This document discusses economic efficiency and market failures in three parts. It first defines economic efficiency as occurring when marginal benefits from production equal marginal costs, incorporating all market and non-market values. Second, it explains that while markets aim for efficiency, they can fail to reach socially efficient outcomes due to externalities. External costs like pollution are incurred by society but not reflected in the market. This can lead to overproduction. Third, it provides examples of how negative externalities from activities like paper mill waste discharge and traffic congestion cause the market to produce at quantities that are not socially optimal.
This document discusses economic efficiency and market failures in three parts. It first defines economic efficiency as occurring when marginal benefits from production equal marginal costs, incorporating all market and non-market values. Second, it explains that while markets aim for efficiency, they can fail to reach socially efficient outcomes due to externalities. External costs like pollution are incurred by society but not reflected in the market. This can lead to overproduction. Third, it provides examples of how negative externalities from activities like paper mill waste discharge and traffic congestion cause the market to produce at quantities that are not socially optimal.
This document discusses economic efficiency and market failures in three parts. It first defines economic efficiency as occurring when marginal benefits from production equal marginal costs, incorporating all market and non-market values. Second, it explains that while markets aim for efficiency, they can fail to reach socially efficient outcomes due to externalities. External costs like pollution are incurred by society but not reflected in the market. This can lead to overproduction. Third, it provides examples of how negative externalities from activities like paper mill waste discharge and traffic congestion cause the market to produce at quantities that are not socially optimal.
Economics, Concordia University Learning Objectives 1. Define social efficiency and illustrate it graphically 2. Explain why a competitive market may fail to reach a socially efficient equilibrium 3. List and explain the causes of market failure 4. Contrast the equilibrium outcomes in markets where externalities are accounted 5. Explain the distinguishing characteristics of public goods and why they give rise to free riding
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Economic Efficiency and Markets • There are two questions of interest: 1. What is the quantity that ought to be produced? 2. What is the quantity that is produced in fact? • The first question deals with the notion of efficiency, the second with the way markets normally function
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Economic Efficiency • Economic efficiency in production is achieved when the marginal benefits from production equal the marginal costs ̶ all market and non-market values are incorporated into the marginal benefits and marginal costs of production
Marginal Willingness To Pay (aggregate demand) =
Marginal Cost (aggregate supply) MWTP = MC
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Efficiency and Equity • Efficiency does not distinguish among people ̶ a market that achieves the maximum net benefits is efficient no matter who receives the benefits (one person can achieve all of them) • Equity is a concept that considers distribution of benefits ̶ to be equitable, the distribution needs to be fair
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Efficiency and Equity • An efficient outcome may not be considered equitable if a small number of people benefit and many do not • It may be hard to define fairness since different people have different views, but fairness usually means that benefits are shared widely among the population
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Economic Efficiency and Equity • Economic efficiency does not demand equity in distribution ̶ efficiency says to maximize the size of the pie, don’t worry about how it is sliced ̶ if a project creates more benefits than costs, then it is good, no matter who pays the costs and who receives the benefits
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The Use of Markets • Can a market system, a system where many buyers and sellers interact with each other, give us results that are socially efficient? • Can we rely entirely on the market to reach a socially efficient outcome?
