1.4. Market Failure

Market failure is a situation in which the free market leads to a misallocation of

society's scarce resources in the sense that either overproduction or

underproduction of a particular good occurs, leading to a less than optimal

outcome.

Reasons for market failure

The reasons for market failure include:

Positive and negative externalities

Lack of public goods

Under-provision of merit goods

Over-provision of demerit goods

Abuse of monopoly power

Inequality

The meaning of externalities

The key feature of an externality is that it is initiated and experienced, not

through the operation of the price system, but outside the market.

Proponents of laissez-faire would argue that externalities particularly arise

because of the absence of markets - as no markets exist for such things as clean

air and seas, beautiful views or tranquility, economic agents are not obliged to

take them into account when formulating their production and consumption

Externalities are costs (negative externalities) or benefits (positive externalities), which are not reflected in free market prices. Externalities are sometimes referred to as 'by-products', 'spillover effects', 'neighbourhood effects' 'third-party effects' or 'side-effects', as the generator of the externality, either producers or consumers, or both, impose costs or benefits on others who are not responsible for initiating the effect.

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decisions, which are based on private costs and benefits i.e. those which are

internal to themselves. Another way of putting this is to say individuals have

no private property rights over such resources as the air, sea and rivers, and

thus ignore them in making their production and consumption decisions.

Property rights refer to those laws and rules that establish rights relating to:

Ownership of property;

Access to property;

Protection of property ownership;

The transfer of property.

Thus a firm may feel free to dump effluent into a river as the spoiling of the

environment and the killing of fish is not a cost that it would directly have to

bear. Those on the political left would be more likely to argue that such an

externality would arise because of the market system which is based upon the

private ownership of resources, with individuals acting in their own self interest

and therefore not having to consider what is in the public interest i.e. the

problem is due to an absence of communal property rights and of a system of

planned production.

Resource: The importance of Property Rights

https://www.youtube.com/watch?v=wYnrUkKR1lo

Types of externalities

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Pollution is an example of an externality which is commonly cited, but it is

important to establish at this stage that there are various types of externalities

and that they can be classified in different ways: they can arise from acts of

consumption or production, and can thus be production, consumption or

mixed externalities, and, as previously mentioned they can be experienced

as external costs (negative externalities) or as external benefits (positive

externalities).

Figure 1 below summarizes the different possibilities and provides some

examples.

Figure 1: The various kinds of externality

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It can be seen from this table that there are in fact four different varieties of

externality:

A) a production externality: initiated in production and received in

production;

B) a mixed externality: initiated in production, but received in

consumption;

C) a consumption externality: initiated in consumption and received in

consumption;

D) a mixed externality: initiated in consumption, but received in

production.

Each of these are sub-divided into two, according to whether they are

experienced as an external cost or as an external benefit, giving a total of eight

varieties.

In practice, the most important externalities are those which affect the

environment, and it is these which have received widespread adverse publicity in

recent years, and which have prompted the rise of 'green' pressure groups and

political parties. Indeed, so great has been the impact of environmental pollution,

that in addition to the externalities identified in figure 1, we can also, in a global

context, identify externalities which are transmitted from one country to

another, and that may be mutually damaging; for example, the Chernobyl

nuclear disaster in 1986 in Russia, not only contaminated the local area, but also

polluted other parts of Europe; emissions of acid rain from West European

nations not only harm the environment in the initiating countries, but also wreak

havoc on the forests, lakes and rivers of the Scandinavian countries. The recent

earthquake in Japan and the dangerously high levels of radiation is another

example of such externalities.

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Task: Try matching the following examples of externalities to each type of

externality in figure 1 (Hint - there is one example of each).

Situation Type of Externality

1. A person smoking a pipe at a football match causes the

person sitting behind to passively smoke.

2. A large retail organization attracts numerous extra

customers to its store, some of who spend money in

other shops in the vicinity (maybe a shopping mall).

3. Children are taken to school by car instead of walking or

using public transport. This worsens congestion and

raises the production costs of firms.

4. Owner-occupiers (people who own their own

houses/apartments) in a particular area take measures

to increase the value of their properties. Estate agents

benefits from the extra commission earned when the

houses are sold.

5. Juggernauts (large trucks/lorries) travel through inner

city areas, causing traffic congestion for other

commercial road users that raise their production costs.

6. A power station emits black fumes into the air that

discolours the paintwork of nearby houses.

7. Farmers provide pathways in the countryside that

benefit walkers.

8. A private gardener plants an assortment of beautiful

plants in her front garden and enhances the environment

for her neighbours and passers-by.

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How do externalities affect allocative efficiency?

Given the existence of perfect competition, allocative efficiency would

automatically occur where price equals marginal cost in all markets, assuming

that neither negative nor positive externalities are present.

So, how do externalities affect our condition for efficiency?

Let's consider case of a firm, which discharges its waste products into a river.

Such a firm would be treating the environment as a free resource, and would be

imposing a cost on society as a whole, rather than just on the consumers of the

good. The price charged to consumers would not therefore, in this instance,

reflect the true cost of the product; if the firm were compelled to install

equipment which could treat its effluent and render it harmless to the

environment, its production costs and prices would rise and consumers would, as

a consequence, reduce their demand for the product in question. Resources

would then be reallocated to other lines of production.

In this case there is a divergence between private and social cost.

The private cost is the internal money cost of production incurred by the

firm i.e. costs such as wages, raw materials, heating and lighting that must

be paid to carry out production, and which would appear in the firm's

accounts.

The social cost, on the other hand, is the real cost to society as a whole; it

is the private, internal costs plus the value of the negative externalities

(external costs).

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Similarly, if the firm's production decisions were to generate positive

externalities, such as the beneficial effects arising from the provision of

employment, then there would be a divergence between private and social

benefit.

The private benefit is the money value of the benefits accruing internally

to the firm from production activity e.g. in the form of sales revenues.

The social benefit, on the other hand, is the private benefit plus the value

of positive externalities (external benefits).

Now, the significance of this analysis is that allocative inefficiency will occur if

private cost or benefit diverges from social cost or benefit. Where

externalities exist the condition for allocative efficiency is that price = social

marginal cost = social marginal benefit i.e. the price must equal the true

marginal cost of production to society as a whole, rather than just the private

marginal cost.

We will now illustrate the above in relation to the firm discharging waste into the

river.

Hence externalities cause market failure:

When a negative production externality is initiated, the firm will not be

made to pay for the cost imposed on others, and will therefore have no

market incentive to produce less; from society's standpoint it will therefore

overproduce;

When a positive externality arises, the firm will lack any incentive to

increase its output to the socially desirable level, as it does not receive any

payment for the generation of the external benefit; underproduction

therefore occurs.

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Negative Externalities of Production/External Costs of Production

Access this webpage and follow the steps

http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/negext

prod.html

Figure 2: Negative Externalities of Production

Task: Explain the relationship between firstly, the free market equilibrium and

the socially efficient equilibrium and secondly the free market price and the

socially optimal price.

8

Negative Externalities in the Chemical Production sector

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Negative Externalities of Consumption/External Costs of Consumption

10

Access this webpage and follow the steps

http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/negext

cons.html

Figure 3: Negative Externalities of Consumption

Task: Explain the relationship between firstly, the free market equilibrium and

the socially efficient equilibrium and secondly the free market price and the

socially optimal price.

The economic theory of traffic congestion

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Figure 1 below shows how the analysis of externalities that we looked at in the

previous section can be applied to the problems of traffic congestion.

