1.4.

Market Failure

Market failure is a situation in which the free market leads to a misallocation of

society's scarce resources in the sense that either overproduction or
underproduction of a particular good occurs, leading to a less than optimal
outcome.

Reasons for market failure

The reasons for market failure include:
 Positive and negative externalities
 Lack of public goods
 Under-provision of merit goods
 Over-provision of demerit goods
 Abuse of monopoly power
 Inequality

The meaning of externalities

Externalities are costs (negative externalities) or benefits (positive externalities), which are
not reflected in free market prices. Externalities are sometimes referred to as 'by-products',
'spillover effects', 'neighbourhood effects' 'third-party effects' or 'side-effects', as the
generator of the externality, either producers or consumers, or both, impose costs or benefits
on others who are not responsible for initiating the effect.

The key feature of an externality is that it is initiated and experienced, not

through the operation of the price system, but outside the market.

Proponents of laissez-faire would argue that externalities particularly arise

because of the absence of markets - as no markets exist for such things as clean
air and seas, beautiful views or tranquility, economic agents are not obliged to

1
take them into account when formulating their production and consumption
decisions, which are based on private costs and benefits i.e. those which are
internal to themselves. Another way of putting this is to say individuals have
no private property rights over such resources as the air, sea and rivers, and
thus ignore them in making their production and consumption decisions.

Property rights refer to those laws and rules that establish rights relating to:
 Ownership of property;
 Access to property;
 Protection of property ownership;
 The transfer of property.

Thus a firm may feel free to dump effluent into a river as the spoiling of the
environment and the killing of fish is not a cost that it would directly have to
bear. Those on the political left would be more likely to argue that such an
externality would arise because of the market system which is based upon the
private ownership of resources, with individuals acting in their own self interest
and therefore not having to consider what is in the public interest i.e. the
problem is due to an absence of communal property rights and of a system of
planned production.

Resource: The importance of Property Rights

https://www.youtube.com/watch?v=wYnrUkKR1lo

2
Types of externalities
Pollution is an example of an externality which is commonly cited, but it is
important to establish at this stage that there are various types of externalities
and that they can be classified in different ways: they can arise from acts of
consumption or production, and can thus be production, consumption or
mixed externalities, and, as previously mentioned they can be experienced
as external costs (negative externalities) or as external benefits (positive
externalities).

Figure 1 below summarizes the different possibilities and provides some

examples.

Figure 1: The various kinds of externality

3
It can be seen from this table that there are in fact four different varieties of
externality:
A) a production externality: initiated in production and received in
production;
B) a mixed externality: initiated in production, but received in
consumption;
C) a consumption externality: initiated in consumption and received in
consumption;
D) a mixed externality: initiated in consumption, but received in
production.

Each of these are sub-divided into two, according to whether they are
experienced as an external cost or as an external benefit, giving a total of eight
varieties.

In practice, the most important externalities are those which affect the
environment, and it is these which have received widespread adverse publicity in
recent years, and which have prompted the rise of 'green' pressure groups and
political parties. Indeed, so great has been the impact of environmental pollution,
that in addition to the externalities identified in figure 1, we can also, in a global
context, identify externalities which are transmitted from one country to
another, and that may be mutually damaging; for example, the Chernobyl
nuclear disaster in 1986 in Russia, not only contaminated the local area, but also
polluted other parts of Europe; emissions of acid rain from West European
nations not only harm the environment in the initiating countries, but also wreak
havoc on the forests, lakes and rivers of the Scandinavian countries. The recent
earthquake in Japan and the dangerously high levels of radiation is another
example of such externalities.

4
Task: Try matching the following examples of externalities to each type of
externality in figure 1 (Hint - there is one example of each).

Situation Type of Externality

1. A person smoking a pipe at a football match causes the

person sitting behind to passively smoke.
2. A large retail organization attracts numerous extra
customers to its store, some of who spend money in
other shops in the vicinity (maybe a shopping mall).
3. Children are taken to school by car instead of walking or
using public transport. This worsens congestion and
raises the production costs of firms.
4. Owner-occupiers (people who own their own
houses/apartments) in a particular area take measures
to increase the value of their properties. Estate agents
benefits from the extra commission earned when the
houses are sold.
5. Juggernauts (large trucks/lorries) travel through inner
city areas, causing traffic congestion for other
commercial road users that raise their production costs.
6. A power station emits black fumes into the air that
discolours the paintwork of nearby houses.
7. Farmers provide pathways in the countryside that
benefit walkers.
8. A private gardener plants an assortment of beautiful
plants in her front garden and enhances the environment
for her neighbours and passers-by.

5
How do externalities affect allocative efficiency?
Given the existence of perfect competition, allocative efficiency would
automatically occur where price equals marginal cost in all markets, assuming
that neither negative nor positive externalities are present.

So, how do externalities affect our condition for efficiency?

Let's consider case of a firm, which discharges its waste products into a river.
Such a firm would be treating the environment as a free resource, and would be
imposing a cost on society as a whole, rather than just on the consumers of the
good. The price charged to consumers would not therefore, in this instance,
reflect the true cost of the product; if the firm were compelled to install
equipment which could treat its effluent and render it harmless to the
environment, its production costs and prices would rise and consumers would, as
a consequence, reduce their demand for the product in question. Resources
would then be reallocated to other lines of production.

In this case there is a divergence between private and social cost.

 The private cost is the internal money cost of production incurred by the
firm i.e. costs such as wages, raw materials, heating and lighting that must
be paid to carry out production, and which would appear in the firm's
accounts.
 The social cost, on the other hand, is the real cost to society as a whole; it
is the private, internal costs plus the value of the negative externalities
(external costs).

6
Similarly, if the firm's production decisions were to generate positive
externalities, such as the beneficial effects arising from the provision of
employment, then there would be a divergence between private and social
benefit.
 The private benefit is the money value of the benefits accruing internally
to the firm from production activity e.g. in the form of sales revenues.
 The social benefit, on the other hand, is the private benefit plus the value
of positive externalities (external benefits).

Now, the significance of this analysis is that allocative inefficiency will occur if
private cost or benefit diverges from social cost or benefit. Where
externalities exist the condition for allocative efficiency is that price = social
marginal cost = social marginal benefit i.e. the price must equal the true
marginal cost of production to society as a whole, rather than just the private
marginal cost.
We will now illustrate the above in relation to the firm discharging waste into the
river.
Hence externalities cause market failure:
 When a negative production externality is initiated, the firm will not be
made to pay for the cost imposed on others, and will therefore have no
market incentive to produce less; from society's standpoint it will therefore
overproduce;
 When a positive externality arises, the firm will lack any incentive to
increase its output to the socially desirable level, as it does not receive any
payment for the generation of the external benefit; underproduction
therefore occurs.

7
Negative Externalities of Production/External Costs of Production

Access this webpage and follow the steps

http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/negext
prod.html

Figure 2: Negative Externalities of Production

Task: Explain the relationship between firstly, the free market equilibrium and
the socially efficient equilibrium and secondly the free market price and the
socially optimal price.

8
Negative Externalities in the Chemical Production sector

9
10
Negative Externalities of Consumption/External Costs of Consumption

Access this webpage and follow the steps

http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/negext
cons.html

Figure 3: Negative Externalities of Consumption

Task: Explain the relationship between firstly, the free market equilibrium and
the socially efficient equilibrium and secondly the free market price and the
socially optimal price.

11
The economic theory of traffic congestion
Figure 1 below shows how the analysis of externalities that we looked at in the
previous section can be applied to the problems of traffic congestion.

