Market Failure

Common Property Resources and Public Goods

Classifications:

• Rival:
  • Does the consumption by one party reduce the supply available for another?
• Excludable:
  • Is it possible to exclude a non-payer from the good or service?

Private Goods

• Rival: Your consumption of the good or service means another party cannot consume it
• Excludable: There are requirements to be met before being able to access the good or service
• E.g. Clothing, food, stationary

Club Goods

• Non-rival: Your consumption of the good or service does not prevent another party from consuming it
• Excludable: There are requirements to be met before being able to access the good or service
• E.g. Gyms, Concerts, Movies

Common Property Resources

• Rival: Your consumption of the good or service means another party cannot consume it
• Non-Excludable: There are no requirements to be met before being able to access the good or service
• E.g. Fish in the ocean
• Leads to tragedy of the commons
  • Refers to the over-consumption of common property recourses, e.g. Over fishing
  • Occurs as the resource is readily available and there are no restrictions on consumption
  • However, once consumed the resource is not available to any other party.

Public Goods

• Non-rival: Your consumption of the good or service does not prevent another party from consuming it
• Non-Excludable: There are no requirements to be met before being able to access the good or service
• E.g. National Parks
• Leads to free rider effect
  • Free riders enjoy the benefits of the consumption of a resource without paying for the cost of provision
  • This can lead to over-consumption and rapid damage of a public resource

To try to prevent these Market Failures…

With common property goods

• Enforce restrictions on consumption
• E.g. Fishing limits, no-fishing zones, fishing licenses

With public goods

• Create ownership of the resource
• E.g. Fees for public transport, fines for damaging public property

Merit Goods: Goods that are produced that have large external benefits for society

• Goods that will be underprovided in the economy if the product is left in the market

Demerit Goods: Goods that are produced that have large external costs for society

• Goods that will be overprovided if left in the market

Merit and Demerit goods are both Private goods as they are both rivalry and exclusive

Externalities

Key concepts to know:

• Demand: Private benefits that consumers receive
• Supply: Private costs of production
• MPC (Marginal Private Cost): Costs to producers of producing one more unit of a good
• MSC (Marginal Social Cost) : Costs to society of producing one more unit of a good
• MPB (Marginal Private Benefit): Benefits to consumers from consuming on more unit of a good
• MSB (Marginal Social Benefit) : Benefits to society from consuming one more unit of a good
• When MPC = MSC and MPB = MSB socially optimal equilibrium is achieved

Externalities occur when the production or consumption of a good/service cause external costs and/or external benefits to a third party.

• Side effects of economic activity or unintended consequences of economic activity

Externalities cause market failure if the price mechanism does not take into account the social costs and benefits of production and consumption.

Negative Externalities

Occurs when production and/or consumption creates an external cost.

Causes overconsumption/production

• Market quantity is greater than optimal quantity
• Market price is less than optimal price
• Results in deadweight loss

Negative Production Externality:

• Where the marginal social cost of production is higher than the marginal private cost
• Examples: Air, Land, Noise, Pollution which results from factory emissions

Negative Consumption Externality:

• When the marginal social benefit of consumption is lower than the marginal private benefit
• Examples: Smoking, Alcoholism

Positive Externalities

External Benefits if consumption or production for third parties

Causes underconsumption/production

• Market quantity is less than optimal quantity
• Market price is greater than optimal price
• Results in deadweight loss

Positive Consumption Externality:

• Where the marginal social benefit of consumption is higher than the marginal private benefit
• Examples: Flu Vaccines, Education

Positive Production Externality:

• Where the marginal social cost of production is lower than the marginal private cost
• Examples: Lower transport costs for local firms following construction of new roads

Policies to Correct Externalities

Overview

1. Negative Production
   • Limits on production, pollutants and change methods of production
   • Tax -> Shift MPC towards MSC
2. Negative Consumption
   • Legislation / Advertising -> Shift MPB towards MSB (Decrease Demand)
   • Indirect Tax -> Shift supply curve + tax (reaches optimum quantity but increased price compared to optimum)
3. Positive Production
   • Direct Government Provision -> MPC towards MSC (increases in supply)
   • Subsidy -> Size of marginal external benefit internalizing it (MPC to MSC)
4. Positive Consumption
   • Legislation -> Increase consumption
   • Advertising -> Increase consumption
   • Government Provision -> Shift S + provision shifts to Qo
   • Subsidy -> Doesn’t impact demand, s + subsidy towards Qo and lowered price

In-Depth Explanations

The Types of Policy Options:

1. Regulation/Legislation (By the government)
2. Market Based approaches (taxes and subsidies)

Negative Production Externalities (Government Regulation)

• Regulations can forbid the dumping of pollutants to the environments
  • Limit the amount of pollutants (set maximum amount)
  • Limit Quantity of output to producers
  • Require Technologies (methods of production) to reduce emissions
• Diagram
  • Limit the quantity produced back to Qo by shifting the MPC to MSC
  • This will force the price to be higher at Po and quantity lower at Qo

Negative Production Externalities (Taxes)

• Impose a tax on per unit of production or pollutant emission
• Internalise the external cost (recognition)
• Diagram
  • Impose a tax the size of the external cost
  • MPC+Tax = MSC
  • Quantity will fall to Qo and price will increase to Po

Negative Consumption Externalities (Government Regulation & Advertisments)

• Prevent consumer activities e.g. Legal restrictions in smoking (public spaces)
• Diagram
  • Reduces demand towards MSB
  • Quantity lowered to Qo and price lowered to Po

Negative Consumption Externalities (Taxes)

• Impose a tax the size of the external cost
• The impact of the tax is passed onto consumers as a higher price they now have to burden.
• Diagram
  • MPC+Tax = MSC
  • Quantity will fall to Qo and price will increase to Pc

Positive Production Externalities (Government Regulation)

• Direct government provision: coming out of government funds
• Diagram
  • MPC shifts towards MSC
  • This will force the price to be lower at Po and quantity increases at Qo

Positive Production Externalities (Subsidies)

• Government can provide subsides the size of the spillover benefit
• Subsidy used to internalize the spillover benefit
• Diagram
  • Quantity increases to Qo and price falls to Po

Positive Consumption Externalities (Legislation/Advertising)

• Legislation: Used to increase consumption
  • E.g by putting compulsory ages to education
• Advertising: Used to increase consumption
  • E.g Public advertisement for education
• Diagram
  • Increases supply from MPB to MSB
  • Quantity increases to Qo and price increases to Po

Positive Consumption Externalities (Government Provision)

• Direct provision to increase consumption e.g. Education and healthcare
• Diagram
  • Increases supply from MPB to MSB
  • Quantity falls to Qo and price falls to Po

Positive Consumption Externalities (Subsidies)

• Government can provide subsides to producers to lower the cost and hence lower the price of consumption.
• Subsidy used to internalize the external benefit
• Diagram
  • Quantity will be higher at Qo and price lower at Pc