Market Failure & Externalities PDF

Market failure & Externalities 1 Main Points ▪ What are externalities? Defining the concept. ▪ Types of externalities ▪ The difference between private and social costs. ▪ The economic consequences of negative externalities: Inefficiency ▪ Solve a prob...

Market failure & Externalities 1 Main Points ▪ What are externalities? Defining the concept. ▪ Types of externalities ▪ The difference between private and social costs. ▪ The economic consequences of negative externalities: Inefficiency ▪ Solve a problem. 2  Market failure ▪ It occurs when the market outcome is not the socially efficient outcome. Some action by the government is sometimes necessary to ensure that the market does work well. ◼ The market fails to arrive at the “correct” price and quantity. ◼ The most common form of market failure is Externalities. 3  Externalities ▪ An externality is a cost or a benefit that arises from: Production that falls on someone other than the producer Consumption that falls on someone other than the consumer ▪ Externalities are conditions arising when the actions of some individuals have (negative or positive) effects on the welfare or utility of other individuals. ▪ As a result, the market fails to yield optimal results (externalities stop market achieving an allocatively efficient equilibrium) 4  Types of externalities Externalities can be either positive or negative. – A negative externality imposes an external cost and a positive externality creates an external benefit. Negative externalities occur when the effects of a decision not taken into account by the decision-maker are detrimental to others. Positive externalities occur when the effects of a decision not taken into account by the decision-maker is beneficial to others. 5 The Four possible types of externality – Negative production externalities – Positive production externalities – Negative consumption externalities – Positive consumption externalities 6  Types of Externalities Negative Production Externalities ◼ Negative production externalities are common. ◼ Examples are logging and clearing of forests, and pollution from producing goods is the major example of this type of externality. 7  Types of Externalities Positive Production Externalities ◼ Positive production externalities are less common than negative externalities. ◼ Example: when firms train their employees which result in better manpower or invest in research and development and succeed in developing new technologies which benefits the society. 8  Types of Externalities Negative Consumption Externalities ◼ Negative consumption externalities are a common part of everyday life. ◼ Smoking in a confined space poses a health risk to others. 9  Types of Externalities Positive Consumption Externalities ◼ Positive consumption externalities are also common. ◼ When you get a flu vaccination, this will prevent spread of infectious disease. ◼ Going to university. Your education gives benefit to rest of society (You can teach others) 10  Negative Externalities: Private &Social costs Private Costs and Social Costs ◼ A private cost of production is a cost that is borne by the producer. ◼ Marginal private cost (MC) is the private cost of producing one more unit of a good or service. ◼ An external cost of production is a cost that is not borne by the producer but is borne by others. ◼ Marginal external cost is the cost of producing one more unit of a good or service that falls on people other than the producer. 11  Negative Externalities: Private &Social costs Private Costs and Social Costs ◼ Marginal social cost (MSC) is the marginal cost incurred by the entire society and is the sum of marginal private cost and marginal external cost. Marginal Private Cost + Marginal External Cost = Marginal Social Cost. ◼ Marginal private cost, marginal external cost, and marginal social cost increase with output. 12  What happens when there is a Negative Production Externality? ◼Next Figure shows the relationship between cost and output. When output is 4,000 tons of chemicals a month: 1. Marginal private cost is $100 a ton. 2. Marginal external cost is $125 a ton. 3. Marginal social cost is $225 a ton. 13  NEGATIVE EXTERNALITIES: Inefficiency ◼Next Figure shows inefficiency with an external cost. 1. The market is in equilibrium at a price of $100 a ton and 4,000 tons of chemical a month is inefficient. 2. Marginal social cost exceeds... 3. Marginal benefit. 15  NEGATIVE EXTERNALITIES: Inefficiency 4. The efficient quantity is 2,000 tons of chemical, where marginal social cost equals marginal benefit. 5. The gray triangle shows the deadweight loss created by the pollution externality. 16  Inefficiency with an External Cost 300 Marginal MSC Price and cost ( dollars per tonne) Social cost 225 Efficient Deadweight loss equilibrium Inefficient 150 Market equilibrium S= MC 100 75 D=MSB Marginal Efficient Social quantity Benefit 2 4 6 Quantity (thousands of tonnes per month) 18 Negative Externality: Consumption 19 Negative Externality: Consumption ◼ Here consumption of cigarettes leads to a social marginal benefit that is below the private marginal benefit and a social optimum Q2 that is lower than equilibrium quantity Q1. Before intervention: ◼ There was over consumption of Q1-Q2 ◼ DWL of area ACB 20  Recall a Competitive Equilibrium Price Supply = Marginal Cost P* Demand = Marginal Benefit Q* Quantity ◼ If the market is producing at Q*,P* then social welfare is maximized. ◼ This assumes there is no externality. 21 CONSUMER SURPLUS Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it. Willingness to pay is the maximum amount that a buyer will pay for a good. Or how much the buyer values the good The area below the demand curve and above the price measures the consumer surplus in the market. 22  Consumer Surplus Consumer Surplus at Price P Price A Consumer surplus P1 B C Demand 0 Q* Quantity 23 Copyright©2003 Southwestern/Thomson Learning PRODUCER SURPLUS ◼ Producer surplus is the amount a seller is paid for a good minus the seller’s cost. ◼ The benefit to sellers participating in a market. ◼ The area below the price and above the supply curve measures the producer surplus in a market. 24 Producer Surplus Producer Surplus at Price P Price Supply B P1 C Producer surplus A 0 Q* Quantity 25 Copyright©2003 Southwestern/Thomson Learning  Consumer and Producer Surplus in the Market Equilibrium Price A D Supply Consumer surplus Equilibrium E price Producer surplus Demand B C 0 Equilibrium Quantity quantity 26 Copyright©2003 Southwestern/Thomson Learning  Problem 1 ◼ Let’s assume that the demand curve for an environmental good MPB = 24-2q, where q refers to the quantity of the good. & assume that the marginal private cost function can be described by MPC = q, and that marginal social costs are always double the marginal private cost. ◼ First: Determine an equation for the marginal social costs (MSC). ◼ Second: Graph the functions and algebraically determine i. The market level of output ii. CS & PS at market equilibrium. iii. The optimal level of output iv. CS & PS at the optimal level of output. v. DWL 27  Problem 2 ◼ Assume that the market demand curve for diamonds is given by the following equation: PD= 1000 − 2 Q and the market supply curve, which is equal to the aggregated marginal cost curve of all producers, is given by PS = 200 + 2 Q Diamond production, however, is associated with harmful side effects on both workers and nearby households and firms. The marginal social cost to the surroundings is : MSC = 250+2Q 28 Problem 2 ◼ From the above information calculate: i. Market equilibrium quantity and price. ii. CS & PS at market equilibrium. iii. Efficient equilibrium quantity and price. iv. CS & PS at efficient equilibrium. v. DWL produced. 29