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The Use of Markets • Almost all countries, including Canada, rely on markets to allocate scarce goods • Markets are not completely efficient, but for most goods and services they beat the alternatives • Some alternatives to markets: ̶ distribution based on ‘need’ ̶ equal distribution ̶ first come first served ̶ lottery ECONOMIC EFFICIENCY AND MARKETS 9 The Use of Markets • All the alternatives raise issues with regard to giving the right incentives to both producers and consumers • Overall markets are preferred to the alternatives to allocate goods to those who value them most highly, and give producers incentives to make the goods that people value
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Market Equilibrium • The price where quantity demanded = quantity supplied is the competitive market equilibrium
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Take me home to the equilibrium… • Markets always try to move toward their equilibrium level where D = S • … and they usually get there…. ̶ stores do not have lots of items they can not sell (if they do, they lower the price) ̶ stores are usually not short of items they can sell (if they are, they raise the price) ̶ stores can adjust prices to reach equilibrium
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Markets and Social Efficiency • Does an unregulated market lead to a socially efficient equilibrium? • Yes, if the market demand and supply curves represent the willingness-to-pay and marginal cost curves • Problem: when environmental values are concerned, there could be differences between market values and social values
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Market Failures • Market failures prevent a socially efficient equilibrium from being reached • People get too much of something they do not want (negative externalities) • People do not get enough of something they want (positive externalities)
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Types of Market Failures 1. Negative externalities • Producers do not pay the full production costs ̶ the production of a good creates pollution that affects other people ̶ the price of the good in the market is below the true price ̶ producers produce more than the socially optimal amount of the good
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Types of Market Failures 2. Positive externalities • Producers can’t capture the full benefits of production ̶ the production of a good affects positively other people ̶ producers produce less than the socially optimal amount of the good
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Private costs • Private costs: when firms decide about what and how much to produce, they take into account the price of what they produce and the cost of the inputs (e.g., labor, raw materials, machinery, energy, etc.) • Any firm that has the objective of maximizing its profits will try to keep its production costs as low as possible
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External Costs • External costs: during production there may be other costs that represent true costs to society but do not show up in the firm’s profit-and-loss statement • They are called “external” because, although they are real costs to some members of society, they are not normally taken into account by firms ̶ costs that are external to firms but internal to society as a whole
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Emissions as a Negative Externality • Pollution emissions may create a negative externality • The negative externality exists when there are costs to society and the environment from the production that the producer of the good does not pay • Even if we removed all negative externalities by forcing producers to pay the full cost of production, pollution would still exist because of the benefits we receive from consuming the good
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Water Pollution - Example • A new paper mill is established on a river and begins discharging waste into the river • Negative effects: lower quality of water, reduction in the number of fishes, non-potable water • If the paper mill does not take those effects into consideration, when deciding how much to produce, it over produces discharging too much emissions • The market fails because there is no incentive for the paper mill to include the external costs in their decision- making process ECONOMIC EFFICIENCY AND MARKETS 20 Full Social Cost • To produce output levels that are socially efficient, decisions about resources used must take into account both types of costs ̶ the private costs of production plus whatever external costs arise from adverse environmental impacts • The full social cost is, Social costs = private costs + external (environmental) costs
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What if we tax the polluter for the damage? (jumping ahead here to policy to make a point) • Impose a tax on the paper mill equal to the damages its pollution causes ̶ this type of tax is known as a Pigouvian tax • Now the paper mill is considering the full social costs • The negative externality no longer exists, but pollution still does ̶ it is the socially efficient level of pollution
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Traffic Congestion as a Negative Externality Number of cars Average travel time between A and B 1 10 2 10 3 10 4 11 5 12 6 14 7 18 8 24 There are already 5 cars, alternative route takes 18 minutes
• Explain the negative external costs in this situation
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Open-Access Resources • A major cause of market failure is the presence of open-access resources • Open-access resources are resources with uncontrolled access ̶ the open ocean, the air or some public lands, a forest where anyone may go and cut wood • No one controls or owns the resource, therefore it can be hard to prevent people from overusing or abusing it
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Review of Negative Externalities • Negative externality: marginal social costs (MSC) of production > marginal private costs (MPC) of production • MPC will not reflect the true or full production cost • If the external costs are not added, the price of the good in the market will be below the correct price and too much of the good will be produced
