph shows that if a subsidy is provided the costs of production firms must meet decrease. The supply curve (MPC) shifts to the right (MPC + subsidy). More is supplied at each price level. The price consumers pay falls (Pp to Ps); the quantity sold/produced increases (Qp to Qs). The price producers receive increases ( Pp to (Ps + subsidy per unit)).The positive externality is brought into the market (i.e. internalised).

TARGETED SUBSIDIES

This is a subsidy paid to individuals who are disadvantaged in some way e.g. those on lower incomes may receive a community service cards [discount card] for health services.

EVALUATING THE USE OF A SUBSIDY TO INTERNALISE AN EXTERNALITY

Advantages: Consumers buy more at a lower price: the market moves towards the allocative efficiency The externality is reflected in the lower market price and higher quantity. Net welfare benefit to society increases.Disadvantages: Increased costs to government (some governments may not be able to afford subsidies) Difficulty is assessing exactly the extent of the externality and matching it with an

equivalent subsidy per unit: the subsidy may be either under or over paid. Subsidies may be subject to political changes and political corruption.

GOVERNMENT DIRECT PROVISION OF GOODS TO INTERNALISE AN EXTERNALITY

If price is charged:Price = Quantity =Dead weight loss = Examples:- Healthcare- education

Advantages: more will be consumed at no, or a very low, price

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Evaluate, using diagrams, the use of policy responses, including direct provision of goods, to the problem of positive externalities of production and consumption.

low income groups have access to these goods: their consumption is independent of income. Inequality reduces.

Disadvantages: Increased costs to government: not all governments will be able to provide the good/service

to the extent that the positive externality requires If it is not compulsory, e.g. child immunisation, not everyone will consume the

good/service ________________________________________________________________________

REGULATION

Evaluate, using diagrams, the use of policy responses, including legislation, to the problem of positive externalities of production and consumption

Examples:- Wearing of cycle helmets on motorbikes and bicycles

- Fitting and wearing of seatbelts in cars- Attending school between the ages of 6 and 16Advantages: More people are likely to consume the good with a positive externality (consumption

increases)Disadvantages:

For some goods, the law will only be successful if the government also provides them free of charge (e.g. education)

Government will need to police the law in order for it to be effective The law may not be politically popular, e.g. some people may see the law as infringing on

the individual freedom/personal choice (e.g. wearing of cycle helmets)

PUBLICITY PROGRAMME/PROMOTION

Evaluate, using diagrams, the use of policy responses, including advertising to influence behaviour, to the problem of positive externalities of production and consumption.

Government can encourage the consumption of Merit goods (discourage the consumption of demerit goods) through publicity programmes, e.g. television advertisements; posters; free booklets etc.Examples:_______________________________________________________________________________________________________________________________________________________________________________________________________________________________________Advantages: Raises awareness – encourages consumption of goods with positive externalities of

consumption (discourages consumption of goods with negative externalities of consumption).

Maybe less costly to government than a subsidy ________________________________________________________________________Disadvantages: Prices of goods may not change (e.g. prices of goods with positive externalities may not

decrease – socially desirable price may not be achieved) Publicity campaigns/ education are costly – government expenditure increases. Change in consumer behaviour may be less than e.g. regulation, i.e. campaign is less

effective. With negative externalities, there is no gain in government revenue as there is for an

indirect tax

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Externality summary:

SOCIAL COST (MSC) = PRIVATE COSTS (MPC) plus- Positive externalities of PRODUCTION MSC < MPC for each unit of output- Negative externalities of PRODUCTION MSC > MPC for each unit of output

MSC = MPC + EXTERNALITIES

SOCIAL BENEFIT (MSB) = PRIVATE BENEFITS (MPB) plus- Positive externalities of CONSUMPTION MSB > MPB for each unit of output- Negative externalities of CONSUMPTION MSB < MPB for each unit of output