Figure 4 Road transport, congestion and economic theory

Economic theory can be used to analyze the issues involved in traffic congestion

as shown here. Figure 4 indicates the relationship between the cost of travel and

the flow of traffic along a particular route. The essence of this theory is based on

the fact that, when making a journey by car, a motorist only considers the

marginal private cost (MPC). This is the cost directly attributable to him/herself,

such as time, fuel and the maintenance of the vehicle, rather than the full cost of

the journey, which may include costs imposed on society such as pollution, noise

and time lost due to congestion. When added to the private costs, these are

termed the marginal social costs (MSC), the difference between the two

representing the externality imposed by the motorist.

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In outlining the theory, it is assumed that, when making a journey, congestion is

the only externality. The graph represents the demand for travel along a

particular stretch of road over a period of time. Up to a flow of traffic F0, there is

no congestion, thus there is no divergence between MPC and MSC, although in

reality, such a situation only applies to extremely low volumes of traffic.

As the flow of traffic increases above F0, congestion is apparent and there is a

divergence between MSC and MPC. Note that the MSC is equal to the MPC, plus

the social cost of congestion.

If the demand for travel on this particular route is of the normal shape

(represented by D on the graph) and is a measure of the marginal benefit, then

the flow of traffic will be determined by the intersection of the demand curve and

the MPC curve at F1 and the private cost to the motorist will be b. At a flow of F1,

the external cost, not taken into account by the motorist, is ab (the difference

between the MPC and MSC). This means that resources are not being allocated

efficiently and that individuals are making more journeys than they would if they

were aware of the full social costs.

Resources

What causes traffic jams?

https://www.youtube.com/watch?v=8ivycTcNvJQ

A solution to traffic congestion?

https://www.youtube.com/watch?v=wOe_mvlzMSk

Can a nudge replace a congestion tax?

https://www.youtube.com/watch?v=CX_Krxq5eUI

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Possible government responses to externalities

The outstanding characteristic of a market economy is that production does not

occur as a result of some grand, master plan; rather, it is the result of the pulls

and pushes of supply and demand, of the numerous uncoordinated decisions of

individuals and firms. As individuals are assumed to seek to maximize their own

satisfaction, and firms their own profits, decisions made are likely to be strictly

on the basis of private costs and benefits, and, as previously explained, herein lies

the problem: unless the full social costs and benefits of production and

consumption decisions are taken into account, so that MSC is equated to MSB,

social inefficiency and a misallocation of society's scarce resources will result.

So, what measures can a government take to rectify such inefficiency, and how

successful is it likely to be? As is the case with most important questions in

economics, a range of answers is possible, depending largely on the political

perspective of the respondent. At one end of the spectrum, governments could

'leave well alone', essentially not interfering with markets but trying to gently

persuade firms and individuals to modify their behaviour. At the other extreme,

the market could be completely replaced by direct government provision, and in

between various policy options are possible. We now turn to an examination of

some of these options.

In practice it is the problem of production externalities, particularly

environmental ones, which most occupy the attention of governments, and our

discussion will mainly, but not exclusively, focus on these.

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The main measures that governments can take include:

Direct provision of goods and services - this means the government

providing the good or service themselves, perhaps through state-owned or

nationalized industries.

The extension of property rights - this means giving people more right of

ownership over their immediate environment, so that they can enforce

environmental and other standards.

Taxes and subsidies - where an activity causes negative externalities it

could be taxed and where there are positive externalities, it could be

subsidized.

Tradeable pollution rights - this involves allowing companies to pollute a

certain amount (a 'permit to pollute') but then creating a market for the

permits, so that if they pollute more than the allowance they have to buy

extra permits. However, if they pollute less, then they can sell their surplus

permits.

Regulation, legislation and direct controls - this involves setting legal

limits or regulations to prevent negative externalities or perhaps to reduce

their impact.

15

Direct government provision

Direct provision of goods and services by the government

The existence of externalities provides an important argument for the common

ownership, or nationalization of a number of key industries.

The argument is that privately owned firms, in order to survive in a competitive

world, necessarily have to put their own interests before those of society at large,

for to do otherwise might be inconsistent with the goal of long run profit

maximization, or even survival. This harsh reality of the market is likely to

manifest itself in the generation of negative externalities such as pollution, as the

control of these externalities would involve higher costs and an adverse impact

on profits; conversely, production activity which conferred net positive

externalities on society might not be undertaken in sufficient quantities if the

criterion of private profitability could not be met.

Nationalized industries, on the other hand, which, on account of being commonly

owned, could be operated according to broad social criteria, rather than the

narrow commercial one of private profitability, and this allows for the possibility

of externalities to be fully incorporated into production decisions. Thus, for

example, questions of workers' safety standards and atmospheric pollution could

be accorded priority status, rather than being ignored on the grounds that to do

otherwise would adversely affect profits and competitiveness; and activities such

as the keeping open of 'uneconomic' coal mines and the provision of postal and

transport services to remote outlying areas, could all be maintained on the

grounds that they provide substantial positive externalities to society at large,

although not necessarily being profitable in the sense that the private revenues

from such activities exceed the private costs.

16

Similarly, an important argument for merit goods such as education and health

being directly provided by the government rather than through the market, is

that they not only confer private benefits on individuals but also significant

positive externalities on society as a whole which individuals would tend to

ignore when making their consumption decisions. As a result, left to the market,

under-provision is likely to occur; for example, individuals would be prepared to

buy education through the market if they had to, as substantial private benefits,

such as higher life-time earnings, are likely to result. However, a case for a higher

level of government provision can be made on the grounds that not all the

benefits accrue solely to the individual - society gains from a more efficient and

adaptable labour force and perhaps a more tolerant and more aware population.

The above arguments for direct government provision would of course be

strongly contested by free market economists who would argue the case for

privatization, the desirability of using markets to provide merit goods and the

extremely poor record of pollution control of the formerly centrally planned

economies of Eastern Europe.

Extension of property rights (Coase Theorem)

Property rights concern the legal entitlement to property and the right to use or

sell the property, as well as the rights that other people have, or do not have, over

the property. It is argued that negative externalities in particular arise because of

the existence of incomplete property rights over natural resources such as air,

land, rivers and seas i.e. as property rights are not fully allocated to these areas as

nobody really owns them, individuals and firms are free to impose external costs

from their production and consumption activities without having to pay any

compensation. The dumping of toxic wastes into the sea and the riding of a noisy

motorbike provide two examples.

17

Thus by extending property rights individuals would be able to stop others

imposing costs on them or to claim compensation if they did so. A person

purchasing a house, for example, could also acquire a set of 'amenity' rights that

would entitle the owner to peace and quiet in the vicinity of the property as well

as a supply of water and air of a reasonable quality. Any infringement of such

rights e.g. by neighbours playing music unduly loudly, or trucks emitting

excessive exhaust fumes into the air, would give the owner of the amenity rights

entitlement to compensation. In this case the externality would be

internalized as the initiators of the external costs would be forced to pay for

them, and adjust their production/consumption decisions to more socially

efficient levels.

However, there may be a number of problems with this solution in practice:

For compensation to be paid, it must be possible to establish the nature

and extent of external costs being imposed; in the case of most types of

pollution, for example, this tends to be an extremely difficult thing to do,

and so appropriate compensation levels become almost impossible to

establish.

Where there are many firms or individuals imposing negative externalities,

it would be exceedingly difficult to claim compensation from them all;

for instance, if many juggernauts, low-flying helicopters and joy-riding

teenagers passed a property, making great noise in the process, it would be

somewhat impractical for the property owner to try to claim compensation

from them all.

