Applied Microeconomics Market Failures (I) PDF

Applied Microeconomics Market Failures (I)  Failure of Welfare Theorems As we discussed Welfare Theorems fail in a variety of settings. Erster Wohlfahrtssatz: Märkte führen bei idealen Bedingungen zu effizienter Allokation. Zweiter Wohlfahrtssatz: Effizienz kann unabhängig von Verteilung...

Applied Microeconomics Market Failures (I)  Failure of Welfare Theorems As we discussed Welfare Theorems fail in a variety of settings. Erster Wohlfahrtssatz: Märkte führen bei idealen Bedingungen zu effizienter Allokation. Zweiter Wohlfahrtssatz: Effizienz kann unabhängig von Verteilungsfragen durch den Markt erreicht werden, wenn Umverteilungen erfolgen. Diese Theoreme liefern die theoretische Basis für die Marktwirtschaft, zeigen aber auch die Notwendigkeit politischer Maßnahmen bei Marktversagen oder Ungerechtigkeit. Die Wohlfahrtssätze scheitern in folgenden Fällen: 1. Imperfekter Wettbewerb (Monopole, Oligopole, Monopsonien). 2. Externe Effekte (negative und positive). 3. Öffentliche Güter (fehlende Bereitstellung durch den Markt). 4. Asymmetrische Informationen (Ungleichheit bei Wissen und Daten). 5. Hohe Transaktionskosten (Handel wird ineffizient) 6. Ungleiche Anfangsverteilungen (sozial ungerechte Ergebnisse). 7. Dynamik und Unsicherheit (Krisen, Anpassungsprobleme).  Failure of Welfare Theorems As we discussed Welfare Theorems fail in a variety of settings. Naturally, when W Th. fail, government intervention is possibly beneficial This is not to say that it is always beneficial if 1st W Theorem fails Counterproductive Policies  Failure of Welfare Theorems As we discussed Welfare Theorems fail in a variety of settings. Naturally, when W Th. fail, government intervention is possibly beneficial This is not to say that it is always beneficial if 1st W Theorem fails Counterproductive Policies Inefficient Implementation  Failure of Welfare Theorems As we discussed Welfare Theorems fail in a variety of settings. Naturally, when W Th. fail, government intervention is possibly beneficial This is not to say that it is always beneficial if 1st W Theorem fails Counterproductive Policies Inefficient Implementation This is not to say that it is never beneficial if 1st W Theorem holds Redistribution Moral Considerations  Failure of Welfare Theorems One of the most important failures is the existence of a relation between someone’s consumption and someone else’s utility. Externalities: Someone else’s consumption (production) affects my utility directly. Pollution, Noise, Vaccinations... Internalities: I do not fully internalize the consequences of my own actions  Failure of Welfare Theorems One of the most important failures is the existence of a relation between someone’s consumption and someone else’s utility. Externalities: Someone else’s consumption (production) affects my utility directly. Public Goods: Certain goods are either non-rival (multiple people can consume them simultaneously) or non-excludable (it is impossible or costly to impede access). Ideas, lighthouse  Failure of Welfare Theorems In this lecture we will discuss some of the most relevant violations of welfare theorems Externalities and Public Goods: Someone else’s consumption (production) affects my utility / consumption directly. Other-regarding preferences: I may derive utility (or disutility) from someone else’s. Envy, inequality-aversion, status comparisons.  