Market Failures Lesson 3

Marginal Analysis and Market Failures The marginal analysis can be likewise applied into consideration for market efficiency of market failures. Market failures are situations or phenomenon in which a pure market allocation will result in incorrect prices, quantities or both. In the contex...

Marginal Analysis and Market Failures The marginal analysis can be likewise applied into consideration for market efficiency of market failures. Market failures are situations or phenomenon in which a pure market allocation will result in incorrect prices, quantities or both. In the context of marginal analysis, a market failure can result into an over provision (market efficiencies inappropriately higher) or under provision (market efficiencies are incorrectly lower) of total benefits under market allocation. There are two types of market failures that will be considered: the production of a public good and the existence of externalities. A public good in Economics is an output that exhibits two characteristics. One of this characteristic of public goods is non-congestibility. The characteristic of non-congestibility refers to the availability of a public good not getting diminished as more of the public good is consumed or produced. The other characteristic of public goods is non-rivalry, meaning that once a public good is produced; there is no feasible way to exclude any market agent from extracting benefits from the existence of a public good. Real world instances of public good are the benefits from the existence of a standard, the protection accorded by an effective vaccine, pleasant natural sceneries and clean air, water and land resources. Graphically, these public goods can be represented as follows. prices MC MC = marginal costs SMB = social marginal benefits P* PMB = private marginal benefits Pm SMB PMB quantities Qm Q * In the preceding graph, there is a segregation presented between the social marginal benefits and private marginal benefits received by consumers from a public good. The social marginal benefits were given as higher since the entire society derives more benefits from the consumption of public goods than individual consumers of public goods. As a result, the socially optimal price (P*) and quantities (Q*) should be higher than the market determined price (Pm) and quantities (Qm). In turn, this will make the market allocation (and marginal analysis) of public goods to be under-priced and under-produced. Notice in the graph that the actual or true consumer and producer surpluses do not get maximized as a result of this under-pricing and under-production of public goods. Example (marginal analysis and public goods) The marginal cost (or supply) function in the production of a public good is represented by MC = 500 + 3Q. Relevant marginal benefit (or demand) functions can be provided as PMB = 800 -2Q for individual consumers while SMB = 1,000 -2Q for the entire society. At market equilibrium (demand = supply or private marginal benefit [PMB] = marginal cost [MC]), price and quantities will be Pm = 680 while Qm = 60 units of the public good. Considering the higher benefits provided by the public good to all market agents, the appropriate or socially optimal (that is, SMB = MC) price and quantities should be P* = 800 and Q* = 100 units of the public good. The market for this public good is represented in the following graph. prices 1,000 MC = 500 + 3Q 800 800 680 SMB = 1,000 -2Q 500 PMB = 800 -2Q quantities 60 100 Notice that as a result of the marginal (market) analysis, a market allocation for public good will result in an under-pricing of 120 and under-production of 40 units of the public good. Moreover, there will be unrealized (opportunity or deadweight losses generated from the market allocation) benefits for both consumers and sellers. Using the information in this example, consumer and producer surpluses at market equilibrium (PMB = MC) will be CSm = 3,600 (determined as ½[120*60)]) while PSm = 5,400 (determined as ½[180*60]). Combining these consumer and producer surpluses under a pure market allocation will result in a net market surplus = NMSm = CSm + PSm = 9,000. A consideration for the higher benefits from the public good (SMB = MC) will result in a consumer surplus CS* = 10,000 (1/2[200*100]) and producer surplus of PS* = 15,000 (1/2[300*100]). The net market surplus with a consideration for the higher social benefits from a public good NMS* would amount to CS* + PS* = 10,000 + 15,000 = 25,000. As the net market surplus considering higher social benefits from the public good is higher than the net market surplus under a pure market allocation, there is a market inefficiency resulting in a market allocation. Alternatively this comparison translates into a deadweight loss (or foregone total benefits) for both consumers and producers amounting to 14,000 (that is, NMS* - NMS or 25,000 – 9,000).  Another type of market failure that will be considered is the existence of externalities from economic activities (i.e. either consumption, production or both). Externalities refer to indirect and unintended effects from economic activities. There are two types of externalities: negative and positive. Negative externalities refer to a market situation in which indirect and unintended costs are imposed on other market agents. Some instances of negative externalities that can be cited are as follows: excessive waste generation (from households and productive activities), pollution (such as vehicle use, household chores, power generation, and factories) and creation of unnecessary noise. These "additional, unwanted costs" as a consequence will result in a higher social marginal costs (SMC) than the own, realizable (of market agent(s) which generates the negative externalities) private marginal costs (PMC); as represented in the following graph. price MB SMC PMC P* Pm quantities m Q* Q Since the market agents (responsible for the negative externalities) make use of their own costs under a pure market allocation (that is, internalize the unintentional and indirect costs imposed on other market agents), the price will be Pm with quantities Qm as represented in the graph. Any recognition of these unintentional and indirect costs should result in a price P* and smaller quantities of Q* for the same market. As a consequence, in this market situation where there is a negative externality, a market allocation results into under-pricing (graphically represented as the vertical distance between P* - Pm) and over-production (graphically indicated as the horizontal distance between Qm – Q*). This is the primary