Figure 4 Road transport, congestion and economic theory

Economic theory can be used to analyze the issues involved in traffic congestion
as shown here. Figure 4 indicates the relationship between the cost of travel and
the flow of traffic along a particular route. The essence of this theory is based on
the fact that, when making a journey by car, a motorist only considers the
marginal private cost (MPC). This is the cost directly attributable to him/herself,
such as time, fuel and the maintenance of the vehicle, rather than the full cost of
the journey, which may include costs imposed on society such as pollution, noise
and time lost due to congestion. When added to the private costs, these are
termed the marginal social costs (MSC), the difference between the two
representing the externality imposed by the motorist.

12
In outlining the theory, it is assumed that, when making a journey, congestion is
the only externality. The graph represents the demand for travel along a
particular stretch of road over a period of time. Up to a flow of traffic F0, there is
no congestion, thus there is no divergence between MPC and MSC, although in
reality, such a situation only applies to extremely low volumes of traffic.

As the flow of traffic increases above F0, congestion is apparent and there is a
divergence between MSC and MPC. Note that the MSC is equal to the MPC, plus
the social cost of congestion.

If the demand for travel on this particular route is of the normal shape
(represented by D on the graph) and is a measure of the marginal benefit, then
the flow of traffic will be determined by the intersection of the demand curve and
the MPC curve at F1 and the private cost to the motorist will be b. At a flow of F1,
the external cost, not taken into account by the motorist, is ab (the difference
between the MPC and MSC). This means that resources are not being allocated
efficiently and that individuals are making more journeys than they would if they
were aware of the full social costs.

Resources
What causes traffic jams?
https://www.youtube.com/watch?v=8ivycTcNvJQ

A solution to traffic congestion?

https://www.youtube.com/watch?v=wOe_mvlzMSk

Can a nudge replace a congestion tax?

https://www.youtube.com/watch?v=CX_Krxq5eUI

13
Possible government responses to externalities
The outstanding characteristic of a market economy is that production does not
occur as a result of some grand, master plan; rather, it is the result of the pulls
and pushes of supply and demand, of the numerous uncoordinated decisions of
individuals and firms. As individuals are assumed to seek to maximize their own
satisfaction, and firms their own profits, decisions made are likely to be strictly
on the basis of private costs and benefits, and, as previously explained, herein lies
the problem: unless the full social costs and benefits of production and
consumption decisions are taken into account, so that MSC is equated to MSB,
social inefficiency and a misallocation of society's scarce resources will result.

So, what measures can a government take to rectify such inefficiency, and how
successful is it likely to be? As is the case with most important questions in
economics, a range of answers is possible, depending largely on the political
perspective of the respondent. At one end of the spectrum, governments could
'leave well alone', essentially not interfering with markets but trying to gently
persuade firms and individuals to modify their behaviour. At the other extreme,
the market could be completely replaced by direct government provision, and in
between various policy options are possible. We now turn to an examination of
some of these options.

In practice it is the problem of production externalities, particularly

environmental ones, which most occupy the attention of governments, and our
discussion will mainly, but not exclusively, focus on these.

14
The main measures that governments can take include:
 Direct provision of goods and services - this means the government
providing the good or service themselves, perhaps through state-owned or
nationalized industries.
 The extension of property rights - this means giving people more right of
ownership over their immediate environment, so that they can enforce
environmental and other standards.
 Taxes and subsidies - where an activity causes negative externalities it
could be taxed and where there are positive externalities, it could be
subsidized.
 Tradeable pollution rights - this involves allowing companies to pollute a
certain amount (a 'permit to pollute') but then creating a market for the
permits, so that if they pollute more than the allowance they have to buy
extra permits. However, if they pollute less, then they can sell their surplus
permits.
 Regulation, legislation and direct controls - this involves setting legal
limits or regulations to prevent negative externalities or perhaps to reduce
their impact.

15
Direct government provision
Direct provision of goods and services by the government
The existence of externalities provides an important argument for the common
ownership, or nationalization of a number of key industries.

The argument is that privately owned firms, in order to survive in a competitive

world, necessarily have to put their own interests before those of society at large,
for to do otherwise might be inconsistent with the goal of long run profit
maximization, or even survival. This harsh reality of the market is likely to
manifest itself in the generation of negative externalities such as pollution, as the
control of these externalities would involve higher costs and an adverse impact
on profits; conversely, production activity which conferred net positive
externalities on society might not be undertaken in sufficient quantities if the
criterion of private profitability could not be met.

Nationalized industries, on the other hand, which, on account of being commonly

owned, could be operated according to broad social criteria, rather than the
narrow commercial one of private profitability, and this allows for the possibility
of externalities to be fully incorporated into production decisions. Thus, for
example, questions of workers' safety standards and atmospheric pollution could
be accorded priority status, rather than being ignored on the grounds that to do
otherwise would adversely affect profits and competitiveness; and activities such
as the keeping open of 'uneconomic' coal mines and the provision of postal and
transport services to remote outlying areas, could all be maintained on the
grounds that they provide substantial positive externalities to society at large,
although not necessarily being profitable in the sense that the private revenues
from such activities exceed the private costs.

16
Similarly, an important argument for merit goods such as education and health
being directly provided by the government rather than through the market, is
that they not only confer private benefits on individuals but also significant
positive externalities on society as a whole which individuals would tend to
ignore when making their consumption decisions. As a result, left to the market,
under-provision is likely to occur; for example, individuals would be prepared to
buy education through the market if they had to, as substantial private benefits,
such as higher life-time earnings, are likely to result. However, a case for a higher
level of government provision can be made on the grounds that not all the
benefits accrue solely to the individual - society gains from a more efficient and
adaptable labour force and perhaps a more tolerant and more aware population.

The above arguments for direct government provision would of course be

strongly contested by free market economists who would argue the case for
privatization, the desirability of using markets to provide merit goods and the
extremely poor record of pollution control of the formerly centrally planned
economies of Eastern Europe.

Extension of property rights (Coase Theorem)

Property rights concern the legal entitlement to property and the right to use or
sell the property, as well as the rights that other people have, or do not have, over
the property. It is argued that negative externalities in particular arise because of
the existence of incomplete property rights over natural resources such as air,
land, rivers and seas i.e. as property rights are not fully allocated to these areas as
nobody really owns them, individuals and firms are free to impose external costs
from their production and consumption activities without having to pay any
compensation. The dumping of toxic wastes into the sea and the riding of a noisy
motorbike provide two examples.

17
Thus by extending property rights individuals would be able to stop others
imposing costs on them or to claim compensation if they did so. A person
purchasing a house, for example, could also acquire a set of 'amenity' rights that
would entitle the owner to peace and quiet in the vicinity of the property as well
as a supply of water and air of a reasonable quality. Any infringement of such
rights e.g. by neighbours playing music unduly loudly, or trucks emitting
excessive exhaust fumes into the air, would give the owner of the amenity rights
entitlement to compensation. In this case the externality would be
internalized as the initiators of the external costs would be forced to pay for
them, and adjust their production/consumption decisions to more socially
efficient levels.

