OCR EC4101 Topic 6: Market Failures & Environment PDF

EC4101 Topic 6: Market failures and the environment Learning objectives Examine different types of market failure, focusing in particular on externalities that impact on the environment Understand some of the main solutions to externalities Understand the ongoing impact of climate change...

EC4101 Topic 6: Market failures and the environment Learning objectives Examine different types of market failure, focusing in particular on externalities that impact on the environment Understand some of the main solutions to externalities Understand the ongoing impact of climate change Competitive markets As we saw in previous topics, competitive markets result in an allocation of resources in the economy that is optimal All buyers and sellers are matched, maximum surplus generated Result of this model of competitive markets led economists and policymakers alike to the conclusion that competition between firms should be encouraged Underpins many policy reforms such as deregulation/liberalisation, competition policy, etc. Market failure However, in reality, most markets are not perfectly competitive This is due to a failure that causes one of the assumptions underpinning the perfect competition model to be violated Leads to free market arriving at an equilibrium that is not efficient Market failure Various sources of market failure and they provide different roles for government Public goods Externalities Information failures Market power Market failures listed above are not mutually exclusive and are often interrelated Public goods Goods which are non-rival and non-excludable “each individuals consumption of that good leads to no subtraction of other individuals’ consumption of that good” (Samuelson) Non-rivalry implies that one unit of the good can be consumed simultaneously by all consumers e.g. radio broadcast, train compartment Non-excludability means it is impossible to prevent consumers consuming good when they have not paid for it e.g. street lighting, radio broadcast Public goods Public goods suffer from free-rider problem and market will fail to provide it without some form of intervention The free-rider problem exists where a person cannot be excluded from consuming a good and therefore has no incentive to pay for it Pure public good has both non-rivalry and non-excludability characteristics while a pure private good has neither Many goods in between exhibit elements of one or other of these characteristics Options to deal with public goods Public production Public finance and private production – privatisation argument Private market solutions Possible in some cases due to tech. developments, e.g. cable TV Private cooperation i.e. voluntary grouping can agree to cover some costs but free rider problem is greater as group gets bigger, e.g. neighbourhood crime patrol or beautification project Information failures Information asymmetry leads to problems of opportunism More informed part can exploit less informed party Such behaviour leads to market failure Two major types of opportunistic behaviour: Adverse Selection (hidden information or unobserved characteristics) Moral Hazard (hidden actions) Information failures Equalise information… Screening Signalling Third party comparisons Standards and certifications Restrict opportunistic behaviour (regulation) Compulsory car insurance Mandatory health insurance in some companies Product liability laws Externalities Where actions of individuals/firms affect others, but external cost/benefit of this is not reflected in the value of their transactions When the impact on the bystander is adverse, the externality is called a ‘negative externality’ When the impact on the bystander is beneficial, the externality is called a ‘positive externality’ Externalities Externalities are like public goods, i.e. non-rival and non- excludable Individuals cannot internalise effects of externality through private trades and an essential market fails to exist Provides allocative role for government NB: Social cost/benefit = Private cost/benefit + cost/benefit due to the externality 4 types of externalities Negative production e.g. pollution caused by manufacturing of steel Negative consumption e.g. smoking, loud party in a house, car exhaust fumes Positive production e.g. beekeeping, painting house, well-kept garden, etc. Positive consumption e.g. vaccinations, education Key message… Negative externalities lead markets to produce a larger quantity than is socially desirable Positive externalities lead markets to produce a smaller quantity than is socially desirable Negative externalities Example: pollution by an aluminium factory If the aluminium factory emits pollution (a negative externality), then the cost to society of producing aluminium is larger than the cost to aluminium producer For each unit of aluminium produced, the social cost includes the private costs of the producer plus the cost to those bystanders (external cost) adversely affected by the pollution € Social D = demand curve or private benefit to cost consumer Supply Supply = supply curve or private cost to producer Social cost = actual cost to society of D output Difference between Supply curve and Q2 Q1 Output Social cost is external cost P2 Producer will produce Q1 with pollution P1 level P1 if left to operate freely P = pollution Without government intervention to force production at Q2 with pollution level P2 Levels of there is overproduction & deadweight loss Pollution of social welfare Negative externalities The intersection of the demand curve and the social-cost curve determines the optimal output level The socially optimal output level is less than the market equilibrium quantity The socially optimal price is higher than the market equilibrium price Negative externalities and property rights External costs such as