Market System: Imperfections & Externalities

Market System Imperfections

• Market systems are subject to imperfections, including varying degrees of power held by economic agents.
• These imperfections can lead to economic outcomes that differ from market model predictions.
• Individuals' belief systems influence their judgment of outcomes and answers to key economic questions.

The Invisible Hand

• Proponents of market systems refer to Adam Smith's "invisible hand" principle.
• The intellectual basis for the market system is individuals acting in self-interest without government interference.
• The "invisible hand" guides self-interest to promote general well-being.
• Critics argue that individuals don't fully understand costs and benefits, causing inefficiencies that the market system alone cannot resolve.

Externalities

• Paper manufacturing produces dioxin, a chemical byproduct linked to health problems such as cancer.
• Dioxin production imposes costs on people that paper firms do not pay.
• An externality occurs when an economic activity affects a bystander who receives no compensation.
• A negative externality has an adverse impact on bystanders, while a positive externality has a beneficial impact
• Decisions are often made considering the private costs and benefits but not always the social costs and benefits.
• The price mechanism may not reflect true costs/benefits, leading to socially inefficient market outcomes and misallocation of resources.

The Social Costs and Social Benefits of Decision-Making

• Market operations rely on decisions made by individuals and groups, producing private costs and benefits.
• Private costs of a car journey include fuel, wear and tear, vehicle tax, and insurance.
• Private benefits include convenience, air conditioning, driving pleasure, music, and quick arrival.
• Decisions may not consider societal costs (congestion, road wear, emissions, noise, accident risk) or benefits.
• Social costs are borne by third parties/taxpayers, while social benefits are gained without payment.
• Externalities mean society's interest extends to bystanders; their well-being also matters.
• Market equilibrium is inefficient with externalities, as buyers and sellers neglect external effects, leading to suboptimal outcomes.

Examples of Externalities

• Car exhaust creates smog (negative externality), so governments set emission standards and tax petrol/vehicles.
• Restored historic buildings convey beauty (positive externality); governments regulate destruction and offer tax incentives.
• Barking dogs disturb neighbors (negative externality), so governments may prohibit disturbing the peace.
• Research creates knowledge (positive externality); governments use patents to incentivize inventors.
• Vaccination programs reduce virus prevalence (positive externality), so governments encourage vaccination.

Welfare Economics: A Recap

• The demand curve reflects buyer value, and the supply curve reflects seller costs.
• The equilibrium quantity maximizes total value to buyers minus total costs to sellers.
• Market equilibrium is efficient in the absence of externalities.
• The demand curve reflects consumer benefits (willingness to pay), and the supply curve reflects seller costs.
• The equilibrium price balances the value of the last unit consumed with the cost to supply it

Negative Externalities

• A pollutant released with aluminum production is a negative externality, with unconsidered health risks/costs to producers.
• The social cost of producing aluminum includes private production costs and pollution costs to bystanders.
• The social cost curve is above the supply curve, accounting for external costs.

The Social Optimum or Socially Efficient Outcome

• Market outcome values benefits to consumers at P, but true cost is higher (at ).
• The optimal amount of aluminum produced is where demand intersects social cost curve (at ).
• The private market outcome is larger than the socially optimal quantity.
• Reducing production below the market equilibrium raises total economic well-being.
• Welfare loss is the difference between the value of consumption and social cost of production.
• A tax on aluminum producers internalizes the externality.
• It shifts the supply curve upwards, aligning with social cost curve.
• In the new equilibrium, producers would produce the socially optimal quantity.

Positive Externalities

• Education yields positive externalities, improving productivity and economic growth which benefits everyone.
• Positive externalities occur where one firm's success encourages others to enter a market, or incentivize export promotion.
• The demand curve doesn't reflect the total value to society of the good, or activity such as education.
• The value of an activity such as education to consumers, is less than the total value to society .
• The social value curve lies above the demand curve.
• The optimal quantity is where the social value curve and supply curve intersect.
• The market failure can be corrected by introducing a subsidy.

Positional Externalities

• Positional goods' utility depends on comparison with others.
• Decisions altering evaluation context generate positional externalities, arising from comparing relative positions.
• Despite income/house size increases, happiness measures are stable partly due to positional externalities.
• Hiring a sports psychologist can improve a squash player's performance but negatively affects rivals.
• Incentive arises for others to also hire one; the overall effect is often neutral and inefficient.
• Universities demanding higher grades and firms requesting particular skills leads to investment that cancels out any competitive advantages but adds costs.
• A positional arms race is when individuals invest to gain an advantage, but these measures simply offset each other.

Private Solutions to Externalities

• Governments intervene to correct market failures, but private solutions also exist.

The Types of Private Solution

• The problem of externalities is sometimes solved with moral codes and social sanctions.
• Many charities are established to deal with externalities.
• The private market can often solve the problem of externalities by relying on the self-interest of the relevant parties.
• Interested parties may enter into a social contracts to deal with external effects.