MSB = MPB + EXTERNALITIES

MARKET FAILURE: LACK OF PUBLIC GOODS- DISTINGUISH BETWEEN PUBLIC GOODS AND PRIVATE GOODS

– IDENTIFY EXAMPLES OF PUBLIC GOODS– EXPLAIN WHY LACK OF PUBLIC GOODS REPRESENTS MARKET FAILURE (WHY

PUBLIC GOODS ARE NOT NORMALLY PROVIDED BY THE MARKET).– DISCUSS THE IMPLICATIONS OF COLLECTIVE (DIRECT GOVERNMENT)

PROVISION OF PUBLIC GOODS.

PRIVATE GOOD

Definition: A private good is rival, depletable and excludable by price. Property rights are clear and there are no externalities.‘Rival’ means that if someone has the good it is NOT available for anyone else to have.‘Depletable’ means that in order for someone else to have the good, more scarce resources must be used.‘Excludable by price ’ means that the good is available only to those who pay the price.Examples:

_________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________

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_________________________________________________________________________Equilibrium is determined by PRIVATE PREFERENCE, i.e. by what consumers demand and producers supply.Private equilibrium is allocatively efficient for private goods, i.e. goods that have NO externalities.For a PRIVATE GOOD the socially desirable equilibrium is the private equilibrium, i.e. MPB = MSB, as there are no externalities. MPC = MSC

PUBLIC GOOD

Using the concepts of rivalry and excludability, and providing examples, distinguish between public goods and private goods

Definition: NON-RIVAL - if one person is using or has a public good, the goods is also available to others,

e.g. traffic lights. NON-DEPLETABLE - no more resources are required to allow others to have use of the good,

e.g. surf life-savers, army (national defence) NON-EXCLUDABLE BY PRICE i.e. public goods have no price signals. We cannot

charge a fee for the use of a public good. Once in existence a public good can benefit anyone who wants to use it; they cannot be stopped from using it if they have not paid, e.g. street lights. This results in FREE-RIDER BEHAVIOUR.

Examples: ________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________

Free rider behaviour

Explain with reference to the free-rider problem, how the lack of public goods indicates market failure

Definition: Free rider behaviour is the refusal to contribute directly to the cost of providing a public good on the grounds that once it is provided no one can be excluded from using the good. Public goods are NON-EXCLUDABLE BY PRICE: people can enjoy the use of the good without the provider being able to charge them for the use of the good, i.e. users have a ‘free ride’. Consumers will think that if they wait for others to pay for the provision of the good they will enjoy the benefits of that good free of charge.There are NO PRICE SIGNALS for public goods: it is impossible to collect payment from users of public goods, thus private producers (profit-orientated firms) will not want to supply public goods, i.e. if they have to incur costs to provide the good, but receive no revenue, there is negative profit. No private producer will provide a price-free service.This represents market failure as the private market fails to produce the public goods society desires.

Provision of public goods is left to government.

Government provision of public goods

Discuss the implication of the direct provision of public goods by government

With a public goods, marginal cost pricing cannot be used: For the individual consumer the marginal cost is zero, because they don’t have to pay (recall:

individual consumer demand – MU- and supply – MC= market price - curves). Producers’ marginal cost for a public good is zero as it is non-depletable: no further resources are

required to enable another person to have the goodMU An Individual Consumer’s Demand

Price $

MU = Demand

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Quantity

Because price signals are absent it is difficult to know how much of a public good to provide. Therefore public goods are allocated through POLITICAL DECISIONS (central or local government). Government provides these goods and charges COLLECTIVELY through the tax/rate system. The quantity of a public good produced is determined by politicians (in a democracy, elected by voters).

