Microeconomics
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Government Prices and Markets: Block 2
5.1. Information Failure 5.2. Externalities 5.3. Public Goods 5.4. Common Resources
Lecture 5 Market Failure
5. Market Failure
Types of Government Intervention
• Education and information
• Institutions, standards • Enforcing property rights • Taxes and subsidies • Providing/subsidising public goods
• Industry regulation • Redistribution and transfers
Market Model Assumptions
• rational agents • perfect information • zero transaction cost • flexible prices • property rights enforced • perfect competition
Definition: Market failure refers to a situation in which the market on its own fails to allocate resources efficiently in that total surplus is not maximised.
A number of types of market failure exist which correspond to violations of the assumptions of the model of the market. When markets fail, governments intervene to try and correct the failure.
Types of market failure
• Bounded rationality • Asymmetric information • Transactions cost • Externalities • Public goods • Imperfect competition • Inequality
Behavioural Business
Minor
5.1. Information Failure: Rationality vs Bounded Rationality Definition: Rationality is the assumption that people are “homo economicus”, i.e. gather information carefully weigh costs and benefits to choose the optimal course of action.
Preferences Information
Decision
Real people sometimes: • fail to understand information and make mistakes; • act against their own self interest; • take excessive risks or act overconfidently; • give too much weight to small no. of vivid observations; • are reluctant to change their minds. • are affected by their peers. • are affected by their past actions.
Definition: Bounded (i.e. limited or imperfect) rationality means that real people are not always able to optimise (choose the best option) because they do not have the necessary information available and/or are unable to process it correctly. They use procedure (routines, habits, rules of thumb) instead that sometimes produce bad decisions.
5.1. Information Failure: Bounded Rationality
Definition: merit goods (bads) are goods or services that government thinks people should (not) consume irrespective of tastes or incomes. In the free market, people under (over) consume merit goods (bads). Government enforces or subsidises (prohibits or taxes) the consumption of merit goods (bads).
Government Intervention • provide information (awareness campaigns) • regulate firms to provide information • regulate consumption/production of goods/services
Behavioural Business
Minor
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5.1.2. Information Failure: Asymmetric Information
Source: Marginal Revolution University
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Definition: Asymmetric information exists when one party to an economic interaction has more (market-) relevant information than another.
Market Solutions • Signalling (informed party reveals private info to uninformed party) • Screening (uninformed party induces informed party to reveal private info)
Adverse selection (hidden characteristics): the seller knows more about the attributes of the good than the buyer who runs a risk of being sold a good of low quality. Examples: used cars, labour, insurance markets. Moral hazard (hidden action): One side takes actions that are relevant to the other side but cannot be observed (shirking, lack of reasonable care).
Asymmetric information can prevent mutually beneficial trades or cause shortages and surpluses in the market.
5.1.2. Information Failure: Asymmetric Information
Government Intervention • provide information (awareness campaigns) • regulate firms to provide information
Behavioural Business
Minor
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Positive Negative
Production Innovation Pollution
Consumption Vaccination, education Public drunken disorder
Definition: externalities exist when the production or consumption of a good has positive or negative side-effects on third parties which are not accounted for in the price of the good. Externalities are the uncompensated impact of one person’s actions on the wellbeing of a bystander.
5.2. Externalities
Government Intervention • Regulation (command-and-control): forbidding, limiting or mandating certain activities • Market-based policies: to align private incentives with social efficiency. eg. corrective
taxes and subsidies: tax activities that have negative externalities and subsidise activities that have positive externalities;
Market Solutions • Moral codes and social sanctions • Charities • Self-regulation: firms voluntarily agree to and monitor an industry code of conduct
Price
Quantity0
Demand (private value)
QMarket
Supply (private cost)
Social cost (private cost + externality)Cost of pollution
QOpt
A production process causes air pollution which creates a health risk for those who breathe the air.
The cost to society of producing a unit of the good is the private costs of sellers plus the costs to bystanders who are adversely affected by the pollution.
