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Market

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Published in: Economics
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This topic will help tp understand the common pool resources and the market failure

Subhojit R / Pune

5 years of teaching experience

Qualification: M.A (Symbiosis College of Arts and Commerce (SCAC), Pune - 2019)

Teaches: Economics, BA Tuition, MA Tuition

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  1. Market failure Externalities & common pool
  2. Learning Outcome That allocative efficiency and social (community) surplus are maximized when MSB = MSC (A02) A diagram that shows allocative efficiency (A04) Positive externalities of production and consumption and welfare loss in the context of merit goods (A02) Negative externalities of production and consumption and welfare loss in the context of demerit goods (A02) Diagrams that show market failure due to: negative externalities of production and consumption, and positive externalities of production and consumption (A04) Welfare loss from a market failure diagram (A04) (HL only) Common pool resources, including the characteristics (with reference to tragedy of commons, and cprs being rivalrous but nonexcludable) (A02) Unsustainable production of common pool resources, thus creating negative externalities (A02) Various methods of government intervention in response to externalities and common pool resources (A02) Diagrams that show government responses to externalities: indirect (pigouvian) taxes, carbon taxes, subsidies, legislation and regulation, and education (A04)
  3. • Market failure occurs when the signalling, incentive and rationing functions of the price mechanism fail to operate optimally, which leads to a loss economic welfare. From society's in point of view, there is a misallocation of resources in the economy. • For example, the market may fail to consider the external costs (such as congestion and pollution) and external benefits (from the provision of public and merit goods) arising from production and consumption.
  4. Essentially, market ailure or inefficient resource allocation results in one of any combination o four outcomes: • Under-provision of certain goods and services • Over-provision of certain goods and services • Under-consumption of certain goods and services • Over-consumption of certain goods and services. Examples of market failure include: • The under-provision of merit goods, such as education and healthcare, as these services would be provided in a market economy only to those who were willing and able to pay. • The over-provision of demerit goods such as tobacco, alcohol and gambling due to the absence of government intervention in such markets.
  5. External benefits (or positive externalities) are the advantages or gains of production or consumption to a third party, i.e. individual and/or firms not directly involved in an economic transaction. External costs (or negative externalities) are the disadvantages or losses incurred from production or consumption by a third party not directly involved in an economic transaction. Private benefits are the advantages or gains of production and consumption enjoyed by an individual firm or person. Private costs of production and consumption are the actual expenses incurred by an individual firm or person. Social benefits are the true (or full) benefits of consumption or production, that is, the sum of private benefits and external benefits (also referred to as positive externalities). Hence, social benefits = private benefits + positive externalities. Social costs are the true (or full) costs of consumption or production, that is, the sum of private costs and external costs. Hence, social costs = private costs + negative externalities.
  6. For example, the private costs of driving include the purchase of a vehicle, petrol (fuel), insurance, parking fees and maintenance costs. However, there are also external costs (negative externalities) imposed on others in society, including pollution, traffic congestion and possible road accidents Social costs of driving include the total of all private and external costs
  7. The socially optimum output occurs when the marginal social benefit (MSB) equals the marginal social cost (MSC). In other words, at the output level where, MSB = MSC.
  8. • Marginal private benefit (MP B) is the additional value enjoyed by households and firms from the consumption or production (output) of an extra unit of a particular good or service. • Marginal private cost (MPC) is the additional expense of production for firms or the extra charge paid by customers for the output or consumption of an extra unit ot a good or service. • Marginal social benefit (MSB) refers to the total gains to society from an extra unit of production or consumption of a particular good or service. It is the sum of the benefits for private individuals and the positive externalities to others in society. • Marginal social cost (MSC) is the total expenses to society from an extra unit of production or consumption of a particular product. The total costs of producing or consuming an additional unit of output includes both private or direct costs of producers and consumers plus the costs to others in society.
