market failure

C. BordoyC. BordoyUWC MaastrichtUWC Maastricht

Market FailureMarket Failure

Evaluation of policies to correct Evaluation of policies to correct externalitiesexternalities


Negative production Negative production externalities: Market-based externalities: Market-based policies and regulationspolicies and regulations Market-based policies: AdvantagesMarket-based policies: Advantages

Internalise the externality, ie, costs that Internalise the externality, ie, costs that were external are made internal: they were external are made internal: they are now paid for by producers & are now paid for by producers & consumers.consumers.

Taxes on emissions are superior than Taxes on emissions are superior than taxes on output:taxes on output:

Taxes on output only provide incentive to Taxes on output only provide incentive to reduce output produced.reduce output produced.


Taxes on pollutants provide incentives to Taxes on pollutants provide incentives to firms to reduce use of polluting resources and firms to reduce use of polluting resources and use production methods that pollute less. use production methods that pollute less.

Costs of reducing emissions differ:Costs of reducing emissions differ: Firms with the lower costs will be the ones most Firms with the lower costs will be the ones most

likely to cut their emissions to avoid the tax.likely to cut their emissions to avoid the tax. Firms with the higher costs will be the ones least Firms with the higher costs will be the ones least

likely to cut their pollutants and so will pay the taxlikely to cut their pollutants and so will pay the tax

Taxation thus leads to lower pollution levels at a Taxation thus leads to lower pollution levels at a lower overall cost.lower overall cost.

In the case of tradable permits:In the case of tradable permits: Firms with a low cost of reducing emissions will do Firms with a low cost of reducing emissions will do

so and sell excess permits. so and sell excess permits. Firms facing a high cost will be forced to buy Firms facing a high cost will be forced to buy

additional permits.additional permits.


Market-based policies: disadvantagesMarket-based policies: disadvantages Taxes:Taxes:

1.1. Difficulty in designing a tax equal in Difficulty in designing a tax equal in value to the amount of the pollution. The value to the amount of the pollution. The following questions need to be answered:following questions need to be answered:

1.1. Identify which production methods produce Identify which production methods produce pollutants.pollutants.

2.2. Identify the harmful pollutants: technically Identify the harmful pollutants: technically difficult, plus much controversy among difficult, plus much controversy among scientists over extent of harm by each scientists over extent of harm by each pollutant.pollutant.

3.3. Attach a monetary value to the harm.Attach a monetary value to the harm.

2.2. Risk that, even while paying the tax, Risk that, even while paying the tax, some polluting firms may not lower their some polluting firms may not lower their pollution levelspollution levels


Tradable permits. In addition to Tradable permits. In addition to technical problems, listed above:technical problems, listed above:

1.1. Require the gov to set a maximum (cap) Require the gov to set a maximum (cap) level for each type of pollutant, which level for each type of pollutant, which requires technical information that may requires technical information that may not be available. If cap is too high it will not be available. If cap is too high it will not reduce pollutants enough. If it is too not reduce pollutants enough. If it is too low, permits will be very costly.low, permits will be very costly.

2.2. Method to distribute permits must be fair.Method to distribute permits must be fair.

In practice, it is unlikely that these In practice, it is unlikely that these policies can achieve optimal results.policies can achieve optimal results.


Government regulations: advantagesGovernment regulations: advantages1.1. Simple and easy to implement. Simple and easy to implement.

Sometimes only option if practical Sometimes only option if practical difficulties of market-based methods are difficulties of market-based methods are too great.too great.

2.2. Regulations force polluting firms to Regulations force polluting firms to comply and reduce pollution levels comply and reduce pollution levels (which taxes may not always do)(which taxes may not always do)

For these reasons they are more For these reasons they are more commonly used in countries around commonly used in countries around the world.the world.


Government regulations: disadvantagesGovernment regulations: disadvantages1.1. They do not create market-based They do not create market-based

incentives.incentives.

2.2. Unable to provide incentives for firms to Unable to provide incentives for firms to use less polluting resources and thus use less polluting resources and thus reduce the size of the externality.reduce the size of the externality.

3.3. Pollution is reduced at a higher overall cost.Pollution is reduced at a higher overall cost.

4.4. Lack of sufficient technical informationLack of sufficient technical information→→ only partial effect in reducing the pollution only partial effect in reducing the pollution created.created.

5.5. Policing involves costs and there may be Policing involves costs and there may be problems with enforcement.problems with enforcement.