A benevolent social planner maximises the value to consumers minus the cost of production, including the external costs.
The planner would choose the level of production at which the demand curve crosses the social cost curve.
Below QOpt the value of the good to consumers exceeds the social cost of producing it. Above QOpt the social cost exceeds the value to consumers.
5.2.1. Negative Externalities in Production The Guardian - The smoke that many Australians inhaled this summer contains fine particles, known as PM 2.5, that are especially damaging because they can enter the bloodstream. “It can affect every system in your body, which means you’re not only talking about respiratory-related and heart-related problems, people are linking it to diabetes [and] dementia,” Green says.
Price
Quantity0
Demand (private value)
QMarket
Supply (private cost)
Social cost (private cost - externality)
Value of spillover
QOpt
A production process gives rise to a chance that the producer will make a technological advance. Such advances create benefits for society as a whole, known as spillovers, because they add to our pool of knowledge.
Because of these spillovers, the cost to society of producing a unit is less than the private cost of sellers.
Once again, a benevolent social planner maximises the value to consumers minus the cost of production.
In this case the planner would want to increase production until the social cost is equal to the private benefit.
5.2.2. Positive Externalities in ProductionSource:Infographic: how much does Australia spend on science and research?
Price
Quantity0
Demand (private value)
QMarket
Supply (private cost)
Externality
QOpt
Social value (private value - externality)
The consumption of alcohol can yield negative externalities if consumers drive under the influence or engage in violent or antisocial behaviour.
Because of the external costs associated with such consumption, the social value is less than the private value.
The planner would want to lower the quantity produced and consumed to QOpt.
5.2.3. Negative Externalities in Consumption
Price
Quantity0
Demand (private value)
QMarket
Supply (private cost)
Externality
QOpt
Social value (private value +
externality)
Vaccines yield positive externalities because they lower the risk of catching diseases for everyone in the population, even those who are not vaccinated.
Because of the external benefits associated with such consumption, the social value is greater than the private value.
The planner would want to increase the quantity produced and consumed to QOpt.
5.2.4. Positive Externalities in Consumption
Behavioural Business
Minor
In the market model, property rights are perfectly defined and enforced. This implies goods and services are excludable and rivalrous in consumption which does not always hold in reality.
Private goods and club goods do not present market failure as they have prices attached to them, i.e. they are excludable
Public goods and common resources, because they are non-excludable, provide incentive for people to free ride (consume without paying).
If a person provides a public good, for e.g. national defence, others would be better off and yet they are not charged for this benefit; little incentive to provide the good
If a person uses a common resources, for e.g. fish in the ocean, others would be worse off and yet they are not compensated for this loss.
Definition: public goods are goods that are non-excludable (once produced, no one can be prevented from using the good) and non-rivalrous (one person’s use of the good does not diminish other people’s use).
Rivalrous Non-Rivalrous
Excludable Private goods (coffee) Club goods (Netflix)
Non-Excludable Common resources (fish stocks) Public goods (national defence,
fireworks, lighthouses)
5.3. Public Goods and Common Resources
Behavioural Business
Minor
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5.3.1 Public Goods: Government Solutions The government can remedy this problem by providing or subsidising the public good and paying for it with tax revenue, to make everyone better off.
National defence - one of the most expensive public goods. Solution: People may disagree on the appropriate levels, but most will agree that some government spending on defence is necessary.
Basic research (knowledge) – general knowledge is a public good; profit seeking firms have incentive to free ride on the knowledge created by others. Solution: Government subsidises the basic research carried out by universities and other research organisations (this is a corrective subsidy on the positive externality generated).
Fighting poverty – everyone prefers living in a society without poverty, but fighting poverty is not a ‘good’ that private actions will adequately provide. Solution: Many government programs are aimed at helping the poor, for e.g. unemployment benefits, old-age pensions, disability support, funded by tax revenue.
Before providing a public good, government conducts a cost-benefit analysis to determine whether it is efficient to do so.