The SOCIALLY OPTIMAL OUTPUT of a public good occurs whereMSB = MSC

Implications: _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________

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MB

MARKETMC/MB$

MSB

COMMON ACCESS RESOURCES AND THE THREAT TO SUSTAINABILITY:

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TYPE OF GOOD PROVISION EXTERNALITIES CHARACTERISTICS

PRIVATE GOOD Free market (forces of demand/supply);consumer sovereignty;MPB = MPC

No externalities Property rights are clear;excludable by price;depletable;;rival

MIXED GOOD Government intervention in market through regulation; provision; taxes; subsidies.MSB = MSC

Has externalities: spillover costs and spillover benefits

Externalities

PUBLIC GOOD Direct provision by government.

Usually has externalities (positive).

Non-excludable by price;non-rival;non-depletable;leads to free-rider behaviour.

COLLECTIVE GOOD Goods provided by government free of direct (user-pays) charge;paid for out of taxes/rates.

Usually have externalities (positive).

Usually have externalities (positive).

MERIT GOOD Government may intervene in the free market by:regulation;subsidy;direct provision.

Usually has positive externalities of consumption.

Good deemed to be good/beneficial for us by government/society; it is considered that we should have it.

DEMERIT GOOD Government may intervene in the free market by:regulation;tax;banning.

Usually has negative externalities of consumption.

Good deemed to be harmful for us by government/society; it is considered that we should not have it.

http://www.youtube.com/watch?v=R8-2gI9fFSE oceanhttp://www.youtube.com/watch?v=rm8TyJ2fOaw foresthttp://www.youtube.com/watch?v=FKI5Krq4r1Q Mekonghttp://www.youtube.com/watch?v=Y1M4nFmwQGY Cambodiahttp://www.youtube.com/watch?v=rUlUddqKyiM droneshttp://www.youtube.com/watch?v=i5mMI8t7vV0 Tuna fishing hand lineshttp://www.theatlantic.com/video/index/265633/inside-japans-quest-to-make-bluefin-tuna-more-sustainable/tuna farminghttp://www.youtube.com/watch?v=21fwYooOgnwdecimated Bluefin tuna.http://www.theguardian.com/environment/2013/jan/31/carbon-tax-cap-and-trade Carbon tax v cap-and-trade: which is better?

COMMON ACCESS RESOURCES

Explain, using examples common access resources.

Describe sustainability and apply the concept of sustainability to the problem of common access resources.

Explain the consequences of the lack of a pricing mechanism for common access

Definition: These are resources that are difficult and expensive to exclude people from using due to property rights (i.e. ownership) being unclear/indeterminate. This leads to an absence of price signals for these resources.Other names: common-pool resources; common property resources.

Examples: common access resources are often natural resources e.g. - fish stocks- rivers and waterways- minerals under the sea floor (submarine)- tropical rain forest- over-exploitation/farming of land

They may also be human-made systems for managing natural resources, e.g. irrigation systems; hydroelectric power generation.

Definition: Sustainability means that scarce resources are being managed and used at a rate such that there will be sufficient available resources to enable economic growth for future generations.

Over-use of these resources results involves harvesting these resources at an unsustainable rate, i.e. at a rate greater than the rate of regeneration of the resource. Resources cannot naturally regenerate to replace stocks used and ensure stocks for future economic growth. The resource becomes depleted, e.g. the results of drift net fishing.Over-use of the resource also leads to degradation of the resources, e.g. soil becomes eroded and/or loses nutrients through overuse and deforestation.

Examples: ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________

These are negative externalities of production and hence market failure occurs: too much of the resource is used at too lower price than is socially desirable.

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resources in terms of these goods being overused/depleted/degraded as a result of activities of producers and consumers who do not pay for the resources they use, and that this poses a threat to sustainability.

As ownership of these resources is common, e.g. in international waters, there are no property rights relating to these resources, and there is no price mechanism operating. Consumers and produces do not pay for the resources they use. The lack of price for common access resources means that they are more likely to be over-consumed leading to depletion of stocks and endangering species, as well as degrading of resources i.e. non-sustainable resources use.