reason why negative externalities are considered market failures. Any application of marginal analysis into a market situation with negative externality will indicate that the net market surplus under a pure market allocation will be bigger than that of the net market surplus with a reflection of negative externalities. Example (marginal analysis and negative externalities) Consider the pollution from (thermal; using fossil fuels) power generation in an economy. Electricity generated from such sources will result in a marginal benefit function MB = 1,000 -5Q. The own or private marginal costs of these power generators can be represented by the function PMC = 200 + 5Q. If the costs of pollution generated from such activities will be considered, then the relevant social marginal cost function will be SMC = 400 + 5Q. This market situation with negative externalities is depicted in the following graph. price 1,000 SMC = 400 +5Q PMC = 200 + 5Q 700 600 400 MB = 1,000 -5Q 200 quantities 60 80 Under a pure market allocation (that is, MB = PMC), the resulting price and quantities of electricity (generated from using fossil fuels) will be Pm = 600 and Qm = 80 units respectively. This price and quantities of electricity generated is considered inappropriate, with no recognition or no consideration of the indirect and unintentional costs from pollution. Once these indirect and unintentional pollution costs will be reflected (that is, SMC = MB), prices should increase to P* = 700 while quantities of electricity generated from fossil fuels decreasing to Q* = 60 units. The electricity market (with negative externalities in the form of indirect and unintentional pollution costs) depicted here translates into an under-pricing of 100 (700 - 600) and over-production of 20 (80 - 60) units. In the context of marginal analysis and assessing relative market efficiencies, the net market surplus under a pure market allocation should be compared with the net market surplus with a reflection of the unintentional and indirect pollution costs from electricity generation. Under a pure market allocation, the net market surplus NMSm will amount to 32,000 (determined as CSm [1/2(400*80) = 16,000] + PSm [1/2(400*80) = 16,000] or 32,000). The net market surplus inclusive of pollution costs NMS* will amount to 18,000 (determined as CS*= [1/2(300*60)] = 9,000 + PS* = [1/2(300*60)] = 9,000 or 18,000). Since the net market surplus under a pure market allocation exceeds the net market surplus reflecting pollution costs, there is an over provision of total benefits under pure market allocation. Equivalently, the situation has "over encouraged" generators using fossil fuels to over-produced and under-priced their electricity. Another type of market situation with externalities is a positive externality. A positive externality refers to a market situation in which unintentional and indirect benefits are generated from the economic activities. Existing instances of positive externalities that can be cited are as follows: locational externalities (adjoining property prices appreciate from nearby property development), generation of useful by-products, improving social well-being from cleaner environs and communal protection provided by effective vaccines. Noticed that economic activities generating positive externalities will result in the social marginal benefits (SMB) that are larger or greater than the own (that is, the market agent-source of the positive externalities) or private marginal benefits (PMB) of output providers. A market situation wherein positive externalities are generated is represented in the following graph.  price MC P* Pm SMB PMB Qm Q* quantities In the preceding graph, a pure market allocation will result price Pm and quantity Qm levels respectively. When the unintentional and indirect benefits of the economic activity is considered, the socially optimal price and quantity levels should be P* and Q* respectively. As a result, resorting to market allocation with positive externalities, there will be under-pricing (the vertical distance P* - Pm) and under-production (the horizontal distance Q* -Qm) as can be seen in the graph. This under-pricing and under-production is the primary reason for positive externalities being considered as a form of market failure. An application of marginal analysis into a positive externality situation will result in smaller net market surplus (market inefficiency) under a pure market allocation. Example (marginal analysis and positive externalities) Steam gets inevitably generated from refining useful products from crude oil. This steam can be further harnessed into power generation (referred to as co-generation). An oil refinery’s marginal benefit function is PMB = 200 -2Q with a corresponding marginal cost function of MC = 100 + 3Q. If the steam is used further into power generation, the relevant social marginal function is SMB = 700 – 2Q. The refining of useful products from crude oil with positive externalities is represented in the following graph. price 700 MC = 100 + 3Q 460 200 160 SMB = 700 -2Q 100 PMB = 200 +2Q 20 120  A pure market allocation in this situation (PMB = MC) will result in price and quantity levels of Pm = 160 and Qm = 20 units respectively. This price and quantities of useful products refined from crude oil does not reflect the benefits from the steam which can be further used into power generation. If the steam generated is further used into power generation, the socially optimal (SMB = MC) price and quantity levels should be P* = 460 and Q* = 120 units. This consideration for the positive externalities of the steam generated implies an under-pricing of 300 (graphically indicated as the vertical distance between P* -Pm = 460 – 160) and under-production of 100 units (graphically, this is the horizontal distance between Q* - Qm = 120 – 20). Under a pure market allocation (without considering the benefits from steam) would result in a net market surplus NMSm of 1,000 (determined as CSm = ½[40*20] = 400 + PSm = ½[60*20] = 600). If the unintentional and indirectly beneficial steam generated by crude oil refining is considered, the net market surplus NMS* will rise to 36,000 (determined as CS* = ½[240*120] = 14,400 + PS* = ½[360*120] = 21,600). This comparison of net market surpluses indicate a lower market efficiencies or deadweight losses from a pure market allocation amounting to 35,000 (that is NMS* - NMSm = 36,000 – 1,000). Alternatively, the market inefficiencies amounting to 35,000 represent the opportunity losses in terms of total benefits for steam users and total benefits to crude oil refiners.