Failure of Welfare Theorems In this lecture we will discuss some of the most relevant violations of welfare theorems Externalities and Public Goods: Someone else’s consumption (production) affects my utility / consumption directly. Other-regarding preferences: I may derive utility (or disutility) from someone else’s. Information: Adverse Selection: Some characteristic of the good traded is unknown to a participant. Moral Hazard: Some party may take an action that affect the other party.  Pollution and Production A cantaloupe farmer and a beekeeper live next to each other. The farmer sells each cantaloupe at a margin of 𝑎𝑎. The total quantity of cantaloupe he produces depends on his use of pesticides. Total profits are then 𝑎𝑎𝑎𝑎 𝑥𝑥 − px, where 𝑥𝑥 is the total amount of pesticides. Bees die because of pesticides. Total honey revenue is 𝑏𝑏𝑏𝑏 𝑥𝑥 where 𝑔𝑔 0 = 1 and 𝑔𝑔′ x < 0  Pollution and Production The problem of the farmer is to choose the optimal amount of pesticides: 𝑎𝑎𝑓𝑓 ′ 𝑥𝑥 = 𝑝𝑝 The socially optimal amount of pesticides maximizes total surplus: 𝑎𝑎𝑓𝑓 ′ 𝑥𝑥 + 𝑏𝑏𝑔𝑔′ 𝑥𝑥 = 𝑝𝑝  Pollution and Production Privetely optimal choice 𝑎𝑎𝑎𝑎(𝑥𝑥) 𝑝𝑝𝑝𝑝 𝑥𝑥 𝐹𝐹  Pollution and Production Privetely optimal choice 𝑎𝑎𝑎𝑎(𝑥𝑥) 𝑝𝑝𝑝𝑝 𝑏𝑏𝑏𝑏(𝑥𝑥) 𝑥𝑥 𝐹𝐹  Pollution and Production Socially optimal choice 𝑎𝑎𝑎𝑎 𝑥𝑥 + bg(x) 𝑝𝑝𝑝𝑝 𝑥𝑥 ∗ 𝑥𝑥 𝐹𝐹  How can we solve this problem? Alfred Pigou was the first to recognize that externalities created a wedge between private and social incentives. Anreize He suggested the use of taxes (now called Pigouvian taxes). The tax is set equal to the difference between the marginal social cost of an action and the marginal social benefit. Ronald Coase then argued that the difference between private and social costs stems from a lack of markets. Absent any frictions (what he called transaction costs) the parties will always end up choosing the option that maximizes their total welfare. Examples of transaction costs are the cost of finding the relevant trading partner, setting up a contract, negotiating, etc.  Pollution and Production Pigouvian Solution The government sets a tax on pesticides The farmer chooses 𝑥𝑥 to maximize 𝑎𝑎𝑎𝑎 𝑥𝑥 − 𝑝𝑝𝑝𝑝 − 𝑡𝑡𝑡𝑡 where t is the tax rate.  Pollution and Production Pigouvian Solution The government sets a tax on pesticides The farmer chooses 𝑥𝑥 to maximize 𝑎𝑎𝑎𝑎 𝑥𝑥 − 𝑝𝑝𝑝𝑝 − 𝑡𝑡𝑡𝑡 where t is the tax rate. The FOC is 𝑎𝑎𝑓𝑓 ′ 𝑥𝑥 − 𝑝𝑝 − 𝑡𝑡 = 0 If 𝑡𝑡 = 𝑏𝑏′ 𝑥𝑥 ∗ , then the farmer voluntarily chooses 𝑥𝑥 ∗  Pollution and Production Socially optimal choice 𝑎𝑎𝑎𝑎 𝑥𝑥 𝑎𝑎𝑎𝑎 𝑥𝑥 − 𝑡𝑡𝑡𝑡 𝑝𝑝𝑝𝑝 𝑥𝑥 ∗ 𝑥𝑥 𝐹𝐹  Pollution and Production Coasian Solution The beekeeper makes an offer to the farmer. “If you use less pesticide, I will compensate you”  Pollution and Production Coasian Solution The beekeeper makes an offer to the farmer. “If you use less pesticide, I will compensate you” The beekeeper offers T as compensation and obtains: 𝑏𝑏𝑏𝑏 𝑥𝑥 𝐶𝐶 − 𝑇𝑇  Pollution and Production Coasian Solution The beekeeper makes an offer to the farmer. “If you use less pesticide, I will compensate you” The beekeeper offers T as compensation and obtains: 𝑏𝑏𝑏𝑏 𝑥𝑥 𝐶𝐶 − 𝑇𝑇 The farmer makes 𝑎𝑎𝑎𝑎 𝑥𝑥 𝐶𝐶 − 𝑝𝑝𝑥𝑥 𝐶𝐶 + 𝑇𝑇, where 𝑇𝑇 is the transfer that the beekeeper gives him. It must then be that 𝑎𝑎𝑎𝑎 𝑥𝑥 𝐹𝐹 − 𝑝𝑝𝑥𝑥 𝐹𝐹 ≤ 𝑎𝑎𝑎𝑎 𝑥𝑥 𝐶𝐶 − 𝑝𝑝𝑥𝑥 𝐶𝐶 + 𝑇𝑇 or the farmer will say no.  