Even if those generating the external costs are few in numbers, the time

and cost involved of pursuing the offenders through the courts may be

prohibitive for all but the very rich; what chance would an ordinary person

have, for instance, in claiming compensation from a large, multinational

18

burger chain, which had permitted the neighbourhood to become unduly

littered with burger wrappings?

The extension of property rights has equity implications; extending

private property rights is likely to favour those who already possess

property at the expense of those who do not: so, Gypsies and travellers may

be prevented from setting up camp, peace campaigners and other

protestors could be prevented from holding their demonstrations and

ramblers' rights of way in the country-side might be infringed; thus those

on the political left tend to favour an extension of communal property

rights and a society based more on public ownership and a set of co-

operative values which, they would argue, are less likely to cause the

problem of negative externalities in the first place.

Resources

The Coase Theorem

https://www.youtube.com/watch?v=zcPRmh5AIrI

I Bought a rainforest

https://www.youtube.com/watch?v=7AtgF7BEoEU

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Taxes and subsidies

The use of taxes and subsidies to tackle the problem of externalities is a market-

based method of control as it works through the price system, i.e. through the

impact of changes in prices.

If negative externalities exist, and there is allocative inefficiency at the free

market price because SMC is greater than price and overproduction is occurring,

then the appropriate solution would be to tax the good; if, on the other hand, the

market is under-producing because positive externalities are not being taken into

account, it would be appropriate for the government to grant a subsidy.

Taxes

There are two types of tax, which may be applied to address the problem of

negative externalities: a tax set equal to each firm's marginal external costs

and an environmental or 'green' tax (Pigovian Tax).

20

The policy of taxing firms according to the marginal external costs that they

impose on society can be illustrated using figure 6 below. In this example we

assumed that a firm was dumping waste products into a river. The government

would have to assess the cost to society of such an action, and impose a tax on the

offending firm equal to the value of the marginal external cost (or negative

externality); in this case the tax would internalize the externality by making

the polluter pay. The levying of such a tax would shift the supply curve from S to

S1which would increase the market price to OP1, and cause the level of output to

fall to OQ1, where P = SMC and allocative efficiency is achieved.

Figure 6 Negative externalities - dumping of waste

21

An environmental tax could be imposed either on a product responsible for

creating pollution, or on the inputs to an industry which have caused

environmental damage e.g. carbon producing fuels, which are believed to play the

major role in the process of global warming. The aim of a carbon tax on each

unit of carbon in fossil fuels would be to: raise the price of those sources of power

with high carbon contents, thus encouraging a switching to power sources

causing lower CO2 emissions; encourage greater conservation of energy in

general; and stimulate the search for more environmentally-friendly

technologies.

Figure 7: Carbon tax on fossil fuel

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Pollution tax in sector emitting CO2

23

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Issues arising from the tax/subsidy approach

Advocates of this approach would argue that it permits the forces of demand and

supply to operate. At the same time generators of negative externalities are

induced to 'cleanup their act' because the less pollution they create, the less their

tax liability; and conversely, grants and subsidies encourage greater output and

consumption of those goods involving net social benefits.

In practice various difficulties are likely to arise:

For the tax solution to work in the way indicated in figure 7 above,

the exact value of the marginal external cost must be established so

that taxes, of exactly the right size can be applied; in reality it is not only

extremely difficult to identify external costs, but it also an extremely

arbitrary matter trying to ascribe a monetary value to them e.g. how should

the emission of black fumes into the air from an industrial chimney be

assessed?

From an environmental point of view a tax on pollution does not solve

the problem, as pollution is still allowed to continue; the tax merely

provides a market-led inducement to firms to find cleaner ways of

producing so as to reduce their costs; moreover, the unwilling third parties

who receive pollution as a negative externality are not in any way

compensated.

Taxation of pollution would require regular monitoring of pollution

emissions and as offending firms are likely to be generating different

quantities and types of pollution, such monitoring is likely to be

administratively complex and very costly.

Distortions and inefficiencies might arise in terms of the cost of

collecting a pollution tax, the inevitable temptation by the less scrupulous

to evade paying it altogether and the possibility of an inflationary impact

on the price level.

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Tradable pollution rights

Like the use of taxes and subsidies, tradable pollution rights (otherwise known as

tradable emission allowances or permits), represent another market-based

solution to the problem of negative externalities, in particular pollution. They

were first introduced in the USA in 1990 under the Clean Air Act in which the

Environmental Protection Agency set a target rate of reduction for power

stations' emissions of sulphur dioxide. Initially, power stations were issued with

emission permits in proportion to their current pollution levels and were allowed

to discharge pollution into the air up to a specified limit. Thereafter, those power

stations for whom the cost of reducing pollution was low, could sell their spare

pollution permits to generators for whom the cost of pollution abatement,

through the installation of appropriate equipment, would be very high. Thus, a

market in tradable pollution rights is created, stimulating pollution reduction

through the possibility of making money out of selling surplus permits.

Figure 8: Tradable Pollution Permits

26

The main argument in favour of such a scheme is that it operates through the

market via the price system: firms are given a profit incentive, i.e. through the

right to sell spare permits, to find cheap ways of reducing their pollution levels;

and such a system should be administratively cheap and simple to

implement, as the regulatory agency need have no information regarding firms'

costs - it simply has to issue the permits and arrange for their sale; in

addition, consumers may benefit if the extra profits made by low pollution

power stations, arising from the sale of their spare permits to other companies,

are passed on in the form of lower prices.

The main argument against the use of tradable emission permits is that they do

not actually stop firms from polluting the environment; they only provide

an incentive to so - where a degree of monopoly power and relatively inelastic

demand exist, the extra cost of purchasing additional permits so as to further

pollute the atmosphere, could easily be offset by the possibility of charging

consumers higher prices; moreover, the system of allocating permits in

accordance to existing emission levels could be seen as a reward for the

greatest polluters!

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Regulation, legislation and direct controls

In practice the use of direct controls represents the most common approach to

pollution abatement. Such controls can be applied both to individuals and firms

and can take a number of forms; for example, restrictions can be imposed on

smoke emissions from private homes and firms; restrictions may be placed on all

forms of building in designated green-belt areas; minimum environmental

standards may be stipulated for air and water quality; laws may be passed to

prevent drinking and driving and the sale of alcohol and tobacco to people under

a certain age.

Apart from restriction, direct controls can also be used more severely: activities

generating negative externalities could be banned completely; for instance, the

dumping of waste into rivers or the sea; or an activity which conferred net

positive externalities on society could be made compulsory; for example, all

children under the age of 16 in the country could be made by law to receive some

form of education, whether it be in a state school, a private school or at home.

The main advantage of regulation is that it is the most direct way of tackling

the problem of externalities; for example, market-based solutions such as taxes

and tradaable emission permits provide incentives to firms to reduce their

pollution levels but do not compel them to do so; as such problems as global

warming and the depletion of the ozone layer are thought by many to threaten

the very survival of our planet, it is argued that we cannot afford to trust our

futures with policies which allow for the possibility of non-compliance. Providing

legal restrictions are backed by inspections that are sufficiently regular and

rigorous, they should be effective.

28

Against this, it is argued that in reality the policing of regulations can present

great difficulties as the less environmentally conscious firms may attempt to

circumvent the controls e.g. through the generation of pollution during the night.

Thus an extremely large number of inspectors might have to be employed to

ensure compliance.

It is also claimed that regulation can be a rather blunt, indiscriminate

instrument of control; for example the setting of maximum emission limits does

not take into account the fact that the cost of reducing pollution would vary

considerably as between different firms, some facing high costs with others

facing low costs. Thus a uniform limit applied to all firms would be an inefficient

way of reducing pollution, implying as it would a high resource cost. Also it may

be the case that once emission targets have been achieved, there would be no

further incentive to continue to reduce pollution, as would be the case with a

pollution tax.