Negative consumption Negative consumption externalities: market-based externalities: market-based

policies, government regulation policies, government regulation and advertisingand advertising

Indirect taxesIndirect taxes (market-based (market-based measure) are preferred, as they measure) are preferred, as they internalise the externality.internalise the externality.

Advantages:Advantages: They create incentives for consumers to They create incentives for consumers to

change their consumption patterns by change their consumption patterns by changing relative prices. changing relative prices.


Disadvantages:Disadvantages:1.1. Technical difficulties involved in Technical difficulties involved in

measuring the value of the external measuring the value of the external costs, as basis to design the tax.costs, as basis to design the tax.

2.2. Some of the goods whose consumption Some of the goods whose consumption leads to negative externalitites have leads to negative externalitites have an inelastic demand, so decreases in an inelastic demand, so decreases in quantity demanded may not be quantity demanded may not be significant. In order to achieve Qsignificant. In order to achieve Qoptopt a a very high tax may be needed, but very high tax may be needed, but would be politically unacceptable.would be politically unacceptable.


Advertising & persuasionAdvertising & persuasion Advantage: simplicityAdvantage: simplicity Disadvantages:Disadvantages:

1.1. Cost to the gov of advertising Cost to the gov of advertising campaigns, funded by tax revenues, campaigns, funded by tax revenues, which have opportunity costs.which have opportunity costs.

2.2. These methods may not be effective These methods may not be effective enough in reducing the spillover cost.enough in reducing the spillover cost.

RegulationsRegulations Very effective in reducing the external Very effective in reducing the external

costs of smoking but cannot be used to costs of smoking but cannot be used to reduce externalities caused by reduce externalities caused by consumption of other goods, such as consumption of other goods, such as gasoline.gasoline.



Final remarksFinal remarks Governments must be selective in Governments must be selective in

the methods they use to reduce the methods they use to reduce consumption externalities, consumption externalities, depending on the particular good depending on the particular good that creates the external costs.that creates the external costs.

With all policies it is only possible to With all policies it is only possible to move the economy in a direction move the economy in a direction towards correction of the externality, towards correction of the externality, rather than achieving Qrather than achieving Qoptopt..


Evaluation of policies to correct Evaluation of policies to correct positive production and positive production and

consumption externalitiesconsumption externalities

Direct provision and subsidiesDirect provision and subsidies Advantages:Advantages:

1.1. Very effective in increasing the Very effective in increasing the quantity of the good produced and quantity of the good produced and consumed.consumed.

2.2. Lower price for consumers.Lower price for consumers.


Disadvantages:Disadvantages:1.1. They both involve the use of government They both involve the use of government

funds that rely on tax revenues and have funds that rely on tax revenues and have an opportunity cost. Choices must be an opportunity cost. Choices must be made on:made on:

a.a. Which goods should be supported, andWhich goods should be supported, andb.b. By how muchBy how much

Ideally, economic criteria would specify the Ideally, economic criteria would specify the amount of social benefits expected in amount of social benefits expected in relation to the cost of providing them. relation to the cost of providing them. However, it is very difficult in practice to However, it is very difficult in practice to calculate the external benefit and calculate the external benefit and therefore to calculate which goods should therefore to calculate which goods should be supported and with which level.be supported and with which level.


2.2. Governments are often susceptible to Governments are often susceptible to political pressures and sometimes political pressures and sometimes make choices based on political rather make choices based on political rather than economic criteria.than economic criteria.

In the real world it is very inlikely In the real world it is very inlikely that governments are able to shift that governments are able to shift the MPC or MPB curves by the the MPC or MPB curves by the amount necessary to correct the amount necessary to correct the positive externalities. positive externalities.


Legislation and advertisingLegislation and advertising Limitations:Limitations:

1.1. Only sometimes can they be effective by Only sometimes can they be effective by helping shift the MPB curve helping shift the MPB curve in the right in the right directiondirection..

Very positive effects in certain cases (compulsory Very positive effects in certain cases (compulsory schooling up to a certain age) but ineffective in others schooling up to a certain age) but ineffective in others (they cannot on their own increase consumption of (they cannot on their own increase consumption of health services and education to the optimum level).health services and education to the optimum level).

2.2. They have the further effect of raising the price They have the further effect of raising the price to consumers, which may make the good to consumers, which may make the good unaffordable for some consumer groups.unaffordable for some consumer groups.

They can sometimes be used more They can sometimes be used more effectively if they are implemented effectively if they are implemented together with direct provision and together with direct provision and subsidies. For example, education, where subsidies. For example, education, where legislation goes together with direct legislation goes together with direct provision by the government.provision by the government.

market failure

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