  9. Allocative efficiency Costs and benefits (S) surplus Produ surplus Al locative efficiency MSC D MPB MSB Quantity (units) Allocative efficiency is achieved when social or community surplus is maximized. This occurs at the socially optimum level of output, that is, where MSB equals MSC. This is because at this level of output, it is not possible to reallocate resources to make one party better off without making others worse off. Social surplus (also known as community surplus) is the sum of consumer and producer surplus at a given market price. It is the net benefit available to society from an economic transaction or activity. Social surplus is shown by the area A + B, which is made up of both consumer surplus (area A and producer surplus area B). Community surp us is maximized when t e price mechanism clears the market of any excess demand or supply. At the market equilibrium price (Pe ) and equilibrium quantity ), there are no shortages or surpluses. In o er words, resources are allocated efficiently (at point X) thereby maximizing social welfare.
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  11. Externalities (also known as spillover effects) are the external costs or benefits of an economic transaction, causing the market to fail to achieve the social optimum level of production or consumption, where marginal social benefits equal marginal social costs (MSB = MSC).
  12. Negative externalities • Negative externalities (also known as external costs) are expenses incurred by third parties in an economic transaction for which no compensation is paid. • For example, the use of fossil fuels (those formed by natural processes, such as coal, crude oil and natural gas) in the production process can pose a threat to economic, social and environmental sustainability.
  13. Watch the following short video and then answer the following question. 1. Why is the absence of a comprehensive metro system an example of market failure? 2. Explain how an electronic road pricing scheme might help reduce the externality caused by excessive car consumption in the city?
  14. Examples of external costs(NE) include: • Air pollution caused by fumes from factories or traffic congestion. • Climate change fuelled by continual demand for higher levels of consumption and production. Excessive advertising (known as advertising clutter) that causes visual blight. • Light pollution. • Litter on public beaches. • Noise pollution from a night club Second-hand (passive) smoking
  15. Negative externalities of production Costs and benefits (S) pe MSC Negative externality Qopt Q. D MPB MSB Output (units) Negative externalities of production occur when producing a good or service causes a harmful etiect to a third party, such as burning fossil fuels, which creates environmental pollution. Hence, the marginal social cost (MSC curve) is greater than the marginal private cost (MPC curve). In a free market without overnment intervention, the level of output wi be at Qe where the MPC = MPB of production. However, the sociall optimal level of output is at Qopt where the MS = MSB, with a higher price of Popt being charged. Hence, from society's point of view, there is over-production of demerit goods and a corresponding welfare loss as shown by the green shaded area. Essentiallv, society would benefit from reducing output of the demerit good from Qe to Qopt, as this level of output eliminates the negative externalities (as shown by the vertical distance between MSC and MSB at all output levels beyond Qopt).
  16. • Negative externalities of consumption occur when consuming a good or service causes a harmful effect to a third party, such as smoking, which causes passive (second- hand) smoking to others in the surrounding area. In this case, the marginal social benefit (MSB curve is less than the margmal private benefit (MPB curve . • In a free market, without government intervention, equilibrium output is at Qe , which exceeds the socially optimal level at Qopt, where the MSC = MSB of consumption. • Hence, from society's point of view, there is overconsumption of demerit goods (such as tobacco or alcohol) and a corresponding welfare loss as shown by the green shaded area. • Essentially, society would benefit from reducing consumption of the demerit good from Qe to Qopt, as this level of output eliminates the negative externalities (as shown by the vertical distance between MSC and MSB at all consumption levels beyond Qopt). Negative externalities of consumption Costs and benefits (S) Qopt S - MSC D MPB externality MSE Output (units)
  17. Positive externalities (6.1) Positive externalities (also known as external benefits) of production and consumption refer to the benefits enjoyed by a third party from an economic transaction. The production and consumption of public goods and merit goods exert positive externalities.
  18. • • • • • Examples of external benefits(PE) include: Flood defence systems Law and order system, including police & emergency Services Lighthouses National defence and security Public firework displays Public parks, libraries and museums Sewage and waste disposal systems Street lighting.
  19. • Positive consumption externalities exist because the marginal social benefit of consumption (MSB curve) is greater than the marginal private benefit (MPB curve) at all levels of output up to the socially optimal level of output (Qopt). Positive consumption externalities Costs and This is due to the existence of positive benefits (S) externalities of consumption. • Hence, there is market failure at the free market equilibrium (Qe and Pe ), that is, there is under-consumption of the merit good. The socially desirable level of output is where MSB = MSC. • In other words, at output level Qopt. The green shaded area represents the welfare loss due to the under-consumption. p S-MPC-MSC exter nality D - MPB Output (units)