Regulation may also give rise to the problem of regulatory capture - those being

regulated may be successful in manipulating the regulatory body to act in

accordance with the private interests of the firms concerned, rather than in the

interests of society as a whole.

29

Positive externalities of Production/External Benefits

Access this webpage and follow the steps

http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/

posextprod.html

Figure 9: Positive externalities of Production

30

Positive externalities of Consumption/External Benefits

Access this webpage and follow the steps

http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/

posextcons.html

Figure 10 Positive externalities of Consumption

31

Market for Education

Education is a product, which exhibits a positive consumption externality i.e., has

positive effects on third parties following the private consumption of this

product. The MSB exceeds the MPB (MXB exists); it is under-provided and hence

under-consumed in the free market.

32

Example of the external benefit from consuming education

33

Government strategies to create a socially efficient equilibrium in

education market

1. Public Provision

2. Subsidisation

3. Vouchers

34

35

36

37

Demerit goods

What are demerit goods?

Demerit goods are goods, which are deemed to be socially undesirable, and which

are likely to be over-produced and over-consumed through the market

mechanism. Examples of demerit goods are cigarettes, alcohol and all other

addictive drugs such as heroine and cocaine.

The problem arises from the fact that so long as an effective demand is present,

such goods are, in all probability, going to be extremely profitable to produce, and

this is all that a price system takes into account - the market neither possesses a

'heart' to enable it to help those in need, nor is it inherently able to make value

judgments about which commodities are good or bad for society as a whole: it is

prices and profits which act as the 'guiding light' to resource allocation.

However, the consumption of demerit goods imposes considerable negative

externalities on society as a whole, such that the private costs incurred by the

individual consumer are less than the social costs experienced by society in

general; for example, cigarette smokers not only damage their own health, but

also impose a cost on society in terms of those who involuntarily passively smoke

and the additional cost to the National Health Service in dealing with smoking-

related diseases. Thus, the price that consumers pay for a packet of cigarettes is

not related to the social costs to which they give rise i.e. the marginal social cost

will exceed the market price and overproduction and over-consumption will

occur, causing a misallocation of society's scarce resources. This is illustrated

in figure 11 below.

Figure 11 Over-consumption of a demerit good

38

The diagram illustrates how the market fails in the case of demerit goods. At a

market price of OP, OQ quantity of the demerit good is consumed, where demand

(private marginal benefit) equals supply (private marginal cost). However, at OQ

the social marginal cost exceeds the price by the vertical distance XY, the value of

the marginal external cost. Social optimality would require a smaller level of

consumption at OQ1, where price = social marginal cost = social marginal

benefit.

Government responses - demerit goods

39

Possible government responses to correct market failure arising from

demerit goods

The government may attempt to reduce the consumption of demerit goods

such as cigarettes, alcohol and addictive drugs through persuasion; this is

most likely to be achieved through negative advertising campaigns,

which emphasize the dangers of drink-driving, drug abuse etc. The aim

here is the opposite of normal commercial advertising, namely to shift the

demand curve for demerit goods to the left.

Figure 12 Negative advertising campaign

40

A contraction of demand (movement along the demand curve for a

demerit good) could be achieved by the imposition of a tax on the demerit

good. This would have the effect of shifting the supply curve to the

left, raising the price and reducing the amount consumed. If the

government could accurately assess the value of the marginal external cost

caused by the consumption of the demerit good a tax equivalent to this

value could be imposed, and a socially optimum outcome could be

achieved. However, in practice, ascribing an accurate monetary value to

negative externalities is extremely difficult to do, and the demand for such

goods as cigarettes and alcohol is often highly inelastic, so that any increase

in price resulting from additional taxation causes a less than proportionate

decrease in demand.

Figure 13: Imposition of a tax

41

The government may use various forms of regulation. In its most extreme

form, regulation could be used to impose a complete ban on a demerit

good, such that its consumption is made illegal; for example, the

Prohibition Laws in the USA in the 1930s criminalized the sale and

consumption of alcohol, as does the law at the moment in Saudi Arabia; also

in the UK and many other countries today anyone found guilty of selling or

consuming heroin can be imprisoned. However, the effect of such

regulation is rarely to completely eliminate the market for the demerit

good; rather, it is usually driven underground in the form of an unofficial or

hidden market.

Less severe regulatory controls might take the form of spatial restrictions e.g.

people may be disbarred from smoking in their place of work, on public transport

and in cinemas and restaurants; there may be time restrictions in that it may be

illegal to sell alcohol during certain periods of the day, or there may be age

restrictions in terms of a minimum age being stipulated at which young people

are permitted to buy cigarettes and alcohol.

42

Merit goods

What are merit goods?

Merit goods are the opposite of demerit goods - they are goods which are deemed

to be socially desirable, and which are likely to be under-produced and under-

consumed through the market mechanism. Examples of merit goods include

education, health care, welfare services, housing, fire protection, refuse collection

and public parks.

In contrast to pure public goods, merit goods could be, and indeed are, provided

through the market, but not necessarily in sufficient quantities to maximize social

welfare. Thus goods such as education and health care are provided by the state,

but there is also a parallel, thriving private sector provision. Indeed, there is

considerable disagreement between economists on the right and left of the

political spectrum over the extent to which such goods should be provided by the

state or the private sector. We consider these arguments later in this section.

Before we proceed with our discussion of merit goods, and in particular the

question of why merit goods tend to be underprovided by the market, it would be

useful at this stage to summarize the main differences between public goods,

private goods and merit goods. Have a go at filling in the blank table below (we

have put in a few entries to help you along). Once you have had a go, follow the

link under the table to compare your answers with ours.

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Public goods

What are public goods?

Pure public goods are ones that when consumed by one person can be consumed

in equal amounts by the remainder of society, and where the possibility of

excluding others from consumption is impossible.

Examples of public goods are:

national defense;

the police service;

street lighting;

lighthouses;

flood-control dams;

pavements;

public drainage.

It is likely that the market, left to itself, will seriously under-produce such goods,

or possibly not produce them at all. This is because the market will only provide

goods for which a profit can be made, and pure public goods possess two

important properties that together make their production on the basis of private

profitability extremely difficult. These features are:

non-rivalry (or non-diminishability);

non-excludabilty.

Firstly, consider the characteristic of non-rivalry: this means that one person's

use of the public good does not deprive any other person of such use or does not

diminish the amount available to others; for example, if one person enjoys the

benefits of being protected by the police-force, a flood control dam or the

national defense system, it does not prevent everyone else doing the same;

similarly, if one person benefits from walking along a street at night-time which

is paved, free of pot-holes, and well-lit, the benefits and the availability to others

would not be diminished.

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Secondly, consider the characteristic of non-excludability: this means that when

the public good is provided to one person, it is not possible to prevent others

from enjoying its consumption - sometimes summarized as: provision at all

means provision for all. For example, if a police force, a flood-control dam or a

national defense system is successful in offering protection to citizens of a

country, once it has been provided it is impossible to exclude anyone within the

country from consuming and benefiting from them. Similarly, for a paved and

well-lit public street, nobody can be prevented from enjoying its benefits.