These externalities are not internalised, i.e. the market equilibrium does not reflect the costs to society incurred by the use of some of our natural resources in production.

The MSC ≠ MPC MSB ≠ MPB MSC > MPC MSB < MPB

International waters – over-fishing and killing of marine life e.g. driftnet fishingDeforestation (tropical rainforest) – loss of bio-diversity; climate change; soil depletion; erosion

SUSTAINABILITY and the BURNING OF FOSSIL FUELS

Discuss, using negative externality diagrams, the view that economic activity requiring the use of fossil fuels to satisfy demand poses a threat to sustainability

Negative externality of Production from the burning of fossil fuels:

The above graph shows that _________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

SUSTAINABILITY and POVERTY in ECONOMICALLY LESS DEVELOPED COUNTRIES

Discuss the view that the existence of poverty in economically less developed countries

POVERTY IN LESS DEVELOPED COUNTRIES and LAND OVERUSE:Economically less developed countries (ELDC) have a high degree of subsistence agriculture. In some of these countries land is cleared/trees felled for fuel (firewood) and farming. These trees are often not replanted and once one area has been deforested the population moves to another. Negative externalities arise from this lifestyle from:

1. Soil erosion and leaching of soil nutrients: trees/plant matter hold the soil, soil moisture and replace nutrients in the soil. Once trees are gone there is greater surface and sub-surface water run-off leading to loss of fertile top layer of soil; leaching of soil nutrients into water ways; flooding; clogging of waterways with soil destroying river fish and plant life.

2. Creation of deserts – unfertile, dry land

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creates negative externalities through over-exploitation of land for agriculture, and that this poses a threat to sustainabilitySUSTAINABILITY

Evaluate, using diagrams. Possible government responses to threats to sustainability, including legislation, carbon taxes, cap and trade systems, and funding for clean technologies.

Definition: Sustainable resource use means that scarce resources are being managed and used at a rate such that there will be sufficient available resources to enable economic growth for future generations.Current economic growth must not be made at the expense of economic growth in the future. An economy/the world should not consume at a rate now that will mean that future generations will be worse, rather than better, off.This is a global problem for resources such, e.g.

- global decrease in fish stocks; increased endangered species- global deforestation leading to increased flooding and soil erosion as well as

climate change- global warming from greenhouse gas emissions- loss of biodiversity- loss of nutrients in soil- global increase in desert area- Ozone layer depletion (fluro-carbon emissions)

...and many more. They arise from overuse of resources that are not owned by anyone e.g. air, oceans, wildlife. These are called ‘common property resources’.

Short-term concerns:e.g. air pollution

Long term concerns: Sustainable developmentBeing able to meet the needs of the present without compromising the ability o future generations to meet their own needs. Using resources now such that there will sufficient resources for future generations.Long term concerns include:

changing climate patterns impacting on agriculture and available land depletion of natural resources. Finding alternative, sustainable sources of energy

GOVERNMENT METHODS FOR ACHIEVING SUSTAINABLE GROWTH : USING REGULATIONS/LAWS TO REDUCE POLLUTION .Examples:

SETTING QUOTAS ON THE HARVESTING OF NATURAL RESOURCES such as fish (or rain forest) so that stocks have time to naturally regenerate to replace stocks used up, and increase in number.

Examples:

MC/MB MSC MPC Ps Pp

MPB=MSB

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Government sets a quota equal to the socially desirable quantity Qs. At the private price Pp there is now a shortage (Qp – Q1). The price is bidded up: the shortage disappears at the socially desirable price Ps. Less is produced at a higher price. Net welfare benefit loss disappears.

Q1 Quota Qp Quantity Qs

USING REGULATIONS/LAWS TO CONTROL LAND USE AND DEVELOPMENT, e.g. so that natural heritage is retained.

Examples:

TRADEABLE EMISSIONS SCHEMES, CAPPING THE EMISSION e.g. of greenhouse gases.