However, there may be a number of problems with this solution in practice:

 For compensation to be paid, it must be possible to establish the nature
and extent of external costs being imposed; in the case of most types of
pollution, for example, this tends to be an extremely difficult thing to do,
and so appropriate compensation levels become almost impossible to
establish.
 Where there are many firms or individuals imposing negative externalities,
it would be exceedingly difficult to claim compensation from them all;
for instance, if many juggernauts, low-flying helicopters and joy-riding
teenagers passed a property, making great noise in the process, it would be
somewhat impractical for the property owner to try to claim compensation
from them all.
 Even if those generating the external costs are few in numbers, the time
and cost involved of pursuing the offenders through the courts may be
prohibitive for all but the very rich; what chance would an ordinary person
have, for instance, in claiming compensation from a large, multinational

18
 burger chain, which had permitted the neighbourhood to become unduly
littered with burger wrappings?
 The extension of property rights has equity implications; extending
private property rights is likely to favour those who already possess
property at the expense of those who do not: so, Gypsies and travellers may
be prevented from setting up camp, peace campaigners and other
protestors could be prevented from holding their demonstrations and
ramblers' rights of way in the country-side might be infringed; thus those
on the political left tend to favour an extension of communal property
rights and a society based more on public ownership and a set of co-
operative values which, they would argue, are less likely to cause the
problem of negative externalities in the first place.

Resources
The Coase Theorem
https://www.youtube.com/watch?v=zcPRmh5AIrI

I Bought a rainforest
https://www.youtube.com/watch?v=7AtgF7BEoEU

19
Taxes and subsidies
The use of taxes and subsidies to tackle the problem of externalities is a market-
based method of control as it works through the price system, i.e. through the
impact of changes in prices.

If negative externalities exist, and there is allocative inefficiency at the free

market price because SMC is greater than price and overproduction is occurring,
then the appropriate solution would be to tax the good; if, on the other hand, the
market is under-producing because positive externalities are not being taken into
account, it would be appropriate for the government to grant a subsidy.

Taxes
There are two types of tax, which may be applied to address the problem of
negative externalities: a tax set equal to each firm's marginal external costs
and an environmental or 'green' tax (Pigovian Tax).

20
The policy of taxing firms according to the marginal external costs that they
impose on society can be illustrated using figure 6 below. In this example we
assumed that a firm was dumping waste products into a river. The government
would have to assess the cost to society of such an action, and impose a tax on the
offending firm equal to the value of the marginal external cost (or negative
externality); in this case the tax would internalize the externality by making
the polluter pay. The levying of such a tax would shift the supply curve from S to
S1which would increase the market price to OP1, and cause the level of output to
fall to OQ1, where P = SMC and allocative efficiency is achieved.

Figure 6 Negative externalities - dumping of waste

21
An environmental tax could be imposed either on a product responsible for
creating pollution, or on the inputs to an industry which have caused
environmental damage e.g. carbon producing fuels, which are believed to play the
major role in the process of global warming. The aim of a carbon tax on each
unit of carbon in fossil fuels would be to: raise the price of those sources of power
with high carbon contents, thus encouraging a switching to power sources
causing lower CO2 emissions; encourage greater conservation of energy in
general; and stimulate the search for more environmentally-friendly
technologies.

Figure 7: Carbon tax on fossil fuel

22
Pollution tax in sector emitting CO2

23
24
Issues arising from the tax/subsidy approach
Advocates of this approach would argue that it permits the forces of demand and
supply to operate. At the same time generators of negative externalities are
induced to 'cleanup their act' because the less pollution they create, the less their
tax liability; and conversely, grants and subsidies encourage greater output and
consumption of those goods involving net social benefits.
In practice various difficulties are likely to arise:
 For the tax solution to work in the way indicated in figure 7 above,
the exact value of the marginal external cost must be established so
that taxes, of exactly the right size can be applied; in reality it is not only
extremely difficult to identify external costs, but it also an extremely
arbitrary matter trying to ascribe a monetary value to them e.g. how should
the emission of black fumes into the air from an industrial chimney be
assessed?
 From an environmental point of view a tax on pollution does not solve
the problem, as pollution is still allowed to continue; the tax merely
provides a market-led inducement to firms to find cleaner ways of
producing so as to reduce their costs; moreover, the unwilling third parties
who receive pollution as a negative externality are not in any way
compensated.
 Taxation of pollution would require regular monitoring of pollution
emissions and as offending firms are likely to be generating different
quantities and types of pollution, such monitoring is likely to be
administratively complex and very costly.
 Distortions and inefficiencies might arise in terms of the cost of
collecting a pollution tax, the inevitable temptation by the less scrupulous
to evade paying it altogether and the possibility of an inflationary impact
on the price level.

25
Tradable pollution rights
Like the use of taxes and subsidies, tradable pollution rights (otherwise known as
tradable emission allowances or permits), represent another market-based
solution to the problem of negative externalities, in particular pollution. They
were first introduced in the USA in 1990 under the Clean Air Act in which the
Environmental Protection Agency set a target rate of reduction for power
stations' emissions of sulphur dioxide. Initially, power stations were issued with
emission permits in proportion to their current pollution levels and were allowed
to discharge pollution into the air up to a specified limit. Thereafter, those power
stations for whom the cost of reducing pollution was low, could sell their spare
pollution permits to generators for whom the cost of pollution abatement,
through the installation of appropriate equipment, would be very high. Thus, a
market in tradable pollution rights is created, stimulating pollution reduction
through the possibility of making money out of selling surplus permits.

Figure 8: Tradable Pollution Permits

26
The main argument in favour of such a scheme is that it operates through the
market via the price system: firms are given a profit incentive, i.e. through the
right to sell spare permits, to find cheap ways of reducing their pollution levels;
and such a system should be administratively cheap and simple to
implement, as the regulatory agency need have no information regarding firms'
costs - it simply has to issue the permits and arrange for their sale; in
addition, consumers may benefit if the extra profits made by low pollution
power stations, arising from the sale of their spare permits to other companies,
are passed on in the form of lower prices.

The main argument against the use of tradable emission permits is that they do
not actually stop firms from polluting the environment; they only provide
an incentive to so - where a degree of monopoly power and relatively inelastic
demand exist, the extra cost of purchasing additional permits so as to further
pollute the atmosphere, could easily be offset by the possibility of charging
consumers higher prices; moreover, the system of allocating permits in
accordance to existing emission levels could be seen as a reward for the
greatest polluters!

27
Regulation, legislation and direct controls
In practice the use of direct controls represents the most common approach to
pollution abatement. Such controls can be applied both to individuals and firms
and can take a number of forms; for example, restrictions can be imposed on
smoke emissions from private homes and firms; restrictions may be placed on all
forms of building in designated green-belt areas; minimum environmental
standards may be stipulated for air and water quality; laws may be passed to
prevent drinking and driving and the sale of alcohol and tobacco to people under
a certain age.

Apart from restriction, direct controls can also be used more severely: activities
generating negative externalities could be banned completely; for instance, the
dumping of waste into rivers or the sea; or an activity which conferred net
positive externalities on society could be made compulsory; for example, all
children under the age of 16 in the country could be made by law to receive some
form of education, whether it be in a state school, a private school or at home.

The main advantage of regulation is that it is the most direct way of tackling
the problem of externalities; for example, market-based solutions such as taxes
and tradaable emission permits provide incentives to firms to reduce their
pollution levels but do not compel them to do so; as such problems as global
warming and the depletion of the ozone layer are thought by many to threaten
the very survival of our planet, it is argued that we cannot afford to trust our
futures with policies which allow for the possibility of non-compliance. Providing
legal restrictions are backed by inspections that are sufficiently regular and
rigorous, they should be effective.

28
Against this, it is argued that in reality the policing of regulations can present
great difficulties as the less environmentally conscious firms may attempt to
circumvent the controls e.g. through the generation of pollution during the night.
Thus an extremely large number of inspectors might have to be employed to
ensure compliance.

It is also claimed that regulation can be a rather blunt, indiscriminate

instrument of control; for example the setting of maximum emission limits does
not take into account the fact that the cost of reducing pollution would vary
considerably as between different firms, some facing high costs with others
facing low costs. Thus a uniform limit applied to all firms would be an inefficient
way of reducing pollution, implying as it would a high resource cost. Also it may
be the case that once emission targets have been achieved, there would be no
further incentive to continue to reduce pollution, as would be the case with a
pollution tax.