Thus, in the case of public goods, the market fails because the private sector

would be unwilling to supply them - their non-excludabilty makes them non-

marketable, because non-payers cannot be prevented from enjoying the benefits

of consumption, and therefore prices cannot be attributed to particular

consumers. This involves the free-rider problem, which arises when it is

impossible to provide a good or service to some without it automatically and

freely being available to others who do not contribute to its cost. For example,

imagine a situation in which you shared an island with five other inhabitants; if

you paid privately for an army to defend the island against violent invaders, your

five co-inhabitants could 'free-ride' off you by enjoying the benefits of the

defenze, without having to pay anything towards it; there would probably come a

point when you would withdraw your payments and, like the others, leave it to

someone else to foot the bill; eventually, the army would not be provided at all.

The concept of a 'public good' can perhaps best be understood by comparing it with its opposite, a private good.

A private good possesses two features, excludability and rivalry, and when consumed by one person, it is not available to others; thus, a person buying a new washing machine can exercise private property rights over it and exclude others from enjoying its cleaning abilities, whilst, at the same time, diminishing the total stock of washing machines available for sale to others.

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Hence, in a free market, a whole range of pure public goods may not be provided,

and the only answer is for the state to provide them, financed out of general

taxation. Moreover, the non-rivalry aspect of public goods means that the cost of

supplying one more user i.e. the marginal cost, is zero; for example, once paving

stones have been laid, it makes no difference how many people walk along them

as there is no additional cost involved. As the condition for the achievement

of allocative efficiency is that price should be set equal to marginal cost, it would

therefore follow that to achieve an optimum level of output and consumption of

public goods the state should provide them at zero prices.

Task: Fill in the table below with the relevant information

Main features Public goods Merit goods Private goods

Rivalry in

consumption

Non-rivalrous

Excludability Excludable

Benefits Individual and

communal (strong

positive externalities)

Provider Usually private

enterprise

Financed by Usually taxation

Examples

Why might merit goods be under-provided by the market?

http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/

meritunder.html

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Government responses - merit goods

Possible government responses to the under-provision of merit goods

One solution would be for the government to play no role whatsoever and to

allow the provision of merit goods to be decided completely through the free

interaction of market forces. However, for all the reasons previously mentioned,

this would lead to extreme under-provision of these goods and a misallocation of

resources from the standpoint of society as a whole. Thus, in practice,

governments play a substantial role in the provision of merit goods such as

health and education, even where they are ideologically committed, as the

present Conservative government is, to the market system. However, the exact

form that such government involvement should take is a subject of much dispute,

and we shall consider each of the following in turn:

Direct government provision – health care that is provided free at the point

of contact and paid for out of taxation revenue

Regulation - In the case of education, it may be compulsory that all children

between the ages of 5-16 receive some form of schooling, be it in the

private or public sector, and quality is controlled in such ways as school

teachers being required to have stipulated qualifications before they are

allowed to teach. In the case of health care, vaccinations against various

contagious diseases could be made compulsory and medical practitioners

such as doctors, dentists, opticians and nurses could be required to obtain

certain qualifications before they can practice. The government could also

use regulation to enforce the consumption of a good provided by the

private sector which is deemed to be a merit good by virtue of the positive

externalities that it generates: the compulsory consumption of seat-belts by

motorists provides one such example. The government could also institute

rent control in the housing market

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Subsidies - For example, the theatre is usually provided by the private

sector, and is often regarded as a merit good on account of the educative

and civilizing benefits that it confers on society. The government might

take the view that without state assistance to the arts, there would be an

unacceptably small number of theatres able to survive. In the health care

sector, prescription medicine may be subsidized with the government

paying part of the price either directly (in pharmacy) or via a

reimbursement system

A combination of government provision and market forces: If the good in

question were loft insulation which confers benefits on society in terms of

energy conservation, households prepared to lag their lofts could be given

a grant, and this would shift the demand curve D=PMB to the right to

D1=SMB. Allocative efficiency is achieved as SMB = SMC at OQ1. A similar

result could be achieved by subsidizing the output of loft insulation, which

would cause the supply curve to shift to the right until the socially optimum

level of production is reached.

Figure 14 Positive externalities - loft insulation

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Common access resources & sustainability

Common access resources

Common access, or common pool resources (CAR/CPR), are natural resources

including forests and pastures, fisheries, oil and gas fields, national parks, grazing

lands and irrigation systems, which are characterized by the difficulty of

excluding people from using them. As a result of the inability to charge a price for

their use, over-consumption, degradation and depletion of these resources is a

likely outcome. Indeed, the use by one individual or group of the resource will

mean that less of that resource is available for use by others. This distinguishes

common access resources from pure public goods, which exhibit both non-

excludability and non-rivalry in consumption.

It is argued that the lack of a price mechanism for common access resources

results in their overuse, depletion and degradation. The consequence of the

actions of producers and consumers, who do not pay for the resources they use,

creates a threat to sustainability and, therefore, the availability of common access

resources for future generations.

The origin of the study of common access resources dates back to medieval land

tenure in Europe, where herders were entitled to graze their cows on common

parcels of land for free. The result was over-grazing and the degradation of the

land. The problem was described and analyzed by Garrett Hardin in his

article 'The Tragedy of the Commons', which appeared in the Science journal in

1968. Hardin explained that it was in each herder's interest to put any additional

cows he acquired onto the grazing land, even if the quality of the common was

damaged for the whole community. This was considered to be a rational

economic decision by the individual herder, because each additional cow added

to the individual's 'marginal utility' while the damage to the common land was

49

shared by the entire group. However, the consequence of these individual

rational economic decisions was market failure because these actions resulted in

the degradation, depletion or even destruction of the resource to the detriment of

all users and, therefore, society in general.

Tragedy of the Commons

https://www.youtube.com/watch?v=EZFkUeleHPY

The overgrazing cost shown in Hardin's analogy is an example of a negative

externality of consumption, where the private utility is diminished by the

negative utility suffered by third parties; in this case the other herders. The

grazing land is over-consumed and so there is a welfare loss.

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To reduce these negative externalities, Hardin suggests potential management

solutions for common goods including privatization, environmental taxation,

government regulation and stricter management by the state. The nature of this

regulation depends on whether the resources are within national boundaries or

global in nature. Where national resources are concerned; rules on their use can

be imposed by national governments. Global common access resources, such as

fishing grounds, will require the creation of international regulatory

organizations to control their use. Hardin also suggests the transfer of common

access resources to private ownership. In keeping with his original pasture

analogy, he categorizes this as the enclosure of the commons.

The 'Tragedy of the Commons' is an analogy. The major theme running through

Hardin's work is, in fact, the growth of human populations with the Earth's

resources being a general 'common'. He focuses on the allocation and

exploitation of larger resources, such as the Earth's atmosphere and oceans, and

the 'negative commons' of pollution.

An interview with Garth Hardin on the Tragedy of the Commons

https://www.youtube.com/watch?v=L8gAMFTAt2M

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Common access resources in practice

In practice neither the state nor the market has been uniformly successful in

solving common access resource problems.

Indeed, Hardin's Common's Theory has been criticized by a number of

economists, not least by Elinor Ostrom the political economist and the 2009

Nobel Memorial Prize winner in Economic Sciences. Together with colleague

Oliver E. Williams, Ostrom's analyzed economic governance, especially those

related to common access resources or 'the commons'.

Ostrom simulated conflicts concerning the allocation of the commons and derived

a complex theoretical framework that went beyond the simple analysis of private

costs and benefits. She focused on additional variables, such as community,

leadership, trust and collaboration in resource sustainability and claimed it is not

necessary to have a 'top-down' management system regulated by the state.