Examlpes: The Kyoto agreement________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

CARBON TAXES :____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

PROMOTING THE DEVELOPMENT AND IMPLEMENTATION OF CLEAN TECHNOLOGIES:

Explain, using examples, that government responses to threats to sustainability are limited by the global

INTERNATIONAL COOPERATION AMOUNG GOVERNMENTS :e.g. to ban drift-net fishing; reduce greenhouse gas emissions.__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

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nature of the problem and lack of ownership of common access resources, and that effective responses require international co-operation

____________________________________________________________________________________________________________________________________________________

GLOBAL RESPONSES TO GLOBAL PROBLEMS:__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

EXTRACT FROM NEW ZEALAND GOVERNMENT MINISTERIAL REPORT ON TRADEABLE EMMISSION SCHEME

1. What is the emissions trading scheme?‘Emissions trading’ is a market-based approach for achieving environmental objectives where emission units are traded between participants. In effect, those emitting greenhouse gases have to pay for increases in emissions and are rewarded for decreases. This encourages emissions reductions.The emissions trading scheme operates within the cap on emissions established by the Kyoto Protocol during its first commitment period (2008–2012). There is no cap on the emissions that occur within New Zealand. However, domestic emissions that exceed New Zealand’s allocation under the Kyoto Protocol must be matched by emission units bought internationally from within the Kyoto cap on emissions. (Country A’s) scheme covers emissions of the following six greenhouse gases: carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), and sulphur hexafluoride (SF6). These are the greenhouse gases covered by the Kyoto Protocol. The emissions trading scheme is part of the government’s response to climate change. Emissions trading will help reduce emissions, encourage and support global action on climate change, and help put (Country A) on a path to sustainability. This factsheet explains how the (country’s) emissions trading scheme works.

What sectors does the emissions trading scheme cover? The emissions trading scheme covers the following sectors of the economy: forestry, liquid fossil fuels

(transport), stationary energy, industrial processes, synthetic gases, agriculture and waste.  People carrying out some specified activities are required to participate in the scheme. People carrying

out other specified activities can choose to participate. How does emissions trading work?- Firms buy or are allocated emission units.- Firms emit green house gases and are required to match their emissions by surrendering an equivalent

number of emission units. Surrendering a unit means it is incapable of being used again, for example, it cannot be transferred to another participant.

- Some firms, such as those with forests planted after 1989, are able to earn emission units for carbon dioxide stored or removed from the atmosphere.

- Firms who do not have to participate can buy units and sell them to other firms who need them.The emissions trading scheme can be explained by using a simple example:

Firm A is an oil company. It needs to buy emission units to cover the greenhouse gas emissions it is responsible for.

Firm B is a large forestry company that receives emission units for land it is planting in forests. It is also undertaking some deforestation, leading to emissions for which it has to surrender emission units. Initially, Firm B has a shortfall of units but, as the new forest matures over time, it will have an overall surplus of

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units. Firm C is a major industrial user of electricity. Its costs increase with the introduction of the emissions

trading scheme. To   help Firm C adapt to these higher costs, the government gives Firm C an allocation of emission units, which Firm C can sell to offset its increased electricity costs.

Under the emissions trading scheme, Firm A and Firm B both buy Firm C’s units in the short term to cover their emissions. Because it now has to pay higher energy prices, Firm C finds it is cheaper to invest in energy efficiency. Alternatively, any firm can import or export eligible units from other countries.Over time, as its forest matures, Firm B has spare units available and sells them to Firm A.

What do participants have to do?Participants are required to:

1. monitor, record and report activities that lead to greenhouse gas emissions, some of which will be the indirect result of their activities

2. surrender emission units (either Kyoto units or New Zealand-specific units called New Zealand Units or NZUs) equal to the amount of emissions associated with their activities in each compliance period.