Regulation may also give rise to the problem of regulatory capture - those being
regulated may be successful in manipulating the regulatory body to act in
accordance with the private interests of the firms concerned, rather than in the
interests of society as a whole.

29
Positive externalities of Production/External Benefits
Access this webpage and follow the steps
http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/p
osextprod.html

Figure 9: Positive externalities of Production

30
Positive externalities of Consumption/External Benefits
Access this webpage and follow the steps
http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/posext
cons.html

Figure 10 Positive externalities of Consumption

31
Market for Education
Education is a product, which exhibits a positive consumption externality i.e., has
positive effects on third parties following the private consumption of this
product. The MSB exceeds the MPB (MXB exists); it is under-provided and hence
under-consumed in the free market.

32
Example of the external benefit from consuming education

33
Government strategies to create a socially efficient equilibrium in
education market

1. Public Provision
2. Subsidisation
3. Vouchers

34
35
36
37
Demerit goods
What are demerit goods?
Demerit goods are goods, which are deemed to be socially undesirable, and
which are likely to be over-produced and over-consumed through the market
mechanism. Examples of demerit goods are cigarettes, alcohol and all other
addictive drugs such as heroine and cocaine.

The problem arises from the fact that so long as an effective demand is present,
such goods are, in all probability, going to be extremely profitable to produce,
and this is all that a price system takes into account - the market neither
possesses a 'heart' to enable it to help those in need, nor is it inherently able to
make value judgments about which commodities are good or bad for society as a
whole: it is prices and profits which act as the 'guiding light' to resource
allocation.

However, the consumption of demerit goods imposes considerable negative

externalities on society as a whole, such that the private costs incurred by the
individual consumer are less than the social costs experienced by society in
general; for example, cigarette smokers not only damage their own health, but
also impose a cost on society in terms of those who involuntarily passively smoke
and the additional cost to the National Health Service in dealing with smoking-
related diseases. Thus, the price that consumers pay for a packet of cigarettes is
not related to the social costs to which they give rise i.e. the marginal social cost
will exceed the market price and overproduction and over-consumption will
occur, causing a misallocation of society's scarce resources. This is illustrated
in figure 11 below.

38
Figure 11 Over-consumption of a demerit good

The diagram illustrates how the market fails in the case of demerit goods. At a
market price of OP, OQ quantity of the demerit good is consumed, where demand
(private marginal benefit) equals supply (private marginal cost). However, at OQ
the social marginal cost exceeds the price by the vertical distance XY, the value of
the marginal external cost. Social optimality would require a smaller level of
consumption at OQ1, where price = social marginal cost = social marginal
benefit.

39
Government responses - demerit goods
Possible government responses to correct market failure arising from
demerit goods
 The government may attempt to reduce the consumption of demerit goods
such as cigarettes, alcohol and addictive drugs through persuasion; this is
most likely to be achieved through negative advertising campaigns,
which emphasize the dangers of drink-driving, drug abuse etc. The aim
here is the opposite of normal commercial advertising, namely to shift the
demand curve for demerit goods to the left.

Figure 12 Negative advertising campaign

40
  A contraction of demand (movement along the demand curve for a
demerit good) could be achieved by the imposition of a tax on the demerit
good. This would have the effect of shifting the supply curve to the
left, raising the price and reducing the amount consumed. If the
government could accurately assess the value of the marginal external cost
caused by the consumption of the demerit good a tax equivalent to this
value could be imposed, and a socially optimum outcome could be
achieved. However, in practice, ascribing an accurate monetary value to
negative externalities is extremely difficult to do, and the demand for such
goods as cigarettes and alcohol is often highly inelastic, so that any increase
in price resulting from additional taxation causes a less than proportionate
decrease in demand.

Figure 13: Imposition of a tax

41
  The government may use various forms of regulation. In its most extreme
form, regulation could be used to impose a complete ban on a demerit
good, such that its consumption is made illegal; for example, the
Prohibition Laws in the USA in the 1930s criminalized the sale and
consumption of alcohol, as does the law at the moment in Saudi Arabia;
also in the UK and many other countries today anyone found guilty of
selling or consuming heroin can be imprisoned. However, the effect of such
regulation is rarely to completely eliminate the market for the demerit
good; rather, it is usually driven underground in the form of an unofficial or
hidden market.

Less severe regulatory controls might take the form of spatial restrictions e.g.
people may be disbarred from smoking in their place of work, on public transport
and in cinemas and restaurants; there may be time restrictions in that it may be
illegal to sell alcohol during certain periods of the day, or there may be age
restrictions in terms of a minimum age being stipulated at which young people
are permitted to buy cigarettes and alcohol.

42
Merit goods
What are merit goods?
Merit goods are the opposite of demerit goods - they are goods which are deemed
to be socially desirable, and which are likely to be under-produced and under-
consumed through the market mechanism. Examples of merit goods include
education, health care, welfare services, housing, fire protection, refuse collection
and public parks.

In contrast to pure public goods, merit goods could be, and indeed are, provided
through the market, but not necessarily in sufficient quantities to maximize social
welfare. Thus goods such as education and health care are provided by the state,
but there is also a parallel, thriving private sector provision. Indeed, there is
considerable disagreement between economists on the right and left of the
political spectrum over the extent to which such goods should be provided by the
state or the private sector. We consider these arguments later in this section.

Before we proceed with our discussion of merit goods, and in particular the
question of why merit goods tend to be underprovided by the market, it would be
useful at this stage to summarize the main differences between public goods,
private goods and merit goods. Have a go at filling in the blank table below (we
have put in a few entries to help you along). Once you have had a go, follow the
link under the table to compare your answers with ours.

43
Public goods
What are public goods?
Pure public goods are ones that when consumed by one person can be consumed
in equal amounts by the remainder of society, and where the possibility of
excluding others from consumption is impossible.
Examples of public goods are:
 national defense;
 the police service;
 street lighting;
 lighthouses;
 flood-control dams;
 pavements;
 public drainage.
It is likely that the market, left to itself, will seriously under-produce such goods,
or possibly not produce them at all. This is because the market will only provide
goods for which a profit can be made, and pure public goods possess two
important properties that together make their production on the basis of private
profitability extremely difficult. These features are:
 non-rivalry (or non-diminishability);
 non-excludabilty.
Firstly, consider the characteristic of non-rivalry: this means that one person's
use of the public good does not deprive any other person of such use or does not
diminish the amount available to others; for example, if one person enjoys the
benefits of being protected by the police-force, a flood control dam or the
national defense system, it does not prevent everyone else doing the same;
similarly, if one person benefits from walking along a street at night-time which
is paved, free of pot-holes, and well-lit, the benefits and the availability to others
would not be diminished.

44
Secondly, consider the characteristic of non-excludability: this means that when
the public good is provided to one person, it is not possible to prevent others
from enjoying its consumption - sometimes summarized as: provision at all
means provision for all. For example, if a police force, a flood-control dam or a
national defense system is successful in offering protection to citizens of a
country, once it has been provided it is impossible to exclude anyone within the
country from consuming and benefiting from them. Similarly, for a paved and
well-lit public street, nobody can be prevented from enjoying its benefits.

The concept of a 'public good' can perhaps best be understood by comparing it with its
opposite, a private good.

A private good possesses two features, excludability and rivalry, and when consumed by
one person, it is not available to others; thus, a person buying a new washing machine can
exercise private property rights over it and exclude others from enjoying its cleaning
abilities, whilst, at the same time, diminishing the total stock of washing machines available
for sale to others.