  20. Positive externality of production Costs and benefits (S) popt S - MPC externali Qopt MSC D = MPB = MSB Output (units) Positive externality of production the marginal private cost (MPC curve) is greater than the marginal social cost (MSC curve). This is true for all levels of production up to the socially optimal level of output (Qopt), when the MSC = MPB, when the existence of positive externalities (as shown by the vertical distance between MPC and MSC) is fully exploited. Hence, there is market failure at the free market equilibrium (Qe and Pe ), that is, there is under-consumption of the merit good. The green shaded area represents the welfare loss as a result of the under-consumption. Government intervention is needed to lower the price from Pe to Popt thereby encouraging an increase in the consumption of the merit good up to Qopt units of output.
  21. N/A
  22. Common Pool Resources
  23. Common pool resources are natural resources that firms and individuals can access in society without restriction. Common pool applies to resources like forests for timber, the sea for areas Of land for mineral
  24. Characteristics of common pool resources • Common pool resources are non-excludable because they occur naturally in the environment, and without government intervention, it is very difficult to limit access to them. Anyone can access fish in the sea and cut down trees in a forest if there IS no legal system to prevent people from doing this • Common pool resources are rivalrous because the consumption of them bv one individual reduces their availability to others. If someone takes fish from the sea or cuts down a tree it is not available for someone else. Tragedy of the commons -Common pool resources create a situation known as the tragedy of the commons. This means, degradation, depletion or destruction of a common access resource caused by the problems of overuse (or abuse) and over-consumption
  25. Government intervention (Policies) in response to externalities and common pool resource Collective self- governance Carbon taxes Government Intemational agreements Government responses to externalities and CPRs islatim and Subsidies regulation Education Tradable (awareness permits creation)
  26. An indirect tax is used to 'internalize' negative externalities. In other words, the buyer and/or seller Indirect (Pigouvian) pays for the true costs of their actions without any burden being placed on third parties. Taxes Pigouvian tax is imposed on a producer creating negative externalities. For example, a logging company causes a divergence between the marginal private costs (MPB) and marginal social costs (MSC) of production. The main purpose of using an indirect tax is to make the price of the product equal to D = MPB = MSB, thereby creating a more socially efficient allocation of resources. Point A shows the free market equilibrium, whereas point B shows the socially optimal level of output (where MSC = MSB) The indirect tax raises costs for the producer, thereby causing the S = MPC curve (or the supply curve of the private firm) to shift leftwards towards the S2 = MSC curve. The lower supply causes the price to rise from Pe to Popt (the socially optimal price level) and the quantity demanded to fall from Qe to Qopt (the socially optimal quantity). price of timber (S) tax Qopt MSC productim externality S - MPC D - MPB - MSB Quantity of timber (units)
  27. Carbon taxes • A carbon tax is similar to a Pigouvian tax Price of product (S) per unit • Qopt = MSC s_MPC Quantity (units) but imposes the tax on carbon emissions. Essentially, the carbon tax identifies the price of greenhouse gas emissions or the carbon content of fossil fuels (such as coal, diesel fuel, propane, gasoline and natural gas) and imposes this external cost on the polluting industry. For example, a factory that pollutes the air causes a divergence between the marginal private costs (MPC) and marginal social costs (MSC) of production. The effect of the per unit carbon tax (Popt - PO ) is a fall in production, from Qe to Qopt, and a higher price for the product, trom Pe to Popt. The government earns tax revenue as shown by the shaded green area.
  28. • Legislation refers to the laws on the use of scarce resources, such as laws to protect fish and marine life or legislation to curb carbon emissions from private and commercial motor vehicles. Regulation refers to the management of complex rules, laws and policies that firms need to comply with. • For eg, legislation and regulation shift the demand curve for cigarettes (or any other demerit good) from MPB to MSB owing to reduced benefits of consumption. Thus, consumption falls from QI to Qopt . Therefore, this also reduces the negative externalities associated with smoking, such as passive (second-hand) smoking and litter, as shown by the area of welfare loss. Legislation & Regulation Price of cigarettes (S) S MPC MSC Welfare loss MSB Quantity (packets)
