CHAPTER 30
 
 

Market Failure: Externalities, Public Goods, and Asymmetric Information

A market failure occurs when the market does not provide the optimal amount of a particular good, despite the rational behavior of the participants in the market.

In this chapter, we turn to two other types of market failures: externalities and public goods.

The first two sections of Chapter 30 develop the theory of externalities—negative and positive—and the ways in which external costs and/or benefits may be “controlled.” The third section analyzes some important environmental issues from an economic perspective. The fourth section introduces the student to the notion of public goods, the free rider problem, and the role of the government in providing public goods.

 CHAPTER OBJECTIVES

Upon completing this chapter, you should be able to:

1. Explain the difference between negative and positive externalities.

2. Explain how externalities can cause market failure.

3. Discuss the various ways in which externalities can be internalized.

4. Discuss the various methods of reducing or eliminating pollution.

5. Identify the characteristics of public goods.

6. Explain why markets fail to produce nonexcludable public goods.

7. Discuss the effects of asymmetric information.

KEY TERMS
 
 
 
 
 
 

•market  failure	• internalizing externalities
• externality	• nonexcludability
• negative  externality	•Coase theorem
• socially  optimal output	• public good
• positive externality	• nonrivalrous in consumption
• rivalrous in consumption	• asymmetric information
• excludability	• adverse selection
free  rider	• moral hazard

CHAPTER OUTLINE

Adam Smith said that price guides self interested buyers and sellers to maximize the total benefits
of the market to society.  Equilibrium represents an efficient allocation of resources.
But, firms that manufacture paper create as a bi-product a chemical called dioxin. It causes
cancer and other health hazards.

Why should this happen? Shouldn't the invisible hand of price guide manufacturers and
consumers away from making this dioxin.

One problem is on the Demand side: that the dioxin doesn't flow the
consumers of the paper, so it doesn't affect their demand for paper.

Another problem is related to the supply side, capturing the dioxin during the production process will raise the costs for making the paper. Manufacturers try to lower
their costs so the release of dioxin isn't affected by the market despite its obvious costs to
society in terms of illness and death.
 

Review of the Supply and Demand Curve.

The Supply curve is based on the costs of the good to the seller, and the demand curve is based on the benefits to the
buyer of the good. But we assume that all the costs of the item are borne by the seller, and all of
the benefits go the consumer. For example a sandwich: the shop pays the costs of the sandwich
and the consumer receives the benefits.

But what if some of the costs go to others as in the case of dioxin.

I. EXTERNALITIES—Sometimes, when goods are produced and consumed, that production/consumption affects people not directly involved in the market exchange.

These “spillover” effects are called externalities, because the costs or benefits that occur are external to the party (-ies) that caused them.

social costs equal private costs plus external costs

 

 A. Negative Externalities— When a person’s or group’s actions cause harmful side effects that are felt by others, we say a negative externality has occurred.
Examples of negative externalities include air, water, and noise pollution.
As a consequence, the costs of the transaction to society (social costs) are not fully reflected in the costs to the purchaser(s)/producer(s) of the good or service (private costs).

What is the result?
Exhaust from a car creates smog.  People other than the driver have to breathe it. That is a negative externality ot external cost.
All of the costs associated with  driving are not incorporated into the costs of driving - the price of the car or the fuel.

These external costs should be added to the marginal costs of production to set the price. Government does this by adding a tax to the cost of gasoline.

Similarly with dog barking.
Price of having a dog to low.
In this case the government  copes with it with noise ordinances.
 
 

 

B. Positive Externalities—When  a person’s or group’s actions cause a beneficial side effect that is felt by others, we say a positive externality exists.
Examples of positive externalities include the rewards to society from education, the pride people feel when their local football team does well, and so on.

Here, the benefits of the transaction to society (social benefits) are greater than the benefits to the individual producers and/or consumers themselves (private benefits).

That is, private benefits are unequal to social benefits.

Other examples are historic buildings where the benefit of the building is experienced by any who can walk by and see it. There is a positive externality.
Gov sometimes buys these buildings or gives people money to maintain them - lowering the cost of owning them.

Another example is education.
We believe that there is a positive externality to human capital- our whole society benefits from having an educated poulation.
So government intervenes to subsidize education and lower the costs to the student.

Technology "Spillovers" and industrial policy. Some people believe that technology is associated with some direct costs and benefits, but also it is more genernally useful than what it was created for. There are positive externalities to the development of technology.
 

It is possible that one of the reasons for the US lead in technology is all of the money spent on research for the military.

Some economists argue that we should have an industrial policy and
the government should subsidize the most productive technologies, so that the incentives to producing the technology would more closely correspond to the social benefit.

Some people belive that we need an industrial policy to encourage technology.

Other economists argue that what will end up being subsidized is the companies that work hardest to get subsidies.

Patents are a way of internalizing technology benefits, and are an alternative to industrial policy.

An interesting issue is the possibility of low cost growth in third worls countries if they can absorb technological knowledge.

In summary, What is the difference between a positive and a negative externality?