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Positive Externalities • An action has some positive benefits to others (society) that are not taken into consideration by the person making the decision about how much of a good or service to produce
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Positive Externalities marginal benefits to society (MSB) > marginal private benefits (MPB)
• The producer produces the goods until MPB = MPC
• The good is underprovided in an uncontrolled market
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Positive Externalities - Examples • Examples of positive externality: ̶ flower gardens (everyone enjoys the beauty of the flowers) ̶ firework shows (everyone enjoys the show) ̶ education (you are able to educate other people and therefore they benefit of your education) ̶ if you walk to work, it will reduce congestion and pollution (this benefits everyone else in the city) ̶ vaccination (decreases the likelihood of your own infection and of others becoming infected through contact with you)
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Positive Externalities • Society would be better off if it finds a way to compensate individuals, who produce goods with positive externalities, to encourage them to produce the socially efficient level • Public goods are related to positive externalities
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Public Goods • A pure public good is: 1. Non-rival: one person’s use of the good does not diminish another person’s ability to use the good ̶ if you breath the air, there is still plenty for me to breath ̶ just because I am listening to a radio station doesn't mean that someone else can't
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Public Goods • A pure public good is: 2. Non-excludable: individuals can not be prevented from using a good for free ̶ breath the air for free ̶ watch a fireworks show without paying
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Classifying Goods
Excludable Non-excludable
Rival Pure private goods Examples: common pool resources
Examples: consumption goods, (fishing grounds, groundwater), food, clothing, housing free parking spaces Non- Examples: cable TV, cinemas, Pure public goods private parks Examples: sunlight, atmosphere, rival environmental quality
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Free Riders • When a public good is involved, each person may have an incentive to free-ride on the efforts of others • Free riders are people who pay less than their marginal willingness to pay (MWTP) for a good • Many public goods suffer from free riders because they are non-excludable ̶ people can’t be excluded from enjoying the benefits of the good even if they do not pay for it
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Public Park as a Public Good • A town wants to build a park • They ask the people of the town if they will contribute towards the costs • Everyone says they will, but they also know that even if they don’t contribute individually, other people will do • Thus, if a private person pays for the park, other people enjoy its benefits for free
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Public Goods - Examples • Which of these are pure public goods? Why? ̶ Lighthouse ̶ Clean air ̶ Public TV ̶ Cable TV ̶ Computer software
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Market Failure and Public Goods • Public goods are underprovided in a free market ̶ non-excludable makes it hard to prevent free riders ̶ people try to avoid paying even with a positive MWTP because someone else will pay and provide the good ̶ policies can be used to address the issue (they may be efficient for society but not necessarily for each individual)
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Aggregate Demand for Public Goods • People’s demand for a public good expresses their marginal willingness to pay, just as does their demand for a private good • The difference comes in the way individual demand curves are aggregated across consumers
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Aggregate Demand for Public Goods • Private goods: when summing individual demand curves, the individual quantities demanded at each price are added together to get the aggregate quantity demanded • But with a public good people are consuming the same units • Individual demand curves must be aggregated in a different way than for a private good
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Aggregate Demand for Public Goods The principle is this: • To aggregate individual demand curves for a public good, each person’s MWTP for a given quantity of the good is added
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Aggregate Demand for Public Goods • Aggregation of individual demand curves for a private good is done by horizontal summation ̶ add up quantities desired at a given price • Aggregation of individual demand curves for a public good is done by vertical summation ̶ for a given quantity of the good, each person’s MWTP is added ̶ this is because of the joint consumption of the good
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Aggregate Demand for Public Goods • Environmental quality improvements are public goods • We cannot use the aggregate demand curve to determine a uniform price for all consumers ̶ each consumer must be charged his MWTP for the good to achieve an equilibrium where D = S • But, we cannot extract each individual’s MWTP for the good due to free-rider problems • Thus, public goods are generally not supplied socially efficiently by decentralized private markets
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Overview • We provided an application of the market model to situations where environmental quality is an issue • Due to external costs and external benefits, market prices and quantities may not be at their efficient level when environmental quality issues are involved • Markets may fail to deliver efficient levels of environmental quality, and therefore environmental policies may be necessary to rectify these market failures