  29. Education — awareness creation Average price Of fruits and vegetables (S) MPC MSC Deadweight D MPB Quantity (units) Educating the general public about the costs of consuming demerit goods and the benefits of consuming merit goods is another approach to correcting market failures. Education, or awareness creation perhaps through advertising, is about influencing consumer behaviour. Examples include: The '5 A Day' programme run in countries such as Germany, UK and USA in line with the World Health Organization's recommendation. Schools educating students about safe sex and family planning Awareness creation programmes about health screening. Advertising about the importance of environmental protection. The impact of education (awareness creation) on the demand curve for fruits and vegetables is an outwards shift from MPB to MSB. This increases consumption from Qm to Qopt.
  30. Tradable permits are government-regulated emissions trading schemes using a market-based approach to reduce production to a more socially efficient level. The regulator sets a limit (the cap) on the total amount of emissions or pollution allowed in an industry and firms are issued emissions permits, such as the right to pollute up to 100 units of carbon dioxide per month. The scheme allows pollution permits to be freely traded (based on the price mechanism) thus enabling more efficient firms to sell their excess permits. Hence, they are referred to as cap and trade schemes (CATS). With economic growth and higher demand for goods and services, the demand for pollution permits can also increase but the cap on pollution creates higher prices for tradable permits. The increased demand for tradable permits from DI to D2 increases the market price from PI to P2. There is no change in the quantity supplied as the government has fixed (capped) the number of pollution permits for the industry. The aim of the pollution permits is to make the polluters pay for the external costs of their auct'" Tradable permits price of pollution '*rmits (S) Qe Quantity (permits)
  31. International Agreements • Governments can also create and develop international agreements to respond to the ' growing problems of negative externalities of may be bilateral agreements (between two countries) while most are multilateral agreements but are nevertheless essential for environment protection. • While international hold agreements countries to account for their actions and potential harm to the environment, they require full commitment from all countries, not just those that sign treaties at different points in time.
  32. Collective self-governance Collective self-governance refers to voluntary communal actions to combat the problems of negative externalities and the problems associated with the exploitation of common pool resources. Collective self-governance has gained attention in the sustainable tourism industry. This includes the collective efforts to conserve natural resources, protect natural environments, safeguard wildlife, and preserve the local area's heritage and culture. Self-governance has become an important aspect when developing and managing sustainable tourism activities while providing authentic experiences for tourists. Collective selfgovernance therefore also creates socio- economic benefits for local communities such as employment opportunities and higher income earnings
  33. Strengths and limitations of government policies
  34. Challenges involved in measurement of externali• There are difficulties and challenges involved in measuring the value of externalities in an accurate way. For example, • What is the value of negative externalities such as noise pollution or carbon emissions, and can these even be measured precisely? • What is the value of positivN externalities from the provision of public goods such as street lighting and flood control systems or from merit goods such as the provision of universal primary education?
  35. Degree of effectiveness It is not always clear whether government intervention corrects market failures in an effective way. Economists use the ceteris paribus assumption to explain how changes in policy can influence market outcomes. However, in reality, there are other factors that may change the amount of demerit and merit goods consumed in the economy. For example, the global decrease in the number of smokers is partly due to several interrelated factors (rather than any single government interventionist policy), such as: Laws banning smoking in public areas: • Health initiatives established by the government • Major retailers opting to stop selling cigarettes as part of their own corporate social responsibility Anti-smoking advertisements in the mass media,
  36. Consequences for stakeholders Different stakeholders are affected by government intervention in different ways. As not all stakeholder groups are necessarily equal, there is scope for exploitation. For example: Large multinational companies can exploit their market power by relocating to low-income countries where legal limits on pollution are not imposed or controlled and monitored to the same extent. Government legislation and regulations such as environmental standards tend to favour large multinational companies that have the financial resources to comply, whereas smaller firms that face higher costs of compliance may struggle to survive. Pigouvian taxes are regressive, so have a larger impact on low-income earners or smaller firms while high-income earners and large firms with strong market share can afford to continue burdening other stakeholders.
  37. References "DP Economics: www.thinkib.net/economics/page/34355/unit-311- measuring-the-level-of-economic-activity. Accessed 20 Aug. 2023. • "Economics for the 1B Diploma 9781510479142, 9781510479296." Dokumen.Pub, dokumen.pub/economics- for-the-ib-diploma-9781510479142-9781510479296.html. Accessed 20 Aug. 2023.

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