Pollution and Production Coasian Solution The beekeeper chooses the transfer to be the lowest possible amount... 𝑇𝑇 = (𝑎𝑎𝑎𝑎 𝑥𝑥 𝐹𝐹 − 𝑝𝑝𝑥𝑥 𝐹𝐹 ) − (𝑎𝑎𝑎𝑎 𝑥𝑥 𝐶𝐶 − 𝑝𝑝𝑥𝑥 𝐶𝐶 ) Notice that the transfer equals the difference in profits between the agreed level of production and the “privately optimal” level.  Pollution and Production Coasian Solution How should the beekeeper choose the level of production? 𝑏𝑏𝑏𝑏 𝑥𝑥 𝐶𝐶 − 𝑇𝑇 = 𝑏𝑏𝑏𝑏 𝑥𝑥 𝐶𝐶 − 𝑎𝑎𝑎𝑎 𝑥𝑥 𝐹𝐹 − 𝑝𝑝𝑥𝑥 𝐹𝐹 + (𝑎𝑎𝑎𝑎 𝑥𝑥 𝐶𝐶 − 𝑝𝑝𝑥𝑥 𝐶𝐶 ) Notice that 𝑎𝑎𝑎𝑎 𝑥𝑥 𝐹𝐹 − 𝑝𝑝𝑥𝑥 𝐹𝐹 is a “constant” that is independent of 𝑥𝑥 𝐶𝐶. The optimal 𝑥𝑥 𝐶𝐶 maximizes 𝑏𝑏𝑏𝑏 𝑥𝑥 𝐶𝐶 + 𝑎𝑎𝑎𝑎 𝑥𝑥 𝐶𝐶 − 𝑝𝑝𝑥𝑥 𝐶𝐶 which is exactly the social optimum! The Coase Theorem says that regardless of what would happen absent negotiation (i.e. regardless of 𝑥𝑥 𝐹𝐹 ), if negotiation is costless, the allocation will maximize the gains from trade (social optimum) Pollution and Production The Coase Theorem says that regardless of what would happen absent negotiation (i.e. regardless of 𝑥𝑥 𝐹𝐹 ), if negotiation is costless, the allocation will maximize the gains from trade (social optimum) In most cases, there are substantial costs of negotiation. Pollution and Production Notice that the farmer’s compensation is highest the higher is the profit she would get by polluting! This is one of the drawbacks of the coasian solution: compensation depends on what happens absent agreement and that, itself, depends on who gets to decide. In this example, the farmer has the right to choose and that gives her some rents.  Kosten oder Nutzen, die eine Person sich selbst zufügt, ohne diese bei der Internalities Entscheidungsfindung vollständig zu berücksichtigen. In many instances, individuals disregard the effects that their choices have on their own welfare Exercise, addictive behavior, saving, etc. We refer to this phenomenon as internalities. Internalities are essentially externalities but present two key differences The individual is the direct beneficiary of the solution so there is no redistributive issue Optimal policy requires taking a stance on the true “welfare” function of the individual Since individuals do not choose optimally, revealed preference arguments fail and we cannot easily learn their preferences. Policy often “defers” to the individual’s choice using “nudges” Politischen Ansatz, der die individuelle Autonomie respektiert, aber gleichzeitig durch den Einsatz von „Nudges“ (Anstupsern) bessere Entscheidungen fördert, anstatt strikte Vorgaben oder regulierende Maßnahmen zu erlassen.  