Microeconomics ii

• Introduction to the concept of Market Failure • Negative and positive externalities • Private and public solutions to externalities • Interfering with the Price Mechanism

– Minimum and Maximum Prices • Public goods – Free goods

Class content

• Market failure: a situation in which a market left on its own fails to allocate resources effectively

• Causes of market failure: – Market power: the ability of a single economic agent to have a

substantial influence on market prices – Externality: the uncompensated impact of one person s

actions on the well-being of a bystander • Negative externality: the impact on the bystander is

adverse – Examples: automobile exhaust, cigarette smoke, loud pets,

loud music

• Positive externality: the impact on the bystander is beneficial

– Examples: immunization, restored historic buildings, research into new technologies

Market failure

• Negative externalities lead markets to produce a larger quantity than is socially desirable

• Social cost: private cost of the producers + cost to those bystanders who adversely affected by the pollution

• Socially optimal output level is less than the market equilibrium quantity!

• Internalization of externalities: creating incentives so that people take account of the external effects of their actions – taxes

Negative externality

• Pollution: aluminum factories emit pollution, then the cost to society of producing aluminum is larger than the cost to aluminum producers

Example of negative externality

• Positive externalities lead markets to produce a smaller quantity than is socially desirable

• The social value of the good exceeds the private value! • Socially optimal output level is more than the market equilibrium

quantity! • Internalization of externalities:

– Subsidies – Industrial policies: promotion of technology-enhancing industries,

patent regulations

Positive externality

• Technology spillover – a technological innovation or design of a firm not only benefits the firm but enters society s pool of technological knowledge and benefits society as a whole

• Education

Example of positive externality

Private: • Government solutions are not

always needed! • Types:

– Moral and social codes – Charitable organizations

(non-profit or not-for-profit) – Business synergies – Contracts

Public: • Command-and-control policies:

regulations – Banning certain behaviors

(pollution) – Requiring certain behaviors

(technology implementation, vaccination)

• Market-based policies: – Corrective taxes and subsidies – Tradable pollution permits

Solutions to externalities

Pigovian tax vs. tradable pollution permits

• The tool of price control • Influence and pressure of different groups of people (lobbying) on

government – Buyers would go for lower prices – Sellers would go for higher prices – Conflict of interest!

• Policy advisors can help select the necessary tool to apply • Government imposes either a price ceiling or a price floor with the

intention to maintain prices at other than equilibrium levels

Introducing government policies

• Price floor: a legal minimum on the price at which a good can be sold

• The government imposes a price floor - > two outcomes are possible: a) If the imposed price floor is lower than the market

equilibrium price then the price floor is not binding (has no effect)

b) If the imposed price floor is higher than the market equilibrium price then the price floor is binding and creates a surplus in the market

Effects of price floors on market outcomes

• Although it was created with the desire to help sellers, not all sellers benefit from it

• Surpluses! • Discrimination by buyers • Strengthening of black markets

• Real world examples: – Minimum wage

Real effect of a binding price floor

• Price ceiling/cap: a legal maximum on the price at which a good can be sold

• The government imposes a price ceiling - > two outcomes are possible: a) If the imposed price ceiling is higher than the

market equilibrium price then the price ceiling is not binding (has no effect)

b) If the imposed price ceiling is lower than the market equilibrium price then the price ceiling is binding and creates a shortage in the market

Effects of price ceilings on market outcomes

• Although it was created with the desire to help buyers, not all buyers benefit from it

• Shortages! • Long queues – waste of time • Discrimination by sellers • Strengthening of black markets

• Real world example: – 1970s gasoline shortage

Real effect of a binding price ceiling

IF GOVERNMENT POLICIES ARE AGAINST MARKET EFFICIENCY, WHY DO WE NEED THEM?

Types of goods

• Excludability: the property of a good whereby a person can be prevented from using it

• Rivalry: the property of a good whereby one person s use diminishes other people s use

Private sector tend not to provide or

manage these types of goods

• For each of the following items, decide first if the good is rival or nonrival and then whether it is excludable or non-excludable:

a) Apples Rival and excludable b) Chinese language Non-rival and n0n-excludable c) Cable television Non-rival and excludable d) Farm-raised salmon Rival and excludable e) Yosemite National Park Rival and non-excludable

Exercise 1.

• Externality: the uncompensated impact of one person s actions on the well- being of a bystander – Negative externality: the impact on the bystander is adverse – Positive externality: the impact on the bystander is beneficial

• Private solutions to externalities: – Moral and social codes – Charitable organizations – Integrating different types of businesses (synergies) – Contracting between parties

• Public solutions to externalities: command and control, market-based policies (taxes, subsidies, permits)

• Price ceiling/cap: a legal maximum on the price at which a good can be sold • Price floor: a legal minimum on the price at which a good can be sold • Types of goods: private, natural monopolies, common, public

Summary