Ostrom's extensive research includes analysis of complex fishing systems in Nova

Scotia, irrigation systems in the Philippines and Sri Lanka and groundwater usage

in California. Her research results suggest that sustainability is possible if the

users of resources collaborate to create democratically agreed, and adaptable,

rules for the exploitation of common access resources, with community sanctions

if these rules are broken. She argues that local communities make better decision

about the use of community resources than governments or private

organizations, because they have access to more information about the local

context and are directly affected. Her conclusions are supported by empirical

data showing that local-level monitoring of resources and community self-

determination is effective in ensuring resource sustainability.

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Other critics of Hardin's 'Tragedy of the Commons' analysis, focus on his proposal

to transfer common goods into the hands of private owners. Professor Heller of

the Columbia Law School, for example, coined the term 'Tragedy of the

Anticommons' to describe a situation in which rational individuals, acting

separately, collectively waste a common resource by under-utilising it. Heller

believes that the existence of numerous private rights holders may frustrate the

achievement of socially desirable outcomes. Supporters of this theory claim that

too many property rights, such as patents, leads to reduced innovation.

Competing patents in biomedical research illustrates a situation where useful and

affordable products are prevented from reaching the market and adding to social

welfare.

Summary of four types of Goods

53

Sustainability

A universally accepted definition of sustainability remains elusive, because they

focus on the many contexts in which the term is used. Most relevant to the study

of market failure are those definitions that relate to natural resources and their

usage.

All these definitions concern the need for humans to:

Live within the limits of the Earth's resources

Examine the distribution of resources and opportunities

Meet the needs of the present without compromising the ability of future

generations to meet their needs

Sustainable development was defined at the 2005 World Summit as development

requiring an understanding and reconciliation of the 'three pillars' of

sustainability, that of environmental, social and economic demands.

Threats to Sustainability

The threat to sustainability comes from the unplanned and often unfettered

exploitation of the world's natural resources. The increase in globalization, the

drive for economic growth, population growth and developments in technology

has made the need for management of global common access resources more

acute, whether this is by governments or by local communities.

Clearly, there are already many examples of threats to sustainability from the

depletion and destruction of common access resources, such as deforestation, soil

erosion and the overfishing of oceans. These are compounded by the pursuit of

economic growth by newly developing countries, and in less economically

developed countries where high levels of poverty and poor regulation creates

negative externalities through over-exploitation of land for agriculture.

54

The depletion of natural resources, such as fossil fuels and fishing resources,

creates individual hardship and political instability and potentially threatens

world peace. Resource depletion is accelerating and the economic growth of

countries that ignore this trend will be eroded by higher commodity prices.

Big Summit seeks big ideas

http://www.bbc.com/news/science-environment-13682012

The threat to sustainability from the use of fossil fuels

Market failure exists when the production or use of a good or service results in

an externalities and welfare loss, because the market does not direct an efficient

amount of resources into the production, distribution, or consumption of a good.

Fossil fuels are non-renewable resources as they take millions of years to form

and accelerating overuse is leading to their rapid depletion. The principles of

supply and demand mean that as fossil fuel supplies diminish, prices rise.

However, since the producers and consumers of fossil fuels do not have to

account to later generations for their overexploitation of resources, fossil fuels

are over-produced, and over-consumed despite their increase in price.

The over-production and overuse of fossil fuels raises environmental as well as

economic concerns, since coal, petroleum, and natural gas contain high

percentages of carbon; the burning of which generates greenhouse gasses

(GHGs), such as Carbon Dioxide (CO2 ) contributing to the process of global

warming. Although there is much argument about the extent to which the human

activity contributes to climate change, the effects of climate change are

undisputed, leading to increases in average temperature, altered habitats,

extreme weather conditions, sea-level changes and flooding.

55

There are huge external costs linked to these environmental changes. As

temperatures increase and rainfall patterns change, crop yields are expected to

drop significantly in Africa, the Middle East and India. Water availability for

irrigation and drinking will be less predictable, because rain will be more

variable and droughts more frequent, creating pressure on agricultural

production and diversity. Up to three billion people could suffer increased water

shortages by 2080. Air and water pollution resulting from the extraction and use

of fossil fuels can lead to significant health and environmental problems.

The economic consequences are significant. All businesses need resources - both

raw materials and energy. As reserves of both are under strain, world prices are

increasingly volatile. National and international commitments to reduce carbon

emissions, are forcing governments to examining the balance of their energy

production and consumption, exploring ways to reduce the use of fossil fuels if

possible, to be replaced by alternative cleaner technologies. With the rapid

economic growth in the emerging BRICS economies (Brazil, Russia, India, China

and South Africa), demand for raw materials and energy is outstripping supply

and countries around the world are beginning to position themselves to protect

their strategic interests.

The state of oil and natural gas production, in particular, is causing alarm. Oil

production peaked during 2006 with global oil production from mature oil fields

now declining at a rate of between 6-7% per year. Oil is becoming more difficult,

expensive and energy intensive to extract. The Peak Oil Crisis website has real

time clocks of global oil consumption and graphics illustrating the impending

crisis as well as articles, graphics and links to industry articles. Countries reliant

on oil imports are desperately seeking new oil and gas sources with global oil

companies seeking out previously untapped reserves in the remotest of regions.

56

The Artic is one of the regions that likely to become an economic and realpolitik

battleground, almost certainly pushing ethical, environmental and moral

considerations aside in the drive to its natural resources. It has been stated by

industry experts that another 5 million barrels of new oil per day must come on

line per year to meet global demand. A 2008 United States Geological Survey

estimated that areas north of the Arctic Circle have 90 billion barrels of

undiscovered, technically recoverable oil representing 13% of the undiscovered

oil in the world. In addition to the size of the untapped resources, environmental

factors are driving moves to develop the Arctic region. In the past, the Northwest

Passage connecting the Atlantic and Pacific Oceans through the Canadian Arctic

Archipelago, has been virtually impassable, because it was covered by thick, year-

round sea ice. However, satellite and other monitoring confirm a progressive,

year-by-year decline in the thickness and extent of Arctic sea ice.

There is general insecurity about oil supplies in many regions. Asia, for example,

only holds about 1% of the world's proven reserves of oil and gas. Oil prices are

predicted to rise abruptly with apocalyptic predictions about a collapse in oil

production by 2015. Asian countries, such as Japan, South Korea and India, are

buying and storing crude oil in unprecedented quantities. China is planning to

increase its reserves to 90 days consumption by 2020 and Singapore, preparing

for the looming oil crunch, is racing to complete a series of vast man-made

caverns beneath the seabed of Banyan Basin, which will include a vast oil storage

complex. The first two caverns providing 480,000 cubic metres (m³) of oil

storage will be constructed by 2013. Three more caves are planned, which would

store enough oil to last Singapore a month.

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The threat to sustainability from poverty

Population increases are both a consequence, and cause, of increasing poverty

and low standards of living around the world, especially in Asia and Africa. As

populations increase the demand on common access resources intensifies

resulting in extensive negative externalities, which threatens sustainability.

With the world's population surpassing 7 billion people in 2011, the global

impact is huge.

The World Bank periodically prepares poverty assessments of countries in which

it has an active programme, in close collaboration with national institutions and

other development agencies. The data it records is presented in a series of

datasets on its website.

Examine the following datasets and featured indicators and identify the major

links between poverty and reliance on agriculture.

World Bank Poverty dataset

For the 70% of the world's poor who live in rural areas, agriculture is the main

source of income and employment. The depletion and degradation of natural

resources poses serious challenges to producing enough food and other

agricultural products to sustain local livelihoods, but also to meet the needs of

urban populations, which rely on this supply.

