17-1Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Chapter 17
Market failure and resource allocation
17-2Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Learning objectives• Discuss the nature, and provide examples
of, spillovers (externalities)• Examine the implications of spillovers for
the efficient allocation of resources• Briefly discuss the problem of the commons
and its implications• Describe the characteristics of public goods
— indivisibility and the inability to apply the exclusion principle — and the potential role of government in ensuring the adequate provisions of these goods
17-3Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Learning objectives (cont.)• Show how we can evaluate government
activity through cost–benefit analysis• Determine the economic considerations
that underlie environmental problems and examine some suggested solutions to the pollution problem
17-4Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Sources of market failureTwo major sources of market failure. The
market either • Produces the wrong amounts of goods or
services, resulting in externalities or ‘spillover’ effects, or
• Fails to allocate sufficient resources to the production of certain goods, called ‘public’ or ‘social’ goods
17-5Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Spillovers or externalities• These are costs or benefits associated with
the production or consumption of a good or service that flow on to parties that are external to the market transaction
• Spillovers– Costs or benefits associated with production
or consumption that flow on to parties external to the market transaction
– The market over-allocates resources– Also called externalities because these are costs or
benefits that are external to the market transactions
17-6Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Spillovers or externalities (cont.)Spillover costs• Production or consumption of a commodity
that inflicts cost on some third party without compensation
• Example: environmental pollution• Spillover costs arise in some cases due
to the problem of the commons
17-7Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Spillover costs
Q0DD
P
Qe Qo
SS11 SS
17-8Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Spillovers or externalities (cont.)Spillover benefits• Production or consumption of goods and
services which confer external benefits for which payment or compensation is not required
• The market under-allocates resources
17-9Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Spillover benefits
Q0
P SS
QoQe
DD DD11
17-10Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Public goods and services• Private goods are produced through
the market system– They are divisible– Subject to the exclusion principle
• Public goods not provided by the market and are:
– Indivisible– Not subjected to the exclusion principle
17-11Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Public goods and services (cont.)
• Public goods are goods and services that are not provided by the market system
• Pure public goods are goods and services that are both indivisible and not subjected to the exclusion principle
• A common problem of public good is the free-rider problem
17-12Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
P
Q
D
When verticallyadded equals
collectivewillingness
to pay
D2
D1
Demand for a public goodSS
3
5
8
17-13Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Solutions to market failure• Correcting for spillover costs• Legislation• Specific taxes• Property rights and individual bargaining
– Coase theorem Property ownership is clearly defined The number of people involved is small Bargaining costs are negligible
17-14Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Over-allocationcorrected
P
Q
D
0
St
S
Spillovercosts
Tax
Q0 Qe
Correcting for spillover costs
17-15Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Correcting for spillover benefits• Subsidise buyers
– This would reduce the private cost to consumers and increase the consumption of the good
• Subsidise producers– Government can encourage the production by
subsidising producers of the good or service
17-16Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Correcting for spillover benefits (cont.)P
Q
D
S
0
Dt
SubsidySubsidyto consumerto consumer
Under-allocationUnder-allocationcorrectedcorrected
17-17Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
P
Q
D
0
St
S′t
Subsidy toproducersincreases
supply
Under-allocationcorrected
Qe Q0
Correcting for spillover benefits (cont.)
17-18Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Allocating resources to public goods
Cost–benefit analysis• Method used to allocate resources to public
goods that maximises society’s welfare• Problems associated with cost–benefit analysis
include the difficulties in measuring the value of certain costs and benefits in practice
17-19Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
The pollution problem• The law of conservation of matter and energy• Four important causes of pollution
1. Population density
2. Rising incomes
3. Technology
4. Incentives
17-20Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Anti-pollution policies• Individual bargaining and liability rules
and lawsuits– The allocation of property rights to individuals
may allow them to negotiate with polluters so that they are compensated for the damage caused by pollution — Coase theorem
• Government intervention: direct control and taxes– Direct controls: legislated standards– Specific taxes: emission fees
• Establishment of a market for pollution rights
17-21Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Market for pollution rights• Involves the establishment of an allowable
amount of pollution — in line with the ability of the environment to recycle — by a pollution control agency, and the development of a set of ‘rights’ to create units of pollution which would be sold or auctioned in the market
17-22Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Market for pollution rights (cont.)• Rights to pollute would be sold or auctioned
off to polluting firms, providing a market for pollution rights
• Polluters would bid for the pollution rights up to the point at which the cost of the pollution rights exceeds the private cost of pollution abatement
• A market for pollution rights ensures an efficient allocation of resources
17-23Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Market for pollution rights (cont.)
500 750 1000Quantity of pollution rights (units)
Pri
ce p
er p
oll
uti
on
rig
ht
$100
$500
D2000
D2008S
17-24Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia
Next chapter:
Inequality and poverty