2.8 market Failure: Common Access Pool

• The most efficient scarce resource allocation in a free market is determined by the price mechanism
• Market failure occurs when there is a less-than-optimum allocation of resources, from the point of view of society.
• Externalities occur when there is an external impact on a third party not involved in the economic transaction between the buyer and seller. They can be positive or negative and are often referred to as spillover effects.
• Example of negative externality: passive smoking
• Public goods are beneficial to society but would be under-provided by a free market. They are non-excludable and non-rivalrous in consumption.
• Common pool resources are collectively shared resources with no private ownership. They are rivalrous (limited in supply) and non-excludable.
• The result of under-provision of public goods and merit goods is an over-allocation of resources (factors of production) used to make these goods/services.
• Market failure occurs when there is a lack of allocative efficiency from the point of view of society.
• Negative externalities of consumption occur when the consumption of a good or service creates costs that are not considered by the consumers, such as waste generated outside fast food outlets.
• Over-consumption of goods and services leads to market failure because consumers only consider the private costs and not the external costs. If the external costs were considered, demand would decrease and the goods/services would be sold at a lower price.
• Common examples include cigarettes, alcohol, fatty foods, and single-use plastic products.
• The free-market equilibrium is affected by external costs of consumption. The larger the external costs, the larger the gap between the marginal private benefit (MPB) and the marginal social benefit (MSB). The optimum allocation of resources would generate an equilibrium where MSB = MSC.
• The welfare loss caused by over-consumption in a free market is represented by the pink triangle on the diagram. It indicates that more factors of production are allocated to producing the over-consumed good/service than what is socially efficient.
• Government interventions addressing welfare loss are through indirect taxes, legislation, regulation, etc., can force the market to be more socially efficient and reduce the welfare loss caused by negative externalities of consumption.
• The welfare loss caused by over-production can be calculated by determining the area of the triangle formed by the arrowhead pointing back towards the socially optimal quantity.
• Positive externalities of consumption are benefits that are created during the consumption of a good or service, which go beyond the private benefits received by consumers.
• Under-consumption occurs because consumers only consider the private benefits and not the external benefits. If the external benefits were considered, the demand would increase and the goods/services would be sold at a higher price.
• Vaccinations not only protect those who receive them but also prevent the spread of disease to others around them. This creates external benefits of consumption, resulting in under-consumption.
• The gap between Qe (equilibrium quantity) and Qopt (optimal quantity) represents the under-consumption caused by the external benefits of consumption. It indicates that the market is failing to allocate resources optimally.
• The optimal allocation of resources can be achieved when the marginal social benefit (MSB) equals the marginal social cost (MSC). This equilibrium ensures that society gains maximum welfare.
• The larger the external benefits in consumption (positive externality), the larger the gap between the MPB and MSB. This gap represents the under-consumption and the potential welfare gain from consuming more.
• The free market fails because it only considers the private benefits and not the external benefits. As a result, there is an under-consumption equal to the difference between the optimal quantity (Qopt) and the equilibrium quantity (Qe).
• Government intervention, such as subsidies or partial provision, can force the market to be more socially efficient. By allocating more factors of production to produce the optimal quantity, societal welfare can be gained.
• The welfare loss caused by positive externalities of consumption can be calculated by identifying the area of potential welfare gain (triangle) and calculating its size.
• Legislation and regulation aim to limit the harm caused by external costs of consumption or production. Regulatory agencies enforce laws and monitor compliance.
• Legislation aimed at the consumer side can change the legal age for alcohol consumption, influencing demand and reducing external costs associated with excessive drinking.
• Legislation that changes the legal age for alcohol consumption shifts the demand curve left, reducing the effective population able to consume alcohol. This leads to a lower price, lower output, and less over-consumption.
• Legislation aimed at the producer side can help alleviate external costs such as overfishing. By reducing the potential supply of a product, legislation aims to reduce negative impacts on the environment.
• Legislation shifts the supply curve left, moving the market closer to the optimum level of output (Qopt) and reducing the welfare loss. This results in a higher price, lower output, and less over-supply.
• A tradable pollution permit is a permit issued by the government that allows firms to emit a certain amount of pollutants. These permits can be bought, sold, or traded among polluting firms.
• In a cap and trade scheme, the government sets a limit (or cap) on the total amount of pollution allowed. They issue permits to polluting firms, each valid for the emission of one ton of pollutant. Firms that exceed their allocated permits must buy additional permits from less-polluting firms.
• The price of a pollution permit is determined by the demand and supply in the market. If the cost of additional permits is higher than investing in new pollution abatement technology, firms are incentivized to switch to cleaner technology. The price changes as it represents an additional cost of production.
• Tradable permits reduce negative externalities of production by creating a market for pollution. Firms that pollute less can sell their spare permits to firms that pollute more, reducing the overall level of pollution.
• Measuring externalities, such as CO2 emissions, is extremely difficult and constantly changing. The initial number of permits is based on this calculation, and if it is too high, the permits will have no impact on emissions. It is challenging to accurately determine the level of externalities in an economy.
• When the calculations are correct, tradable permits can be effective in decreasing emissions and reducing welfare loss. However, it still provides a permit to pollute, and larger firms with more resources may buy all the permits while smaller firms struggle.
• The increased costs of production for firms may lead to some firms investing in new technology to avoid the need for permits, while others may no longer be able to compete. Some firms may relocate their production to countries without a pollution permit scheme, and consumers may experience higher prices.
• Over time, tradable permits can effectively create monopolies in polluting industries if larger firms buy up all the permits. If the demand for the end product is price inelastic, firms can pass on the cost of permits to consumers in the form of higher prices.
• Which Externality does this graph show?

  Negative Consumption Externality (MPB>MSB)

  A) DWL

  B) MSB

  C) MPB

  D) MPC=MSC

  
• Which Externality is this graph showing?

  Positive Production Externality (MSC>MPC)

  A) DWL

  B) MPB=MSC

  C) MSC

  D) MPC

  
• Which Externality is this diagram showing?

  Negative Production Externality

  A) DWL

  B) MSC

  C) MPC

  D) MPB=MSB