Secondary market traders,  such as brokers, can hold and trade NZUs, but do not have reporting obligations and are not required to surrender emission units. They can hold and trade emission units to take advantage of market opportunities.How are emission units acquired?Participants may acquire emission units by receiving a free allocation from the government. In addition, participants and secondary market traders can acquire emission units from the following sources:

buying them from the government (although the government has no surplus units to auction at present) buying them from approved overseas sources buying them from another participant or secondary market trader, either by entering into a direct bilateral

contract with the other party, or trading through a broker or trading exchange.

2. EVALUATION OF AM EMTS:Price-based options: emissions tax or emissions trading?The two options for a price-based measure are:

an emissions tax levied on all economic activity that involves emissions the trading of a limited number of emission units, whose price would be determined by supply and demand.

The government has decided against proceeding with an emissions tax because it is a blunt instrument that would require regular alteration to ensure its effectiveness and to keep it in line with international emissions prices.  An emissions trading regime would be preferable because:

provides the government with relative certainty about the volume of emissions, and hence the environmental objectives, whereas a tax simply imposes a price on each unit of emissions and does not limit emissions per se

is easily linked into the international emissions price and global emission reduction efforts, which minimises the risk to the New Zealand taxpayer of overshooting or undershooting our Kyoto Protocol and future international commitments

provides New Zealand firms with maximum flexibility through enabling them to reduce or offset their emissions (including managing credits and liabilities over time) by accessing emission reduction opportunities at the lowest cost

has wide support, being preferred as the primary means of managing New Zealand’s emissions in the long term by many submitters on the five discussion documents released in December 2006

allows New Zealand to devolve forest credits and liabilities to landowners as part of a broader economic

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instrument is emerging as the favoured measure among developed countries, and early adoption by New Zealand

would bring significant benefits.

3. Impacts of (an) ETSThe desired impact of the NZ ETS will be to change investment and consumption behaviours by integrating a price for emissions into decision-making by producers and consumers.  The result will be a progressive shift in our economy and lifestyle towards consuming, using and investing in goods and services with lower greenhouse gas emissions.Introducing an emissions price will increase the cost of transport fuels and other non-renewable energy (such as coal and natural gas), and will cause relative price increases in other sectors that involve emissions, such as industrial processing and agriculture.  Conversely, it will reduce the relative price of low-emission goods and services and increase the relative returns on investment in low-emissions technologies (eg, making it more cost-effective for electricity generators to invest in renewable energy such as wind and solar power).  It will also increase the profitability and cash flow for afforestation activities through the devolution of credits (with associated liabilities) for forest sinks to landowners.

4. WHY IS AN EMTS NECESSARY?Climate change is an unprecedented challenge – for the global community, for the world environment, for the world economy, and therefore for (Country A) as well.  Without global action to reduce and stabilise greenhouse gas emissions, the world is projected to experience a rise in temperature, increasing sea levels, more frequent extreme weather events and a change in rainfall patterns....Climatic changes may have a severe impact on our native ecosystems, industries, infrastructure, health, biosecurity and economy.  If greenhouse gas emissions are not reduced significantly over the coming decades, the damage to our environment and quality of life could be significant and irreparable....we need to recognise the shift in attitudes in our key overseas markets, where climate change issues are having a growing impact on the thinking of governments and consumers....There will be significant new economic opportunities for these sectors if they can position themselves at the forefront of the development of new carbon-friendly technologies.Many of the things we do in the name of climate change achieve other commonsense objectives.  Warm, energy-efficient homes are healthy homes.  Fuel and energy efficiency saves money.  Forestry reduces erosion and improves water quality.  Becoming a leader in new sustainable technologies and smarter ways of doing things gives us the chance to transform the economy and improve our quality of life, as well as protect the environment.Executive SummaryClimate change is a major problem for (Country A) and the worldThe Earth’s climate is changing at an increasingly rapid rate, largely due to ongoing high rates of greenhouse gas emissions caused by human activity.  Even with concerted global effort to reduce greenhouse gas emissions there are likely to be changes in temperature and rainfall patterns, increases in the number of significant wind and storm events, and an increased risk of flooding and coastal erosion.  These impacts have flow-on effects for air and water quality, the retention of nutrients in soils, and preserving biodiversity.... most countries could suffer severe adverse effects to our economy, our infrastructure and our way of life.Climate change, sustainability and economic transformationReducing greenhouse gas emissions is therefore imperative, for both environmental and economic reasons.  ...Indeed, economic transformation and environmental sustainability can be seen as two sides of the same coin.  For example: improved efficiency in the use of energy and natural resources is central to improving productivity and