The Coase Theorem

• It suggests that the private market can solve the problem of externalities and allocate resources efficiently if private parties can bargain without cost.
• The distribution of rights determines the distribution of economic well-being
• It does not matter for the reach of the market.

Why Private Solutions Do Not Always Work

• The Coase theorem applies only when parties can reach and enforce an agreement without trouble.
• Transaction costs are incurred in the process of agreeing to and following through on a bargain
• Bargaining breaks down if each party tries to hold out for a better deal.
• Reaching an efficient bargain is tough when many parties are involved because coordinating everyone is costly.
• Asymmetric information and rational behavior are critical to an efficient bargain.

Public Policies Towards Externalities

• Public policies correct perceived market failure by directly regulating behavior or incentivizing private decision-makers through price signals.

Command and Control Policies: Regulation

• The government can remedy an externality by making certain behaviors either required or forbidden.
• Environmental regulations dictate pollution levels or require specific emission-reducing technologies.
• Government regulators need industry-specific details and knowledge of alternative technologies.

Market-Based Policy: Corrective Taxes and Subsidies

• The government can use market-based policies to align private incentives with social efficiency.
• They internalize an externality by taxing activities with negative externalities and subsidizing those with positive externalities.
• Pigovian taxes can reduce pollution at a lower cost.
• A tax is as effective as a regulation in reducing the overall level of pollution.
• Pigovian taxes place a price on polluting and incentivize factories to develop cleaner technologies.
• Government can intervene with tax, to make price signal more accurate and incentivize the producer to pay the external costs.

Tradable Pollution Permits

• Allowing the steel mill to increase its emissions by 100 tonnes if the paper mill reduces its emission by the same amount is economically efficient.
• Deals must make the owners of the two factories better, voluntarily agreeing to it with no external societal effects.
• A new scarce resource is created where there is a market (a good) to trade.
• The firms that can reduce pollution only at high cost will be willing to pay the most for the pollution permits.
• The firms that can reduce pollution at low cost will prefer to sell whatever permits they have.
• Initial allocation doesn't matter economically, final allocations are efficiently traded.
• Pigovian taxes and pollution permits internalize the externality of pollution by making it costly for firms to pollute.

Public/Private Policies Towards Externalities

• Private solutions to externalities can occur but need some form of legal back-up to be able to work.
• Property rights refer to the exclusive right of an individual, group or organization to determine how a resource is used.
• If property rights are not well established, the market fails to allocate resources efficiently

Government Solutions to the Absence of Property Rights

• Government can solve the absence of well established property rights. Establishing such rights can extend market forces.
• Ownership of common resources such as rivers can be put under an agency established by the government.
• For any economy to work efficiently, a system of property rights must be established and understood.
• If property rights over the air that we breathe can be extended, then any firm polluting that air could face prosecution for doing so.
• Extension of property rights also means that the owner of the property can also exercise the right to sell or share that property.
• Establishing property rights is crucial in good governance, particularly relevant to developing countries.

Difficulties in Establishing Property Rights

• How do we apportion rights to such things as air, the seas, rivers and land?
• The cost of establishing property rights and getting international agreement on what they entail is considerable.
• Property owners may also have insufficient knowledge about their rights and exactly what they mean
• It is not a costless exercise to prove that property rights have been violated.

Control of Positional Arms Races

• To reduce instances of positional arms races, an incentive must prevent investment in mutually offsetting attempts to gain some benefit.
• Incentives could exist through legislation, informal agreements or a social norm on behavior.
• In other cases, a legally binding arbitration agreement where participants are bound to adhere to a decision, might be made.

Objections to the Economic Analysis of Pollution

• Environmentalists argue it is morally wrong to allow pollution in return for payment.
• The response to this view acknowledges the importance of trade-offs.
• Eliminating all pollution would reverse technological advances.
• A clean environment conforms to the law of demand.
• Pigovian taxes reduce the cost of environmental protection and increase the public's demand for a clean environment.

Government Failure

• Decision-making must be of high quality and decisions should improve market outcomes, based on positive analysis.
• Government decision-making can be flawed and not based on perfect information.

The Importance of Power

• Economic decisions being taken by government inevitably become political decisions.
• The benefit of decisions/outcome to the people must be greater than the costs.
• Inefficient market outcome: the benefits of government decision-making accrue to a small number of people but the costs are spread across large sections of the population.
• When governments make decisions that conflict with economic efficiency it is termed government failure

Public Choice Theory

• Governments are urged to help improve market outcomes, or solve perceived problems in many different areas.
• Governments may intervene as a reaction to public pressure or moral panic spread by news organizations.
• Moral panic can lead to excessive pressure being put on governments and, in such situations, decisions can be made not on the basis of rationality and efficiency but on placating some individual or group self-interest.
• There are three key actors Public choice theory: voters, law-makers or politicians, and bureaucrats.
• Public choice theory is the analysis of governmental behavior, and the behavior of individuals who interact with government.
• Government failure might exist, if there is a minority of winners where their benefits are outweighed by the costs of the majority of losers.

An Example: Road Congestion

• One solution for road congestion is to make people pay for the use of the roads.
• A vocal group that disagrees, might use their political power to have the road pricing abandoned.