pollution are difficult to tackle in the absence of property rights Property rights are the power of residual control, including the right to be compensated for externalities Assigning property rights can ‘internalise’ an externality According to Coase theorem, if trading externalities is possible, then the trading mechanism will lead to an efficient outcome independent of the initial allocation of the property rights In simple terms, if people must pay for an externality, they will take its effects into account in making private decisions and there will no longer be market failure Negative externalities and property rights Assigning property rights to externalities and creating ‘missing’ markets is not straightforward Creating a market is costly to organise and then there is also the ‘free-rider’ problem Recall: the free-rider problem exists where a person cannot be excluded from consuming a good and therefore has no incentive to pay for it Negative externalities – solutions? Pigouvian taxes: tax the level of pollution Cap-and trade permits: allow the voluntary transfer of the rights to pollute from one firm to another, creating a market for the right to pollute Regulations: set limits on the acceptable amount of pollution allowed (emission standards) or require polluters to install a certain technology to reduce emission levels (technology standards) Voluntary agreements: (in general between some public authority and a private enterprise) may be introduced to encourage environmentally friendly measures Carbon taxes Interventions like carbon taxes are seen as important tools to force consumers/producers to internalise the externality of carbon emissions Introduced in Ireland in 2010, current charge of €56 per tonne, expected to increase to €100 per tonne by 2030 and raise €9.5b from 2021-2030. Is it enough? A brief history of global temperatures Paris agreement The agreement established a process for moving the world toward stabilising concentrations of greenhouse gases (GHGs) at a level that would avoid dangerous climate change UN Climate Review September 2023 Global emissions need to be slashed 43 percent by 2030 to limit warming to 1.5 degrees Celsius The report calls for “phasing out all unabated fossil fuels” and for a “radical decarbonisation of all sectors of the economy.” Governments can’t overlook the role of sectors like industry, which contributes to 25 percent of global emissions, and transportation, which contributes 15 percent Reducing these emissions requires targeting the demand and the supply in these sectors The world’s GHG emissions are not in line with net-zero by 2050 Decarbonisation requires a drastic acceleration in performance Sectoral shares of emissions vary across countries Ireland – GHG emissions 2023 v. 1990 Most countries underprice their carbon emissions Carbon taxes While most governments impose carbon taxes, many still balk at levying a carbon tax high enough to reduce emissions to the necessary extent A carbon tax on fossil fuels is often regressive in its impact - hurting poorer people relatively more than wealthier people Offsetting regressive impact of mitigation policies by recycling the revenues of some of these policies is key to bolster public acceptability Also, carbon taxes target carbon dioxide emitted from fossil fuels. They do not directly target other carbon compounds, such as methane, which has a short atmospheric lifetime but a large warming potential What about Ireland? Ireland’s temperatures are increasing, rainfall levels rising, and extreme weather events appear more frequent Climate targets for Ireland Ireland legally bound to achieve carbon neutrality by 2050 and to stay within three sequential carbon budgets between 2021 and 2035 These require GHG emissions to be reduced by 51% by 2030 compared to 2018 levels. However, projections for Ireland based on existing plans indicate a reduction of just 29% by 2030 All sectors look set to exceed 2021-2025 carbon budgets How to think of long-run growth impacts of climate change So what’s to be done…? There is no single magic bullet to deal with the issue of emissions and meeting climate targets A mix of different carrot and stick approaches is required across multiple sectors, with coordination of policies and strategies key to success Also important is the need to improve transparency and communication around targets and progress Reducing information and knowledge gaps are key to building trust and making behaviour more climate-friendly Positive externalities Example of a positive externality: education sector A better-educated population leads to improved productivity and economic growth The economic growth is the positive externality as it benefits everyone If tuition fees are levied and these are too high, private markets may produce a smaller quantity than is socially desirable Positive externality exists as the social benefit of the good exceeds the private benefit  Supply = private cost to producer with no € Supply external cost Demand = private benefit to consumer Social benefit = actual benefit to society P2 of consumption or production P1 Difference between Demand and Social benefit is external benefit to society Social benefit Without intervention, only Q1 is consumed or produced and there is Demand deadweight social welfare loss Q2 will be produced or consumed if Q1 Q2 Output government intervenes and subsidises difference between P1 & P2 Positive externalities The optimal output level is more than the market equilibrium quantity Market failure occurs because individuals consider only their private benefits (e.g. higher income) from education and not the full social benefit (economic growth, lower crime rates etc.), thus less of the good than is socially desirable is consumed Solution… allocative role for government: To provide a subsidy To provide the service