Internalities: Taxation Ann enjoys consuming veggies 𝑥𝑥1 and soda 𝑥𝑥2 according to the utility function 𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝑥𝑥1 + 𝑎𝑎 ln 𝑥𝑥2 She has income 𝑤𝑤 > 𝑎𝑎 and the prices of veggies is 1. Unfortunately, Ann cannot stop herself from drinking too much soda. In 𝑏𝑏 particular, her demand of soda is observed to be equal to 𝑥𝑥2 𝑝𝑝1 , 𝑝𝑝2 = for 𝑝𝑝2 some 𝑏𝑏 and the rest of her income is spent on veggies (O’Donnaghue & Rabin 06) Internalities: Taxation soda “true” preferences 𝑏𝑏/𝑝𝑝2 𝑎𝑎/𝑝𝑝2 “Behavioral” preferences veggie  Internalities: Taxation Suppose the government sets up a tax 𝜏𝜏 on expenditure in soda and transfer the tax revenue back to Ann. 𝑏𝑏 Then, 𝑥𝑥2 𝜏𝜏 = 1+𝜏𝜏 𝑝𝑝2 The optimal tax maximizes: max 𝑤𝑤 + 𝑇𝑇 − 𝑥𝑥2 (𝜏𝜏)𝑝𝑝2 (1 + 𝜏𝜏) + 𝑎𝑎 ln 𝑥𝑥2 𝜏𝜏 𝜏𝜏 max 𝑤𝑤 + 𝜏𝜏𝑝𝑝2 𝑥𝑥2 𝜏𝜏 − 𝑥𝑥2 (𝜏𝜏)𝑝𝑝2 (1 + 𝜏𝜏) + 𝑎𝑎 ln 𝑥𝑥2 𝜏𝜏 𝜏𝜏 max −𝑥𝑥2 (𝜏𝜏)𝑝𝑝2 + 𝑎𝑎 ln 𝑥𝑥2 𝜏𝜏 𝜏𝜏 𝑏𝑏 𝑏𝑏 max − + 𝑎𝑎 ln 𝜏𝜏 1 + 𝜏𝜏 1 + 𝜏𝜏 𝑝𝑝2 𝑏𝑏 max − − 𝑎𝑎 ln(1 + 𝜏𝜏) 𝜏𝜏 1 + 𝜏𝜏  Internalities: Taxation Hence, the government sets: 𝑏𝑏 1 + 𝜏𝜏 = 𝑎𝑎 𝑎𝑎 And Ann chooses 𝑥𝑥2 𝜏𝜏 = which maximizes her true welfare! 𝑝𝑝2 The amount of tax is redistributed back to her, which (given quasilinearity) is fully spent on other goods. Equivalently, the money is spent in other things by the government, which leads to a reduction in other taxes.  Internalities: Taxation soda “true” preferences New budget line “Behavioral” preferences veggie  Internalities: How to measure (Bernheim & Taubinsky 20) The problem is that the government cannot really obtain a measure of a since, by definition, the individual uses b when making decisions. Researchers have developed smart methods to come up with a Objective measures of b based on estimates of the value of life and the impact of soda on our body. Provide an intensive information campaign to a group of people. The ratio of their purchases before and after is a “sufficient statistic” for the tax. Make the health issue “salient” in the decision. Still, because preferences are no longer revealed in every decision, we need to make a choice of “which” decisions to defer to.  Nach der Idee von Coase können externe Effekte durch klare Vereinbarungen zwischen Internalities: Coase den betroffenen Parteien gelöst werden. There are now many apps that act as “self-commitment” devices. For instance, Stickk asks you to commit to a goal and if you miss it pay a fine to a charity. In a sense, this is equivalent to you signing a contract with your future self instead of relying on the Government  Cap and Trade Markets Often governments use “market-like mechanisms” when real markets are not available. One famous example is the European Carbon Trade Market. Companies trade pollution permits Each firm is indifferent in the margin between polluting a bit more and buying a permit or reducing their pollution and selling the permit. For a given endowment of permits, the allocation is efficient in that the firms with highest “abatement costs” (costs of reducing their pollution) are the ones who pollute more. The total amount of permits is chosen with the idea that the price reflects the social cost of pollution (although many believe it too generous).  