The Invisible Hand versus Public Interest

• Public choice theory developed out of an economics tradition that stems from Adam Smith’s invisible hand.
• Public choice theory tries to look at the economic analysis of human behaviour as individuals and transfers this analysis to political.
• Individuals can become political animals where interest leads to what leads to inefficient decisions and allocation of resources.

Voter Incentives

• Voters chose parties/politicians promising most benefits at least cost.
• Voters have little incentive to gather information due to low individual vote impact (rational ignorance effect) and instead rely on skewed info.
• The rational ignorance effect is reinforced with heavy bias through family, TV, party leaflets lacking in detail .
• People do not vote as they simply do not see that their vote makes any difference and so there is little incentive for them to do so.

Politician Incentives

• Politicians' decisions are motivated by attracting votes, and they will reflect the interests of the local.
• Some rely on the rational ignorance effect, and communities have voter inertia.

Bureaucrat Incentives

• Bureaucrats administer government, provide advice, and carry out the legislative programme.
• Civil servants wield power and seek to represent their agency's interests by protecting budgets.
• Such a policy might have some economic merit but for the particular departments, such a policy would be highly damaging to the politicians and bureaucrats involved
• There might exist a conflict where an efficient economic outcome might not occur due to departments having too much power

The Special Interest Effect

• The electorate want those who are most organised and attract access to the political decision-makers, whether they are politicians or bureaucrats, to be voted for.
• Individuals have specific knowledge about issues closely related to them.
• Special interest groups develop and can exercise power through lobbying or cultivating close relationships.
• The special interest effect may lead to minorities gaining significant benefits, but the cost is borne by the population.
• The incentives to align might not only be publicity but also the possibility of accessing funds to help support future election campaigns
• Logrolling is vote trading in government, reinforcing the special interest effect and is an aspect of government failure.
• Logrolling is when a member will vote for what they do no support on the understanding that another member will vote in support of what they do support.
• The argument for logrolling decisions: Laws that might not have a wide enough effect and impact on society without the net effects.

Rent Seeking

• ‘Rent’ refers to the income some individual or group receives from an activity that might not have positive social benefits; they are likely to have a negative social impact
• Rent seeking refers to cases where resources are allocated to provide rents for individuals or groups and where those rents have negative social value. For example when tariffs on steel are imposed, in the United States. The benefits to this group were balanced out against the wider effects, these benefits might pale into insignificance.
• Threat of retalliation by other nations affectted by the US tariffs can lead to a reduction in demand for US manufactured goods.
• Ultimate effect: Rents to the US Steel Industry that could ultimately have a negative social value.
• Rent seeking amounts to a particular group being able to influence policy to the extent that they are able to gain favors transfering wealth.
• If rent seeking is sucessful, it diverts more resourcs to such an activitiy, rather than solving experienced problems.

Short-Termism

• Most political systems allow for governments to be in power for relatively short periods of time.
• Politicians tend to respond more to short-term projects for reelection rather than long-term efficient projects.
• During the financial crisis, several governments were reliant on debt financing.
• The long tern cost of the above: Increased taxation and austerity measures.

Public Sector Inefficiency

• From the 1980's publicly owned asserts were being transferred to the private sector
• Public sector cannot run activitiy in ways the the private sector can. A profit motive leads to increased efficiency, productivity and cutting costs.
• Risk inherent in decision-making is not the same public and private sector as the first one benefits from taxpayer bailout.
• Public sector managers do not see the returns from returns that is the case in the private-sectror as such are more likely to be inefficienct.

Cronyism

• Markets allocate resources based on supply/demand and the price mechanism.
• The market mechanism is distorted when the government intervenes such as taxes and subsidies. .
• Resource allocation is determined by political forces due to external interventions.
• Political forces are influenced by favours, and the term cronyism is relevant as the system responds to government intervention.
• Cronyism means governments implement regulations, taxes, and subsidies favoring powerful groups in return to favours and political support.

Inefficiency in the Tax System

• Firms and individuals seek to avoid and evade taxes leading to substantial losses.
• The underground economy represents 15% of total tax receipts of some governments.
• the designs of the tax system provides people with an incentive to avoid or envade the system.
• Where there is a perception of an unfair system individuals will seek to avoid taxation to increase their welfare.

Conclusion

• Market mechanism assumptions point to an efficient economic outcome from society's standpoint.

• Evaluating outcomes requires considering externalities and well-being of third parties, because the market may fail to allocate resources efficiently.

• People can privately solve the problem of externalities. The Coase theorem states that interested parites can bargain among themselves and agree on a efficient soluation. However an efficient outcome cannot be reached because of a party numbers making it hard.

• Governments may sometimes intervene when private bargains are hard by requiring decision-makers to bare to full cost through use of policy. Pigouvian and permits design to interalise externaitlies are effect at protecting enviroment to force market direction to remedy market failure. Even with goverment interbvention, they can create failure. Through incentives and politcal influences lead to economic distortion and inefficency. The cost outweighs the benefits.