World Bank Rural and Agriculture development dataset

Where low-income rural populations rely on subsistence agriculture, the

likelihood is that common access resources will become depleted, unless there is

some form of community collaboration along the lines suggested by Elinor

Ostrom. Sustainability of resources may be lost if poor communities are forced to

sell land and resources, such as forests, to external private corporations who do

not have the interests of the local community as a priority, but need to satisfy

58

their shareholders. Logging companies, for example, will wish to maximise their

utilisation of timber resources taking only their private costs into consideration,

ignoring the external costs to the local population. As a consequence, there will

be overexploitation of timber and deforestation creating negative externalities

such soil erosion, landslides, flooding and loss of bio-diversity.

The World Bank is one of the key promoters and financiers of environmental

upgrading in the developing world. The following dataset covers forests,

biodiversity, emissions, and pollution.

World Bank Environment dataset

59

Government responses to threats to sustainability

Market failure in production occurs when the production of a good or service

creates external costs that are harmful to third parties, e.g. when a factory

pollutes a river with waste or the atmosphere with greenhouse gasses. The total

costs to society of these activities are the private costs of the firm plus the

external costs that the firm creates, but does not pay for. Since the producer does

not pay the total cost, the good or service is over-produced, which results in

a welfare loss.

National governments can respond to negative externalities of production and to

resource depletion and CO2 pollution using a number of mechanisms designed to

reduce emissions of global greenhouse gasses and promote sustainability. These

include:

Environmental taxation, such as carbon taxes, to recover the external costs

of pollution

Legislation setting environmental standards and banning firms which fail

to meet these standards

Adoption of cap and trade schemes for carbon trading

Funding for cleaner technologies

Taxation and financial penalties increase the market price of carbon. This

provides strong incentives to reduce carbon emissions by sending signals:

1. To consumers about what goods and services produce high carbon

emissions and which should be used more sparingly.

2. To producers about which inputs emit more carbon, and which emit less, so

encouraging them to move to lower-carbon technologies.

3. To inventors and innovators to develop and introduce lower-carbon

products and processes.

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Cap and Trade Schemes

Cap and trade schemes set specific limits on GHG emissions for countries and

organizations. They promote the trading of emissions allowances between

emitters, who can meet the cap efficiently and those who face more of a challenge

in reducing emissions.

The choice between environmental taxation and cap and trade schemes to

address climate change has generated considerable discussion with impassioned

arguments on both sides.

Taxation has the advantage that individual governments without international

agreement can implement it, but environmental taxes have dead-weight losses in

addition to their beneficial effects in addressing externalities. It is also argued

that establishing a price for GHGs through cap and trade schemes has the

advantage of providing some certainty about reductions in quantities of

emissions and creates a market to achieve the climate change mitigation target at

the lowest cost.

Promoting Clean technologies

Cap and trade schemeA cap and trade scheme is a market-based approach to reduce carbon emissions via financial incentives that allows corporations or national governments to trade emissions allowances under an overall cap, or limit, on those emissions. Fines are imposed for producers exceeding those limits, while producers operating below their carbon limits can sell or "trade" their offsets to companies that are operating above the limits.

Clean technologiesClean technologies are designed to minimize pollution and the emissions of greenhouse gasses, by creating electricity and fuels with a smaller environmental and carbon footprint. These technologies include recycling, renewable energies (wind and solar power, biomass and biofuels and hydropower), green transportation, waste-water recycling and energy efficient lighting, homes, buildings, electric motors and commercial and domestic appliances.

61

The World Bank is the trustee of the Clean Technology Fund (CTF), focused on

making renewable energy cost-competitive with coal-fired power. Since its

launch in 2008, $US6.5 billion has been allocated to climate change projects in 45

developing countries. These payments represent a subsidy on the development

and use of clean technologies.

If government or World Bank subsidies are particularly focused on the

generation of electricity using renewable energy sources, such as wind and solar

power, then firms generating electricity using cleaner technologies will face

lower costs of production. This will encourage energy producers to produce more

wind and solar power, shifting the supply curve to the right and lowering prices

for consumers.

62

Subsidies or tax credits should also encourage increased investment in clean

technologies. However, UN research showed 'green' investment in Europe

dropped by one-fifth in 2010, while that in developing countries surge ahead.

Resource

http://www.unep.org/newscentre/Default.aspx?

DocumentID=2647&ArticleID=8805&l=en

The 'dirty side' of cleaner technologies

Local and national communities do not always welcome cleaner technologies.

'Wind farms', for example, may consist of hundreds of wind turbines and are

frequently criticized by some local communities for their negative environmental

impacts. They are often seen as a 'blot on the landscape' as well as posing

a danger for birds and bats, whose migratory and flight paths may take them into

collision with wind turbines and towers.

Other alternative energy sources have created similar controversies. The

production of biofuels has resulted in food price inflation worldwide, with land

previously used for growing food for human consumption being transferred to

the production of crops used to produce biofuels.

63

A 2011 report from the Nuffield Council on the Bioethics examined the ethical

issues of biofuels and the serious negative impacts on the livelihoods of some of

those who cultivate the land, on the sustainability of cultivation systems and on

biodiversity.

The following videos discuss the role of science in addressing some of the

problems associated with finding, and commercializing, alternatives to fossil

fuels:

Asymmetric information

For markets to function perfectly, all parties to an economic transaction should

have perfect knowledge about the terms of the contract, the products and

services that form the subject of the agreement and the prices in the market. In

practice, the real commercial world rarely confirms to this ideal, and it is

common for one of the parties to have better and/or more knowledge than the

other, leading to imperfect competition and market failure. This situation is called

asymmetric or imperfect information.

Properly functioning markets provide a valuable service to society, because

consumers are able to purchase the goods and services that best match their

preferences. However, asymmetric information can be used as a source of power

in determining the outcome of the transaction. As a consequence, the market will

64

not achieve allocative efficiency, because one of the parties - in this case normally

the consumer, pays a higher price for a product than they would have done if they

had perfect knowledge. In a perfect market, consumer and producer surplus

should both be maximized at the market price, i.e. the conditions are in place for

a Pareto optimum allocation of resources.

A common example of where the buyer pays more for a good than is socially

efficient is where the seller knows much more about the characteristics of that

good than the buyer. For example where:

The seller of a product knows it is faulty

Commercial ideas with technical aspects are hard to describe contractually,

but privately known by innovators

Labeling of food products use alternative terms for ingredients consumers

would normally avoid, e.g. various names for sugars such as glucose,

sucrose and fructose

Firms may have no incentive to provide consumers with information in

markets with a public good aspect

It is also possible that the consumer has more information than the seller. For

example, purchasers with specialist knowledge of antiques may be able to buy a

antique for a price less than its true market value from a private seller, who does

not have this expert knowledge.

The government has a number of policy tools at its disposal to correct

asymmetric information and to control externalities. These include taxes,

education programmes and production regulation intended to increase the flow

of information to consumers. Government may decide to intervene in the market

to require producers to disclose critical information, such as mandatory product

labelling. The objective of this government intervention may not be to alter

65

consumption behaviour in particular, but to increase informed consumption.

However, these measures can be expensive and ineffective and perceived as

government interference in the free market.

The growth of computer ownership with access to the Internet has reduced the

opportunities for asymmetric information, as consumers are able to access

greater details on products, prices and customer reviews.

Resource

The Rise and Fall of Sunny Delight

http://news.bbc.co.uk/2/hi/business/3257820.stm

Abuse of monopoly power

A most important assumption of the ideal free market economy is that markets

within it are competitive, so that a large number of competing firms

passively take the price that is set in the market as a whole and either increase or

decrease their output in response to shifts in consumer demand.