Cap and Trade Markets The government sets the total quantity of pollution in the market. Each company equates the marginal benefit of pollution with the price: 𝜋𝜋 ′ 𝑥𝑥𝑖𝑖 − 𝑝𝑝 = 0; 𝑥𝑥𝑖𝑖 (𝑝𝑝) 𝑝𝑝 The market price adjusts so that the market clears ∑𝑥𝑥𝑖𝑖 p = 𝑥𝑥̅ 𝑥𝑥̅ Since 𝑝𝑝 = 𝜋𝜋 ′ 𝑥𝑥𝑖𝑖 for all firms, and in the social optimum 𝑆𝑆 ′ 𝑥𝑥̅ = 𝑝𝑝 (Pigouvian tax) Cap and Trade Markets According to some, it sells the wrong signal: if you have 30€ you can send a ton of coal to the atmosphere. The question for economists is not whether you can but whether you will... And you will only if the cost of avoiding it is too high. 30€ was probably too low...  Cap and Trade Markets vs Taxes The advantage of the cap and trade market is that it is easier to know what is the (tolerable, efficient?) amount of pollution than what is the optimal tax. For instance, countries may set particular goals like a 20% reduction and the market would implement it with little additional information. The disadvantages There may be unanticipated shocks (covid) that may lead to large changes in prices that are unrelated to the social costs of carbon prices. Individual reductions in CO2 emissions by companies in sectors covered by the system do not result in aggregate reductions but only in decreases of the price! Cap and Trade Markets Prices have sky-rocketed recently. While this may be good (it reflects a better approximation to the actual externality), it is clear that the social cost has not doubled since the summer.  Uncertainty: Prices vs. Taxes Notice that the social cost of pollution is independent of productivity! The price of a pollution permit should be constant (on expectation) Because the quota is constant, the price adjusts to reflect the marginal product of one more ton of CO2 equivalent rather than its cost! That means that a quota is inefficient.  Uncertainty: Quotas vs. Taxes Suppose all firms are identical. Then, 𝑥𝑥̅ = 𝑁𝑁𝑁𝑁. The problem of the social planner who chooses a quota gives max 𝑁𝑁𝑁𝑁[𝜋𝜋 𝑥𝑥 ] − 𝑆𝑆(𝑁𝑁𝑁𝑁) x FOC is 𝐸𝐸 𝜋𝜋 ′ 𝑥𝑥 = 𝑆𝑆 ′ 𝑁𝑁𝑁𝑁 Where 𝐸𝐸 refers to the expectation over market conditions. In “good times”, 𝜋𝜋 ′ 𝑥𝑥 = 𝑝𝑝 > 𝑆𝑆𝑆 while in “bad times” 𝜋𝜋 ′ 𝑥𝑥 = 𝑝𝑝 < 𝑆𝑆𝑆 If instead we fix the price equal to 𝑆𝑆 ′ , then 𝑥𝑥 adjusts and we obtain efficiency.  The Total Quota Problem Some governments have thought of adding regulation on top in certain markets (e.g. taxes to short-haul flights, Uni Wien does this) Since air transport is part of the system, this does not change the total amount of emissions (fixed equal to 𝑥𝑥)̅ It leads to a reduction in the price Other sectors pollute more instead! It is inefficient since CO2 emissions are equally harmful regardless of the source but now air transport faces a higher marginal cost than other sectors (misallocation).  Pigou: Externalities and Market Power In most real-world markets, polluters have market power (either in product or input/labor market). These two evils fight each other Social Marginal Cost Private Marginal Cost 𝑝𝑝𝑀𝑀 = 𝑝𝑝∗ Demand 𝑄𝑄∗ = 𝑄𝑄𝑀𝑀 Marginal Revenue  Pigou: Externalities and Market Power In most real-world markets, polluters have market power (either in product or input/labor market). These two evils fight each other Because of the polluting externality, there tends to be overproduction. Because of market power, prices are kept artificially high, requiring underproduction. Yet, they make policy ineffective Because of market power, the “pass-through” of costs (taxes) to prices tends to be low. To achieve the same impact on output, we need a much larger tax In general, the tax will differ from the marginal externality.  