1.4 Market Failures

Annotations:

• Externality leads to a market failure as either more or less than the socially optimal amount is produced or consumed (therefore inefficient resource allocation)

1. Components
   1. MSC
   2. MSB
   3. MPB
   4. MPS
2. Types
   1. Positive Externality of Consumption

      Annotations:

      • If there is an external benefit then the MSB curve lies below the D,MPB curve
      • Example: - Flu Shots (less people infected)
      1. Underconsumption of certain products
         1. Merit Goods

            Annotations:

            • Consumption of these goods creates a very positive externality (e.g. education and health care)
            • Alternative Definition: Goods that government would like all members of society to consume in adequate quantities independently of their income or even their preferences (e.g. compulsory education)
      2. Solution
         1. Granting a Subsidy

            Annotations:

            • Type of MARKET-BASED SOLUTION
         2. Legislation and Direct Provision

            Annotations:

            • Type of COMMAND-AND-CONTROL SOLUTION e.g. Free Education
         3. Advertisements/ Moral Pursuation
   2. Positive Externality of Production

      Annotations:

      • If there is an external benefit from the MSC curve lies below the S,MPC curve
      • Example: - Beekeepers producing honey next to apple orchards (as bees will pollinate flowers)
      1. Underproduction of Good
      2. Solution
         1. Granting a Subsidy

            Annotations:

            • Type of MARKET-BASED solution 
         2. Assigning Intellectual Property Rights

            Annotations:

            • Type of MARKET-BASED solution 
         3. Mergers

            Annotations:

            • Type of MARKET-BASED solution 
         4. Direct Regulation

            Annotations:

            • Type of COMMAND-AND-CONTROL SOLUTION
   3. Negative Externality of Consumption

      Annotations:

      • If there is an external cost then the MSB curve lies below the D, MPB curve
      • Example: Consumption of alcoholic beverages (leading to violence, drunk driving, etc.)
      1. Overconsumption of certain products
         1. Demerit Goods

            Annotations:

            • The consumption of a good creates very significant negative externalities (e.g. Alcoholic drinks and Tobacco)
            • Alternative Definition: Goods of which governments would like to limit consumption
      2. Solutions
         1. Imposing Indirect Taxes

            Annotations:

            • Type of MARKET-BASED solution
         2. Direct Regulation

            Annotations:

            • Type of Command-and-Control Solution
         3. Advertisements

            Annotations:

            • Type of Command-and-Control Solution
   4. Negative Externality of Production

      Annotations:

      • If there is an external cost then the MSC curve lies above the S, MPC curve
      • Example: Cement INdustry polluting the atmosphere
      1. Overproduction of the good/ service
      2. Solutions
         1. Market-Based Solutions
            1. Indirect Taxation

               Annotations:

               • - raises the production costs (therefore forcing the supply curve to shift to the left)
            2. Property Rights over Assets
            3. Tradable Pollution Permits

               Annotations:

               • e.g. cap and trade schemes
         2. Command and Control Solutions
            1. Direct Government Regulations
            2. Advertisements
               1. Persuading the public through education

Annotations:

• Pure Public Goods example: Lighthouse, Traffic Lights, Law and Order (debatable), Broadcast Television and Radio (debatable) 

1. Characteristics
   1. Non-Excludable
      1. Existence of Free-Riders

         Annotations:

         • Individuals hiding their true preferences due to the fact that they can enjoy the good without having to pay for it once it becomes available for others
   2. Non-Rival
      1. No marginal cost of an extra user
2. Externality
   1. Positive Externality of Consumption
      1. MSB > MPB
      2. BUT: MPC > MPB
         1. Good may not be supplied
            1. Lack of incentives

1. Tragedy of the Common
   1. Causes Negative Externality of Production
   2. Solutions
      1. Extending Property Rights
      2. Appropriate Institutional Framework
      3. Direct Regulation
      4. Education

1. Solutions
   1. Governments ensure competitive conditions
      1. Liberalizing Free Trade
      2. NO mergers / acquisitions
      3. Monitoring anti-competitive practices
2. Abnormal Profits

1. Problems
   1. Adverse Selection

      Annotations:

      • Producers may not be able to test the true quality of its product
   2. Misalignment of incentives
   3. Moral Hazard Problem arises
2. Solutions for Firms
   1. Signalling

      Annotations:

      • One of the parties tries to convey information about itself that will make it seem credible (e,g, issuing warranties, etc.)
   2. Screening

      Annotations:

      • Individuals try to infer additional information from other observable characteristics
   3. Building good reputations
   4. Contracts Creations
3. Solutions for Governments
   1. Providing more information
   2. Legislations
      1. Standards
   3. Regulating Firm's Behavior