However, as we saw in the section on monopoly, markets may be dominated by a

single producer of the good or service, in which case a situation of

monopoly exists, or by a few producers, in which case an oligopoly exists. In

either situation, producers may not be content to take a price set in the market.

Having significant control over supply, firms in pursuit of maximum profits may

attempt to make the market price higher than it would otherwise have been by

restricting output. The outcome for consumers may therefore be that they are

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paying a higher price for a smaller output. This would represent market failure

and a misallocation of society's scarce resources, as the economy would be

deprived of some of the output, which would be valued more highly than that

currently being consumed.

Also, in a situation of monopoly or oligopoly, profits may not perform the

function that they are supposed to in the 'ideal' free market situation. Here, the

making of profit is deemed to be a sign of efficiency; that is, the goods that are

being produced are precisely those that consumers want and of a suitably high

quality, and because firms cannot influence price, the profit has been achieved by

operating efficiently, with costs being kept below the ruling price. However, given

the power of firms in monopoly and oligopoly to restrict output to keep price

artificially high, the making of profits may reflect market power and dominance

rather than efficiency. Monopoly may involve both allocative and technical

inefficiency. 

Inequality

Advocates of a freely operating price system often liken it to a political

democracy where all voters can cast their votes for the candidates of their choice,

with everyone who is eligible having an equal say: the price system, according to

this line of reasoning, is a consumers', economic democracy; every time we go out

and buy a particular good, we are affecting the demand for that good, and hence

also its profitability and supply. Hence, the simple act of buying a good is akin to

casting a 'vote' in favour of the production of that good, and is the way in which

consumers determine how scarce resources should be allocated.

Unlike the political democracy however, in which each person has equal voting

rights, the consumer democracy described above, given the unequal

distribution of income that exists in most capitalist economies, is unlikely to be

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one in which all have an equal say _ clearly voting power is directly related to

income so that the rich would have many more votes, and thus a much greater

pull on resources, than the poor. Consequently, the resulting pattern of resource

allocation may overlook the pressing, often life and death needs of the poor, and

reflect instead the more trivial wants of the rich. In the economics of the market

place, human wants are those that are supported by effective demand i.e.

demand backed by the ability and willingness to pay the market price.

Human needs, however, if unaccompanied by the wherewithal to pay, are simply

ignored. This is the overriding reason for the existence of mal-nutrition and

starvation in the world today: it is not that there is an overall shortage of food -

there is more than enough in total terms to feed everyone; the problem, quite

simply, is that those who need the food lack the money to pay for it.

Hence the 'free' market, given the degree of inequality which typically exists, is

likely to be one in which many people are severely disadvantaged in terms of

their market power. 'Electoral successes' will be the fast cars, exquisite jewellery

and luxury hotels etc. for those who can pay, with basic health care, education,

safe drinking water and nutritious food for the poor almost certainly 'losing their

deposits'. Clearly, some consumers are a lot more 'sovereign' than others!

Source:

http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/page_155.htm,

accessed Friday 15th of January 2016

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Short answer questions

1: Not painting a pretty picture

The Non-Drip paint company is considering whether or not to locate a new factory near the town of Greensville. The company estimates that the new paint will cost $5 million a year to run, but should add $6 million to revenue from the sale of the paint it produces.

The people of Greensville are worried that the new factory will release smoke, containing harmful chemicals, into the air. These chemicals will pollute the air and even get into the soil and water supplies, as rain will bring the chemicals down from the air.

The local health authority estimates that over many years this smoke will damage people’s health and increase the need for medical care at an estimated cost of $4 million a year.

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The local authority believes that the smoke will blacken the walls of historic buildings in the area, and cause their eventual erosion. Regular cleaning will therefore be needed at an estimated cost of $2 million each year.

On a more positive note, it estimates that the paint factory will encourage other firms to locate in the area as suppliers of materials, providers of transport etc, and that this will reduce local unemployment and help other local businesses. These external benefits are valued at $3 million.

(a): What two factors does the Non-Drip paint company take into account when deciding whether or not to produce paint with its resources?

(b): From society’s point of view should the firm take other factors into consideration?(c): Using the figures presented in the case study, calculate:

i. The paint company’s estimated yearly profit.ii. Whether or not paint production at the factory is worthwhile for society.

(d): A conflict of interest between the paint company and the local community has arisen. How does this illustrate the central economic problem?

2: Smoking

(a): List three private costs that a cigarette manufacturer will have to pay.

(b): How will the manufacturer calculate the total revenue from the sale of

cigarettes?

(c): How are other people in a café affected by a man’s decision to consume a

cigarette?

(d): Many countries have introduced laws to ban smoking in public places. What

sort of costs will a government have to pay for in order to make sure the ban is

observed?

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(e): Research has shown that smoking can damage your health.

i. What is the opportunity cost of increased health spending on treating

smokers?

ii. Who will bear the cost of increased health spending?

(f): Imagine that the government decides to increase the tax payable on a packet

of cigarettes. What effect may this have on?

i. The number of cigarettes consumed?

ii. The revenue of cigarette-makers?

iii. The workers in cigarette factories?

3: Belt up

Amiya Bundhun was an economics student at college and now works for a bank. She was injured in a car accident and has just spent six months in a hospital paid for by the government.

Amiya decides to work out the opportunity cost of not wearing her seat belt. She values the wages she has lost over six months at $12000 and she values her social life at $4000. Amiya calculates that the opportunity cost of not wearing her seat belt is $16,000.

The police and ambulance driver that attended to her at the scene of her accident said that Amiya would not have been hurt had she been wearing her seat belt.

(a): What is meant by the term opportunity cost?

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(b): What type of cost has Amiya forgotten about when she calculated the opportunity cost of not wearing her seat belt?

(c): “Wearing a seat-belt is up to me to decide. It’s my life and if I get hurt in an accident it affects nobody else”. Car drivers often say this, but would an economist agree with them? Explain your answer and say whether or not you agree that wearing a seat belt should be law.

Data Response Questions

1:

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(a) Use an appropriate diagram explain how a subsidy is likely to affect the

price and quantity of wind-generated energy

(b) Evaluate the decision to construct the world’s largest wind farm (at the

time) in Texas

2:

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(a) Using an appropriate diagram, explain how rising biofuel production will

affect the market for corn

3:

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(a) Using an appropriate diagram, explain why the problem discussed in the

text is an example of market failure

(b) Evaluate the use of regulation as a solution to the market failure caused

bu the pollution of the Cisadane River

4:

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(a) Using an appropriate diagram, explain why illegal dumping of toxic

waste by these manaufacturing firms is an example of a market failure

(b) Using an appropriate diagram, explain the expected effect on the local

carrot market resulting from the contamination of the river

(c) Evaluate the solutions that the government could employ to reduce the

negative externalities caused by the river pollution in Viotia

5:

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(a) Using an appropriate diagram, explain why in a free market, low-

emission vehicles may be under-provided

(b) Using an appropriate diagram, explain how ‘halving the indirect tax on

cars with smaller engines is likely to affect the car market in China

(c) Evaluate three of the policies that the Chinese government has

introduced or might introduce to bring cleaner, low-emission vehicles to

its roads

6:

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(a) Using an appropriate diagram, explain the possible effect on the market

for cigarettes of a ban on tobacco advertising in Ireland

(b) Evaluate the economic effects of the imposition of a minimum price for

cigarettes in Ireland

7:

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(a) Using an appropriate diagram, explain why the Emissions Trading

Scheme (ETS) could lead to higher prices for electricity

(b) With the aid of a diagram, explain how carbon emissions are a form of

market failure

(c) Evaluate the possible effects on the Australian economy of

implementing the Emissions Trading Scheme (ETS)

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