Thus, in the case of public goods, the market fails because the private sector
would be unwilling to supply them - their non-excludabilty makes them non-
marketable, because non-payers cannot be prevented from enjoying the benefits
of consumption, and therefore prices cannot be attributed to particular
consumers. This involves the free-rider problem, which arises when it is
impossible to provide a good or service to some without it automatically and
freely being available to others who do not contribute to its cost. For example,
imagine a situation in which you shared an island with five other inhabitants; if
you paid privately for an army to defend the island against violent invaders, your
five co-inhabitants could 'free-ride' off you by enjoying the benefits of the
defenze, without having to pay anything towards it; there would probably come a
point when you would withdraw your payments and, like the others, leave it to
someone else to foot the bill; eventually, the army would not be provided at all.

45
Hence, in a free market, a whole range of pure public goods may not be provided,
and the only answer is for the state to provide them, financed out of general
taxation. Moreover, the non-rivalry aspect of public goods means that the cost of
supplying one more user i.e. the marginal cost, is zero; for example, once paving
stones have been laid, it makes no difference how many people walk along them
as there is no additional cost involved. As the condition for the achievement
of allocative efficiency is that price should be set equal to marginal cost, it would
therefore follow that to achieve an optimum level of output and consumption of
public goods the state should provide them at zero prices.

Task: Fill in the table below with the relevant information

Main features Public goods Merit goods Private goods

Rivalry in Non-rivalrous
consumption

Excludability Excludable

Benefits Individual and

communal (strong
positive externalities)

Provider Usually private

enterprise

Financed by Usually taxation

Examples

Why might merit goods be under-provided by the market?

http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/meritu
nder.html

46
Government responses - merit goods
Possible government responses to the under-provision of merit goods
One solution would be for the government to play no role whatsoever and to
allow the provision of merit goods to be decided completely through the free
interaction of market forces. However, for all the reasons previously mentioned,
this would lead to extreme under-provision of these goods and a misallocation of
resources from the standpoint of society as a whole. Thus, in practice,
governments play a substantial role in the provision of merit goods such as
health and education, even where they are ideologically committed, as the
present Conservative government is, to the market system. However, the exact
form that such government involvement should take is a subject of much dispute,
and we shall consider each of the following in turn:
 Direct government provision – health care that is provided free at the point
of contact and paid for out of taxation revenue
 Regulation - In the case of education, it may be compulsory that all children
between the ages of 5-16 receive some form of schooling, be it in the
private or public sector, and quality is controlled in such ways as school
teachers being required to have stipulated qualifications before they are
allowed to teach. In the case of health care, vaccinations against various
contagious diseases could be made compulsory and medical practitioners
such as doctors, dentists, opticians and nurses could be required to obtain
certain qualifications before they can practice. The government could also
use regulation to enforce the consumption of a good provided by the
private sector which is deemed to be a merit good by virtue of the positive
externalities that it generates: the compulsory consumption of seat-belts by
motorists provides one such example. The government could also institute
rent control in the housing market


47
  Subsidies - For example, the theatre is usually provided by the private
sector, and is often regarded as a merit good on account of the educative
and civilizing benefits that it confers on society. The government might
take the view that without state assistance to the arts, there would be an
unacceptably small number of theatres able to survive. In the health care
sector, prescription medicine may be subsidized with the government
paying part of the price either directly (in pharmacy) or via a
reimbursement system
 A combination of government provision and market forces: If the good in
question were loft insulation which confers benefits on society in terms of
energy conservation, households prepared to lag their lofts could be given
a grant, and this would shift the demand curve D=PMB to the right to
D1=SMB. Allocative efficiency is achieved as SMB = SMC at OQ1. A similar
result could be achieved by subsidizing the output of loft insulation, which
would cause the supply curve to shift to the right until the socially optimum
level of production is reached.

Figure 14 Positive externalities - loft insulation

48
Common access resources & sustainability
Common access resources
Common access, or common pool resources (CAR/CPR), are natural resources
including forests and pastures, fisheries, oil and gas fields, national parks, grazing
lands and irrigation systems, which are characterized by the difficulty of
excluding people from using them. As a result of the inability to charge a price for
their use, over-consumption, degradation and depletion of these resources is a
likely outcome. Indeed, the use by one individual or group of the resource will
mean that less of that resource is available for use by others. This distinguishes
common access resources from pure public goods, which exhibit both non-
excludability and non-rivalry in consumption.

It is argued that the lack of a price mechanism for common access resources
results in their overuse, depletion and degradation. The consequence of the
actions of producers and consumers, who do not pay for the resources they use,
creates a threat to sustainability and, therefore, the availability of common access
resources for future generations.

The origin of the study of common access resources dates back to medieval land
tenure in Europe, where herders were entitled to graze their cows on common
parcels of land for free. The result was over-grazing and the degradation of the
land. The problem was described and analyzed by Garrett Hardin in his
article 'The Tragedy of the Commons', which appeared in the Science journal in
1968. Hardin explained that it was in each herder's interest to put any additional
cows he acquired onto the grazing land, even if the quality of the common was
damaged for the whole community. This was considered to be a rational
economic decision by the individual herder, because each additional cow added
to the individual's 'marginal utility' while the damage to the common land was

49
shared by the entire group. However, the consequence of these individual
rational economic decisions was market failure because these actions resulted in
the degradation, depletion or even destruction of the resource to the detriment of
all users and, therefore, society in general.

Tragedy of the Commons

https://www.youtube.com/watch?v=EZFkUeleHPY

The overgrazing cost shown in Hardin's analogy is an example of a negative

externality of consumption, where the private utility is diminished by the
negative utility suffered by third parties; in this case the other herders. The
grazing land is over-consumed and so there is a welfare loss.

50
To reduce these negative externalities, Hardin suggests potential management
solutions for common goods including privatization, environmental taxation,
government regulation and stricter management by the state. The nature of this
regulation depends on whether the resources are within national boundaries or
global in nature. Where national resources are concerned; rules on their use can
be imposed by national governments. Global common access resources, such as
fishing grounds, will require the creation of international regulatory
organizations to control their use. Hardin also suggests the transfer of common
access resources to private ownership. In keeping with his original pasture
analogy, he categorizes this as the enclosure of the commons.

The 'Tragedy of the Commons' is an analogy. The major theme running through
Hardin's work is, in fact, the growth of human populations with the Earth's
resources being a general 'common'. He focuses on the allocation and
exploitation of larger resources, such as the Earth's atmosphere and oceans, and
the 'negative commons' of pollution.

An interview with Garth Hardin on the Tragedy of the Commons

https://www.youtube.com/watch?v=L8gAMFTAt2M

51
Common access resources in practice
In practice neither the state nor the market has been uniformly successful in
solving common access resource problems.

Indeed, Hardin's Common's Theory has been criticized by a number of

economists, not least by Elinor Ostrom the political economist and the 2009
Nobel Memorial Prize winner in Economic Sciences. Together with colleague
Oliver E. Williams, Ostrom's analyzed economic governance, especially those
related to common access resources or 'the commons'.

Ostrom simulated conflicts concerning the allocation of the commons and

derived a complex theoretical framework that went beyond the simple analysis of
private costs and benefits. She focused on additional variables, such as
community, leadership, trust and collaboration in resource sustainability and
claimed it is not necessary to have a 'top-down' management system regulated by
the state.