increasing the value of our exports, and will help to conserve valuable non-renewable resources for use by future generations

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developing renewable domestic energy sources will improve (a country’s) energy security there is a growing market for products and services which involve low greenhouse gas emissions, as has

already been recognised by sectors such as tourism, agriculture and viticulture the move towards a “knowledge economy” involves shifting the production balance towards value-added

activities that draw upon information technology, the creation of intellectual property, and the development of new technologies in areas such as biotechnology, all of which tend to be less emissions intensive

conversely, failure to control greenhouse gas emissions could have trade risks, both at a political level (because countries that do not take the issue seriously may find it hard to improve access to markets and may face trade barriers) and at a global consumer level

the impetus towards sustainability creates new incentives to develop efficient technologies and improve management practices across all sectors of the economy.

In fact, many of the things we do in the name of climate change achieve other commonsense objectives.  Warm, energy-efficient homes are healthy homes, and are known to reduce the incidence of chronic conditions such as asthma.  Energy efficiency frees up resources for households and improves business profitability.  Planting or maintaining forests reduces erosion and improves water quality.Countries that are proactive in responding to the challenge of reducing emissions will position themselves to achieve a smoother transition to emission constraints and are more likely to benefit from the new market opportunities that will emerge.(Country A’s) challengeThere are four main climate change challenges for(Country A).  We need to:

control our own greenhouse gas emissions and reduce them relative to the current growth trend support international initiatives for multilateral action on greenhouse gas emissions, principally through

maintaining momentum on the implementation of the Kyoto Protocol and ensuring this momentum is carried through into whatever agreements emerge for the period after 2012

prepare for, and adapt to, the impacts of changes in our physical environment, by responding to the risks and taking advantage of the opportunities they present

realise the above objectives at the lowest achievable long-term cost. ..... has already introduced a range of measures to reduce emissions.  These include:

financial incentives (such as the Permanent Forest Sink Initiative and incentives to promote solar hot water heating and better home insulation)

improved standards and codes (such as energy efficiency standards for new homes and household products) direct regulation of major emission sources (such as the biofuels sales obligation) public education (such as Energy Star efficiency labelling and Fuelsaver information on vehicle fuel

efficiency) joint investment in research for mitigation of agricultural greenhouse gases.

Although significant, these measures are not sufficient to achieve the long-term emission reductions that will be integral to (a country’s) sustainable development pathway, particularly given that by 2020 our gross emissions (excluding the land use, land-use change and forestry sector) are estimated to be roughly 48 per cent above our 1990 levels (Country A’s) emissions are the product of a broad range of economic activities, and we need a correspondingly broad-based economic measure, based on prices, to bring about the behavioural changes needed to implement our greenhouse gas reduction strategy.A price-based measure has a number of significant advantages in this respect.It can provide a strong incentive (depending on the price it uses) for those making decisions about emissions to reduce them to a level that reflects the total cost to society, including the environmental cost.

It harnesses the market dynamic by providing automatic incentives for firms to invest in reducing emissions and to shift to lower-emissions products and services.

It provides flexibility for firms and fosters innovation and the seeking out of least-cost emission reduction

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strategies. It can be linked into international efforts to reduce emissions.

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