Definition: cost-benefit analysis is a study that compares the costs and benefits to society from the provision of a public good.
5.3.2 Public Goods: Do we need Government Solutions?
The provision of public goods may not require government intervention.
Free-to-air TV and radio - non-excludable and non- rivalrous, yet provided by private firms as for-profit business. For e.g. Freeview.
How is revenue generated, when consumers enjoy for free? Solution: broadcasters sells a complementary, private good i.e. advertising. Sells airtime to advertisers.
Advertisers are willing to pay more if their ads are shown during a program that has many viewers. This gives broadcasters incentive to show programs that viewers want to watch. Hence, viewer demand drives what is shown.
Other examples of the private provision of public goods: search engines e.g. Google and Bing; and video sharing sites e.g. YouTube and Vimeo. These are funded by the revenue from the ads displayed on the webpages.
Charitable Donation - Contributions to charitable causes can be similar to the provision of public goods. Appealing to consumers to contribute rather than free ride can often lead to individuals contributing towards the public good.
The tragedy of the commons refers to the overuse of communal resources. Each fisherman fishing in the common fish stocks reduces the quantity of fish available for others. Because people neglect this negative externality when deciding how much to fish, the result is an excessive number of fish caught. Overfishing eventually damages the fish population’s ability to renew itself, destroying the common resource for everyone.
Definition: Common resources are goods that are non-excludable but rivalrous. Examples include clean air and climate change, oil deposits, congested non-toll roads, fish, whales and other wildlife stocks.
University of Washington - Most countries are trying to provide long-term sustainable yield of their fisheries … We want to know where we are overfishing. Still, most of the fish stocks in South Asia and Southeast Asia do not have scientific estimates of health and status available. Fisheries in India, Indonesia and China alone represent 30% to 40% of the world’s fish catch that is essentially unassessed.
5.4 Common Resources
The Guardian - Around 90% of the world’s stocks are now fully or overfished and production is set to increase further by 2025, according to report from UN’s food body.
5.4.1 Common Resources: Government Solutions Congested roads - yield a negative externality. When one person drives on the road, it becomes more crowded, and other people must drive more slowly. •Solution: Government levies a toll or a congestion charge. A toll is a corrective tax on the externality of congestion. Sometimes congestion is a problem only at rush hour. Government can charge higher tolls at rush hour as an incentive for drivers to alter their schedules.
Many species of animals (fish, whale, other wildlife) – are common resources. Fish, for instance, have commercial value, and anyone can go to the ocean and catch whatever is available. Each person has little incentive to maintain the species for the next year. Just as excessive grazing can destroy the commons, excessive fishing can destroy marine populations. •Solution: ??
Two problems prevent successful Government regulation of fish stocks: (1) many countries have access to the oceans, so any solution would require international cooperation among countries that hold different values; (2) Since oceans are so vast, enforcing any agreement is difficult.
5.4.2 Common Resources: Do we need Government Solutions? Overfishing on the commons - the community can prevent the tragedy in a number of ways. Solution: regulate the number of fishing boats in each waterbody or divide up the waterbody among the families.
Clean air and climate change – greenhouse gasses emitted in one country spread around the world contributing to climate change in every country. When a government in one country regulates emissions, it considers only its own environment, not the effects on other countries. Solution: the Coase Theorem suggests that nations can enter into a treaty (e.g. the Paris Accord) which commits them to reduce their own emissions. The treaty behaves like contract, internalising the externality.
Oil deposits – a large oil field lies under many properties with different owners. Any of the owners can extract the oil, but when one owner extracts oil, less is available for the others. Because each owner who drills a well imposes a negative externality on the other owners, the benefit to society of drilling a well is less than the benefit to the owner who drills it. If owners of the properties decide individually how many oil wells to drill, they will drill too many. Solution: some type of joint action or agreement among the owners is necessary to solve the problem and ensure that oil is extracted at lowest cost.