Ostrom's extensive research includes analysis of complex fishing systems in Nova

Scotia, irrigation systems in the Philippines and Sri Lanka and groundwater
usage in California. Her research results suggest that sustainability is possible if
the users of resources collaborate to create democratically agreed, and adaptable,
rules for the exploitation of common access resources, with community sanctions
if these rules are broken. She argues that local communities make better decision
about the use of community resources than governments or private
organizations, because they have access to more information about the local
context and are directly affected. Her conclusions are supported by empirical
data showing that local-level monitoring of resources and community self-
determination is effective in ensuring resource sustainability.

52
Other critics of Hardin's 'Tragedy of the Commons' analysis, focus on his proposal
to transfer common goods into the hands of private owners. Professor Heller of
the Columbia Law School, for example, coined the term 'Tragedy of the
Anticommons' to describe a situation in which rational individuals, acting
separately, collectively waste a common resource by under-utilising it. Heller
believes that the existence of numerous private rights holders may frustrate the
achievement of socially desirable outcomes. Supporters of this theory claim that
too many property rights, such as patents, leads to reduced innovation.
Competing patents in biomedical research illustrates a situation where useful
and affordable products are prevented from reaching the market and adding to
social welfare.

Summary of four types of Goods

53
Sustainability
A universally accepted definition of sustainability remains elusive, because they
focus on the many contexts in which the term is used. Most relevant to the study
of market failure are those definitions that relate to natural resources and their
usage.

All these definitions concern the need for humans to:

 Live within the limits of the Earth's resources
 Examine the distribution of resources and opportunities
 Meet the needs of the present without compromising the ability of future
generations to meet their needs
Sustainable development was defined at the 2005 World Summit as development
requiring an understanding and reconciliation of the 'three pillars' of
sustainability, that of environmental, social and economic demands.

Threats to Sustainability
The threat to sustainability comes from the unplanned and often unfettered
exploitation of the world's natural resources. The increase in globalization, the
drive for economic growth, population growth and developments in technology
has made the need for management of global common access resources more
acute, whether this is by governments or by local communities.

Clearly, there are already many examples of threats to sustainability from the
depletion and destruction of common access resources, such as deforestation,
soil erosion and the overfishing of oceans. These are compounded by the pursuit
of economic growth by newly developing countries, and in less economically
developed countries where high levels of poverty and poor regulation creates
negative externalities through over-exploitation of land for agriculture.

54
The depletion of natural resources, such as fossil fuels and fishing resources,
creates individual hardship and political instability and potentially threatens
world peace. Resource depletion is accelerating and the economic growth of
countries that ignore this trend will be eroded by higher commodity prices.

Big Summit seeks big ideas

http://www.bbc.com/news/science-environment-13682012

The threat to sustainability from the use of fossil fuels

Market failure exists when the production or use of a good or service results in
an externalities and welfare loss, because the market does not direct an efficient
amount of resources into the production, distribution, or consumption of a good.
Fossil fuels are non-renewable resources as they take millions of years to form
and accelerating overuse is leading to their rapid depletion. The principles of
supply and demand mean that as fossil fuel supplies diminish, prices rise.
However, since the producers and consumers of fossil fuels do not have to
account to later generations for their overexploitation of resources, fossil fuels
are over-produced, and over-consumed despite their increase in price.

The over-production and overuse of fossil fuels raises environmental as well as

economic concerns, since coal, petroleum, and natural gas contain high
percentages of carbon; the burning of which generates greenhouse gasses
(GHGs), such as Carbon Dioxide (CO2 ) contributing to the process of global
warming. Although there is much argument about the extent to which the human
activity contributes to climate change, the effects of climate change are
undisputed, leading to increases in average temperature, altered habitats,
extreme weather conditions, sea-level changes and flooding.

55
There are huge external costs linked to these environmental changes. As
temperatures increase and rainfall patterns change, crop yields are expected to
drop significantly in Africa, the Middle East and India. Water availability for
irrigation and drinking will be less predictable, because rain will be more
variable and droughts more frequent, creating pressure on agricultural
production and diversity. Up to three billion people could suffer increased water
shortages by 2080. Air and water pollution resulting from the extraction and use
of fossil fuels can lead to significant health and environmental problems.

The economic consequences are significant. All businesses need resources - both
raw materials and energy. As reserves of both are under strain, world prices are
increasingly volatile. National and international commitments to reduce carbon
emissions, are forcing governments to examining the balance of their energy
production and consumption, exploring ways to reduce the use of fossil fuels if
possible, to be replaced by alternative cleaner technologies. With the rapid
economic growth in the emerging BRICS economies (Brazil, Russia, India, China
and South Africa), demand for raw materials and energy is outstripping supply
and countries around the world are beginning to position themselves to protect
their strategic interests.

The state of oil and natural gas production, in particular, is causing alarm. Oil
production peaked during 2006 with global oil production from mature oil fields
now declining at a rate of between 6-7% per year. Oil is becoming more difficult,
expensive and energy intensive to extract. The Peak Oil Crisis website has real
time clocks of global oil consumption and graphics illustrating the impending
crisis as well as articles, graphics and links to industry articles. Countries reliant
on oil imports are desperately seeking new oil and gas sources with global oil
companies seeking out previously untapped reserves in the remotest of regions.

56
The Artic is one of the regions that likely to become an economic and realpolitik
battleground, almost certainly pushing ethical, environmental and moral
considerations aside in the drive to its natural resources. It has been stated by
industry experts that another 5 million barrels of new oil per day must come on
line per year to meet global demand. A 2008 United States Geological Survey
estimated that areas north of the Arctic Circle have 90 billion barrels of
undiscovered, technically recoverable oil representing 13% of the undiscovered
oil in the world. In addition to the size of the untapped resources, environmental
factors are driving moves to develop the Arctic region. In the past, the Northwest
Passage connecting the Atlantic and Pacific Oceans through the Canadian Arctic
Archipelago, has been virtually impassable, because it was covered by thick, year-
round sea ice. However, satellite and other monitoring confirm a progressive,
year-by-year decline in the thickness and extent of Arctic sea ice.

There is general insecurity about oil supplies in many regions. Asia, for example,
only holds about 1% of the world's proven reserves of oil and gas. Oil prices are
predicted to rise abruptly with apocalyptic predictions about a collapse in oil
production by 2015. Asian countries, such as Japan, South Korea and India, are
buying and storing crude oil in unprecedented quantities. China is planning to
increase its reserves to 90 days consumption by 2020 and Singapore, preparing
for the looming oil crunch, is racing to complete a series of vast man-made
caverns beneath the seabed of Banyan Basin, which will include a vast oil storage
complex. The first two caverns providing 480,000 cubic metres (m³) of oil
storage will be constructed by 2013. Three more caves are planned, which would
store enough oil to last Singapore a month.

57
The threat to sustainability from poverty
Population increases are both a consequence, and cause, of increasing poverty
and low standards of living around the world, especially in Asia and Africa. As
populations increase the demand on common access resources intensifies
resulting in extensive negative externalities, which threatens sustainability.
With the world's population surpassing 7 billion people in 2011, the global
impact is huge.

The World Bank periodically prepares poverty assessments of countries in which

it has an active programme, in close collaboration with national institutions and
other development agencies. The data it records is presented in a series of
datasets on its website.

Examine the following datasets and featured indicators and identify the major
links between poverty and reliance on agriculture.
 World Bank Poverty dataset
For the 70% of the world's poor who live in rural areas, agriculture is the main
source of income and employment. The depletion and degradation of natural
resources poses serious challenges to producing enough food and other
agricultural products to sustain local livelihoods, but also to meet the needs of
urban populations, which rely on this supply.
 World Bank Rural and Agriculture development dataset
Where low-income rural populations rely on subsistence agriculture, the
likelihood is that common access resources will become depleted, unless there is
some form of community collaboration along the lines suggested by Elinor
Ostrom. Sustainability of resources may be lost if poor communities are forced to
sell land and resources, such as forests, to external private corporations who do
not have the interests of the local community as a priority, but need to satisfy

58
their shareholders. Logging companies, for example, will wish to maximise their
utilisation of timber resources taking only their private costs into consideration,
ignoring the external costs to the local population. As a consequence, there will
be overexploitation of timber and deforestation creating negative externalities
such soil erosion, landslides, flooding and loss of bio-diversity.