Pigou: Externalities and Market Power Consider the production of meat in South America (Dominguez-Lino 24). Small farmers can produce more by de-foresting 𝐹𝐹. They sell to agribusinesses with strong market power. Agribusiness take price of meat as given and choose the price they pay to farmers to maximize profit: 𝑝𝑝 − 𝑤𝑤 𝑦𝑦 These businesses are taxed (tariffs, carbon taxes?) at rate 𝜏𝜏 The de-forestation externality is 𝜉𝜉 (released carbon)  Pigou: Externalities and Market Power Farmers choose F to maximize 1 𝑤𝑤𝑤𝑤 − 𝑐𝑐𝐹𝐹 2 2 𝑤𝑤 The amount of deforestation is then 𝐹𝐹(𝑤𝑤) = 𝑐𝑐 Farmer prices are chosen by the agribusiness to maximize 𝑤𝑤 (𝑝𝑝 − 𝑤𝑤 − 𝜏𝜏) 𝑐𝑐 𝑝𝑝 − 𝜏𝜏 𝑝𝑝 − 𝜏𝜏 𝑤𝑤 = ; 𝐹𝐹 = 2 2𝑐𝑐 So the pass-through of taxes is only 50%!  Pigou: Externalities and Market Power What would the social planner do? 1 max 𝑝𝑝F − 𝑐𝑐𝐹𝐹 2 − 𝜉𝜉𝜉𝜉 2 And hence 𝑝𝑝 − 𝜉𝜉 𝐹𝐹 𝑆𝑆𝑆𝑆 = 𝑐𝑐 𝜉𝜉 = 0, 𝜏𝜏 = −𝑝𝑝 (eliminate market power) What is the optimal tax? 𝑝𝑝 − 𝜏𝜏 𝑝𝑝 − 𝜉𝜉 𝑝𝑝 𝜉𝜉 = , 𝜏𝜏 = 0 (evils cancel) 𝐹𝐹 ∗ = = = 𝐹𝐹 𝑆𝑆𝑆𝑆 2 2𝑐𝑐 𝑐𝑐 𝜏𝜏 = 2𝜉𝜉 − 𝑝𝑝 𝜉𝜉 → 𝑝𝑝, 𝜏𝜏 → 𝑝𝑝 (ban meat production)  Additionality Umweltmaßnahme tatsächlich einen zusätzlichen positiven Effekt hat, der ohne die Maßnahme nicht erreicht worden wäre In many settings, governments opt for “substitutes” of Pigouvian taxation (politically costly). One example are conservation offsets Government pays farmers (via auction) to commit not to crop their lands for a period of time.  Additionality Outcome of the auction Farmers bid their expected profit of farming over the next 10 years. If they win, they get paid at least that; if they lose they farm. Those farmers with the lowest benefit of farming win, which is efficient...  Additionality Outcome of the auction Farmers bid their expected profit of farming over the next 10 years. If they win, they get paid at least that; if they lose they farm. Those farmers with the lowest benefit of farming win, which is efficient...... unless some farmers would have chosen not to crop their lands regardless of the outcome of the auction! These are called “non-additional” farmers, as they do not add anything to welfare by winning. Additionality Example: A has a rice plot and farms it every year, getting 10k. B has a wheat plot and farms it only if the price is high enough (half of the time); when he farms it he gets 15k. The value for society of conservation is 12k Additionality Example: A has a rice plot and farms it every year, getting 10k. B has a wheat plot and farms it only if the price is high enough (half of the time); when he farms it he gets 15k. The value for society of conservation is 12k Efficiency requires A to win the auction and conserve her land, while B should crop it when profitable. 1.5 units of land are (on average) under conservation (18k) and profit is 7.5k... Total 25.5k per unit of time Yet the auction ends with B bidding 7.5k and winning. B produces and gets 10. Total 22