Then how do externalities cause market failure? If there were no government intervention in a good with negative externalities
If we were add the external costs to the private costs, the true costs- the social costs would be higher.
So without government intervention, a larger quantity of goods is sold at a lower price than is warranted.

draw curve here show supply of paper with and without external costs.

then do the same for education.

 

A. Persuasion an Voluntary Agreements— Many  negative externalities occur simply because the parties that create them do not consider the effects of their actions on others.
By informing the parties responsible for an externality of the consequences of their actions and persuading them to alter their behavior, we may get them to consider social costs (not just private costs) in their cost benefit calculations.

 

Voluntary Agreements—Externalities may also be internalized through voluntary agreements between the creator(s) of the externality and the third party (-ies) affected by it.

In order for such an agreement to be reached, however, the transactions costs associated with making the agreement must be lower than the expected benefits of the agreement.

 

B. Taxes and Subsidies—Taxes and subsidies are often used to correct a market failure caused by externalities.
Specifically, a tax is used to adjust for a negative externality, and
a subsidy to promote an activity with positive externalities.
The rationale  is to bring the price of the good close to the social cost: taxing the good and raising its price if  their is an external cost and and subsidizing the good and lowering its price if their is external benefit.

 

Graphs here show how taxes and subsidies
 

C. Beyond Internalizing: Setting Regulations—Another way to deal with externalities, particularly negative externalities, is for government to apply regulations directly to the activity that generates the externality. For instance, if steel mills emit air pollutants through their smokestacks, the government may regulate smokestack emissions.

 
Critics of the regulatory approach often complain that, once enacted, regulations are difficult to remove—even if they are no longer productive. In addition,
regulations are often applied across the board, when circumstances dictate otherwise. Finally, regulations are expensive to create and enforce, and they require the reallocation of otherwise productive resources, thus reducing the economy’s ability to produce.

 

 

 

B. Three Methods to Reduce Pollution—There are a number of alternative means for reducing pollution: setting government pollution standards, using taxes on ploluters and employing market environmentalism (using market forces to clean up the environment). Let’s see how these two approaches work and how they differ.

 

1. Government Sets Pollution Standards— One alternative is for the government to set emission standards that limit the amount of pollution that a given polluter may generate.

2. Government Taxes on polluters To increase marginal cost at w\each level of output to social costs.

 
3. Another Approach: Market Environmentalism at Work: Government Allocates Pollution Permits and Then Allows Them to Be Bought and Sold —
The basic idea is that, for a given area, a certain amount of pollution is “acceptable.”
That “acceptable” amount of each given type of pollution is then parceled into permits that would-be polluters “bid” for in an “auction.”
The idea is that this allows polluters to compare the (internalized) cost of polluting to the revenues that could be earned by producing the additional output that would generate that pollution.
It also allows producers to pass on the cost of pollution (more specifically, the cost of buying pollution rights) to their customers.
If one firm can reduce its pollution more cheaply than another firm, it can buy the other firm’s pollution rights and profit from the transaction.
The same level of pollution is achieved as under the regulations discussed above, but the firms that are the most efficient at reducing pollution carry out these activities rather than having all firms reduce pollution.

 

A.Nonrivalry in Consumption—Consumption of the good by one person does not reduce its consumption by others.
Consider national defense: once produced, national defense protects all persons within the geographic region, and its consumption by one person does not reduce its value to anyone else.

Another example might be music in the digital age. Once it is recorded, the digital file of the music can be freely shared amongst people at about zero cost.
 

By contrast, a good has rivalry in consumption if its consumption by one person does reduce its consumption by others.

For example, if I take a bite from an apple, less apple is left for the next person.

 
B.Nonexcludability—It is impossible, or prohibitively costly, to exclude someone from obtaining the benefits of the good once it has been produced.

Consider a sunset: once it is “produced” in the western sky, it is impossible (or “prohibitively costly”) to exclude someone from viewing it.

By contrast, a good is excludable if it is possible, or not prohibitively costly, to exclude someone from obtaining the benefits of the good once it has been produced.

For example, if I charge an enforceable price for my good, then I may exclude anyone unwilling or unable to pay that price from consuming my good.

C.Nonrivalry Does Not Necessarily Imply Nonexcludability—There is a tendency to believe that nonrivalry and nonexcludability go hand in hand. In fact, many goods that are nonrivalrous in consumption are also excludable, and many goods that are excludable are nonrivalrous. Only a public good, by definition, is both nonrivalrous and nonexcludable.

 
D. The Free Rider—When a good is nonexcludable, it is possible for individuals to benefit from the good without paying for it.
Persons who do so are called free riders, and

it is because of free riders that the market will fail to produce the appropriate quantities of public goods, if it produces them at all.

The reason is that no rational producer will supply a good for which no one has to pay in order to consume (unless, perhaps, the cost of production is zero).
 

The free rider problem is part of the basis for accepting the public provision of goods. We need to be careful, though, that we do not assume that all government-provided goods—any good or service provided by the government—are public goods.

The government provides many goods and services that are not public goods, because they are either rivalrous in consumption, excludable, or both.

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