The World Bank is one of the key promoters and financiers of environmental
upgrading in the developing world. The following dataset covers forests,
biodiversity, emissions, and pollution.
 World Bank Environment dataset

59
Government responses to threats to sustainability
Market failure in production occurs when the production of a good or service
creates external costs that are harmful to third parties, e.g. when a factory
pollutes a river with waste or the atmosphere with greenhouse gasses. The total
costs to society of these activities are the private costs of the firm plus the
external costs that the firm creates, but does not pay for. Since the producer does
not pay the total cost, the good or service is over-produced, which results in
a welfare loss.

National governments can respond to negative externalities of production and to

resource depletion and CO2 pollution using a number of mechanisms designed to
reduce emissions of global greenhouse gasses and promote sustainability. These
include:
 Environmental taxation, such as carbon taxes, to recover the external costs
of pollution
 Legislation setting environmental standards and banning firms which fail
to meet these standards
 Adoption of cap and trade schemes for carbon trading
 Funding for cleaner technologies
Taxation and financial penalties increase the market price of carbon. This
provides strong incentives to reduce carbon emissions by sending signals:
1. To consumers about what goods and services produce high carbon
emissions and which should be used more sparingly.
2. To producers about which inputs emit more carbon, and which emit less, so
encouraging them to move to lower-carbon technologies.
3. To inventors and innovators to develop and introduce lower-carbon
products and processes.

60
Cap and Trade Schemes

Cap and trade scheme

A cap and trade scheme is a market-based approach to reduce carbon emissions via
financial incentives that allows corporations or national governments to trade emissions
allowances under an overall cap, or limit, on those emissions. Fines are imposed for
producers exceeding those limits, while producers operating below their carbon limits
can sell or "trade" their offsets to companies that are operating above the limits.

Cap and trade schemes set specific limits on GHG emissions for countries and
organizations. They promote the trading of emissions allowances between
emitters, who can meet the cap efficiently and those who face more of a challenge
in reducing emissions.

The choice between environmental taxation and cap and trade schemes to
address climate change has generated considerable discussion with impassioned
arguments on both sides.

Taxation has the advantage that individual governments without international

agreement can implement it, but environmental taxes have dead-weight losses in
addition to their beneficial effects in addressing externalities. It is also argued
that establishing a price for GHGs through cap and trade schemes has the
advantage of providing some certainty about reductions in quantities of
emissions and creates a market to achieve the climate change mitigation target at
the lowest cost.

61
Promoting Clean technologies

Clean technologies
Clean technologies are designed to minimize pollution and the emissions of greenhouse
gasses, by creating electricity and fuels with a smaller environmental and carbon footprint.
These technologies include recycling, renewable energies (wind and solar power, biomass
and biofuels and hydropower), green transportation, waste-water recycling and energy
efficient lighting, homes, buildings, electric motors and commercial and domestic
appliances.

The World Bank is the trustee of the Clean Technology Fund (CTF), focused on
making renewable energy cost-competitive with coal-fired power. Since its
launch in 2008, $US6.5 billion has been allocated to climate change projects in 45
developing countries. These payments represent a subsidy on the development
and use of clean technologies.

If government or World Bank subsidies are particularly focused on the

generation of electricity using renewable energy sources, such as wind and solar
power, then firms generating electricity using cleaner technologies will face
lower costs of production. This will encourage energy producers to produce more
wind and solar power, shifting the supply curve to the right and lowering prices
for consumers.

62
Subsidies or tax credits should also encourage increased investment in clean
technologies. However, UN research showed 'green' investment in Europe
dropped by one-fifth in 2010, while that in developing countries surge ahead.

Resource
http://www.unep.org/newscentre/Default.aspx?DocumentID=2647&ArticleID=
8805&l=en

63
The 'dirty side' of cleaner technologies
Local and national communities do not always welcome cleaner technologies.
'Wind farms', for example, may consist of hundreds of wind turbines and are
frequently criticized by some local communities for their negative environmental
impacts. They are often seen as a 'blot on the landscape' as well as posing
a danger for birds and bats, whose migratory and flight paths may take them into
collision with wind turbines and towers.

Other alternative energy sources have created similar controversies. The

production of biofuels has resulted in food price inflation worldwide, with land
previously used for growing food for human consumption being transferred to
the production of crops used to produce biofuels.

A 2011 report from the Nuffield Council on the Bioethics examined the ethical
issues of biofuels and the serious negative impacts on the livelihoods of some of
those who cultivate the land, on the sustainability of cultivation systems and on
biodiversity.

The following videos discuss the role of science in addressing some of the
problems associated with finding, and commercializing, alternatives to fossil
fuels:

64
Asymmetric information
For markets to function perfectly, all parties to an economic transaction should
have perfect knowledge about the terms of the contract, the products and
services that form the subject of the agreement and the prices in the market. In
practice, the real commercial world rarely confirms to this ideal, and it is
common for one of the parties to have better and/or more knowledge than the
other, leading to imperfect competition and market failure. This situation is
called asymmetric or imperfect information.

Properly functioning markets provide a valuable service to society, because

consumers are able to purchase the goods and services that best match their
preferences. However, asymmetric information can be used as a source of power
in determining the outcome of the transaction. As a consequence, the market will
not achieve allocative efficiency, because one of the parties - in this case normally
the consumer, pays a higher price for a product than they would have done if
they had perfect knowledge. In a perfect market, consumer and producer surplus
should both be maximized at the market price, i.e. the conditions are in place for
a Pareto optimum allocation of resources.

A common example of where the buyer pays more for a good than is socially
efficient is where the seller knows much more about the characteristics of that
good than the buyer. For example where:
 The seller of a product knows it is faulty
 Commercial ideas with technical aspects are hard to describe contractually,
but privately known by innovators
 Labeling of food products use alternative terms for ingredients consumers
would normally avoid, e.g. various names for sugars such as glucose,
sucrose and fructose

65
  Firms may have no incentive to provide consumers with information in
markets with a public good aspect
It is also possible that the consumer has more information than the seller. For
example, purchasers with specialist knowledge of antiques may be able to buy a
antique for a price less than its true market value from a private seller, who does
not have this expert knowledge.

The government has a number of policy tools at its disposal to correct

asymmetric information and to control externalities. These include taxes,
education programmes and production regulation intended to increase the flow
of information to consumers. Government may decide to intervene in the market
to require producers to disclose critical information, such as mandatory product
labelling. The objective of this government intervention may not be to alter
consumption behaviour in particular, but to increase informed consumption.
However, these measures can be expensive and ineffective and perceived as
government interference in the free market.

The growth of computer ownership with access to the Internet has reduced the
opportunities for asymmetric information, as consumers are able to access
greater details on products, prices and customer reviews.

Resource
The Rise and Fall of Sunny Delight
http://news.bbc.co.uk/2/hi/business/3257820.stm

66
Abuse of monopoly power
A most important assumption of the ideal free market economy is that markets
within it are competitive, so that a large number of competing firms
passively take the price that is set in the market as a whole and either increase or
decrease their output in response to shifts in consumer demand.

However, as we saw in the section on monopoly, markets may be dominated by a

single producer of the good or service, in which case a situation of
monopoly exists, or by a few producers, in which case an oligopoly exists. In
either situation, producers may not be content to take a price set in the market.
Having significant control over supply, firms in pursuit of maximum profits may
attempt to make the market price higher than it would otherwise have been by
restricting output. The outcome for consumers may therefore be that they are
paying a higher price for a smaller output. This would represent market failure
and a misallocation of society's scarce resources, as the economy would be
deprived of some of the output, which would be valued more highly than that
currently being consumed.

Also, in a situation of monopoly or oligopoly, profits may not perform the

function that they are supposed to in the 'ideal' free market situation. Here, the
making of profit is deemed to be a sign of efficiency; that is, the goods that are
being produced are precisely those that consumers want and of a suitably high
quality, and because firms cannot influence price, the profit has been achieved by
operating efficiently, with costs being kept below the ruling price. However, given
the power of firms in monopoly and oligopoly to restrict output to keep price
artificially high, the making of profits may reflect market power and dominance
rather than efficiency. Monopoly may involve both allocative and technical
inefficiency.

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Inequality
Advocates of a freely operating price system often liken it to a political
democracy where all voters can cast their votes for the candidates of their choice,
with everyone who is eligible having an equal say: the price system, according to
this line of reasoning, is a consumers', economic democracy; every time we go out
and buy a particular good, we are affecting the demand for that good, and hence
also its profitability and supply. Hence, the simple act of buying a good is akin to
casting a 'vote' in favour of the production of that good, and is the way in which
consumers determine how scarce resources should be allocated.

Unlike the political democracy however, in which each person has equal voting
rights, the consumer democracy described above, given the unequal
distribution of income that exists in most capitalist economies, is unlikely to be
one in which all have an equal say _ clearly voting power is directly related to
income so that the rich would have many more votes, and thus a much greater
pull on resources, than the poor. Consequently, the resulting pattern of resource
allocation may overlook the pressing, often life and death needs of the poor, and
reflect instead the more trivial wants of the rich. In the economics of the market
place, human wants are those that are supported by effective demand i.e.
demand backed by the ability and willingness to pay the market price.
Human needs, however, if unaccompanied by the wherewithal to pay, are simply
ignored. This is the overriding reason for the existence of mal-nutrition and
starvation in the world today: it is not that there is an overall shortage of food -
there is more than enough in total terms to feed everyone; the problem, quite
simply, is that those who need the food lack the money to pay for it.

Hence the 'free' market, given the degree of inequality which typically exists, is
likely to be one in which many people are severely disadvantaged in terms of

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their market power. 'Electoral successes' will be the fast cars, exquisite jewellery
and luxury hotels etc. for those who can pay, with basic health care, education,
safe drinking water and nutritious food for the poor almost certainly 'losing their
deposits'. Clearly, some consumers are a lot more 'sovereign' than others!

Source:
http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/page_155.htm,
accessed Friday 15th of January 2016

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Short answer questions
1: Not painting a pretty picture

The Non-Drip paint company is considering whether or not to locate a new

factory near the town of Greensville. The company estimates that the new paint
will cost $5 million a year to run, but should add $6 million to revenue from the
sale of the paint it produces.

The people of Greensville are worried that the new factory will release smoke,
containing harmful chemicals, into the air. These chemicals will pollute the air
and even get into the soil and water supplies, as rain will bring the chemicals
down from the air.

The local health authority estimates that over many years this smoke will damage
people’s health and increase the need for medical care at an estimated cost of $4
million a year.

The local authority believes that the smoke will blacken the walls of historic
buildings in the area, and cause their eventual erosion. Regular cleaning will
therefore be needed at an estimated cost of $2 million each year.

On a more positive note, it estimates that the paint factory will encourage other
firms to locate in the area as suppliers of materials, providers of transport etc,
and that this will reduce local unemployment and help other local businesses.
These external benefits are valued at $3 million.

(a): What two factors does the Non-Drip paint company take into account when
deciding whether or not to produce paint with its resources?

(b): From society’s point of view should the firm take other factors into
consideration?

(c): Using the figures presented in the case study, calculate:

i. The paint company’s estimated yearly profit.
ii. Whether or not paint production at the factory is worthwhile for society.

(d): A conflict of interest between the paint company and the local community
has arisen. How does this illustrate the central economic problem?

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2: Smoking

(a): List three private costs that a cigarette manufacturer will have to pay.

(b): How will the manufacturer calculate the total revenue from the sale of
cigarettes?

(c): How are other people in a café affected by a man’s decision to consume a
cigarette?

(d): Many countries have introduced laws to ban smoking in public places. What
sort of costs will a government have to pay for in order to make sure the ban is
observed?

(e): Research has shown that smoking can damage your health.
i. What is the opportunity cost of increased health spending on treating
smokers?
ii. Who will bear the cost of increased health spending?

(f): Imagine that the government decides to increase the tax payable on a packet
of cigarettes. What effect may this have on?
i. The number of cigarettes consumed?
ii. The revenue of cigarette-makers?
iii. The workers in cigarette factories?

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3: Belt up

Amiya Bundhun was an economics student at college and now works for a bank.
She was injured in a car accident and has just spent six months in a hospital paid
for by the government.

Amiya decides to work out the opportunity cost of not wearing her seat belt. She
values the wages she has lost over six months at $12000 and she values her social
life at $4000. Amiya calculates that the opportunity cost of not wearing her seat
belt is $16,000.

The police and ambulance driver that attended to her at the scene of her accident
said that Amiya would not have been hurt had she been wearing her seat belt.

(a): What is meant by the term opportunity cost?

(b): What type of cost has Amiya forgotten about when she calculated the
opportunity cost of not wearing her seat belt?

(c): “Wearing a seat-belt is up to me to decide. It’s my life and if I get hurt in an

accident it affects nobody else”. Car drivers often say this, but would an
economist agree with them? Explain your answer and say whether or not you
agree that wearing a seat belt should be law.

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Data Response Questions
1:

(a) Use an appropriate diagram explain how a subsidy is likely to affect the
price and quantity of wind-generated energy
(b) Evaluate the decision to construct the world’s largest wind farm (at the
time) in Texas

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2:

(a) Using an appropriate diagram, explain how rising biofuel production will
affect the market for corn

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3:

(a) Using an appropriate diagram, explain why the problem discussed in the
text is an example of market failure
(b) Evaluate the use of regulation as a solution to the market failure caused
bu the pollution of the Cisadane River

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4:

(a) Using an appropriate diagram, explain why illegal dumping of toxic

waste by these manaufacturing firms is an example of a market failure
(b) Using an appropriate diagram, explain the expected effect on the local
carrot market resulting from the contamination of the river
(c) Evaluate the solutions that the government could employ to reduce the
negative externalities caused by the river pollution in Viotia

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5:

(a) Using an appropriate diagram, explain why in a free market, low-

emission vehicles may be under-provided
(b) Using an appropriate diagram, explain how ‘halving the indirect tax on
cars with smaller engines is likely to affect the car market in China
(c) Evaluate three of the policies that the Chinese government has
introduced or might introduce to bring cleaner, low-emission vehicles to
its roads

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6:

(a) Using an appropriate diagram, explain the possible effect on the market
for cigarettes of a ban on tobacco advertising in Ireland
(b) Evaluate the economic effects of the imposition of a minimum price for
cigarettes in Ireland

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7:

(a) Using an appropriate diagram, explain why the Emissions Trading

Scheme (ETS) could lead to higher prices for electricity
(b) With the aid of a diagram, explain how carbon emissions are a form of
market failure
(c) Evaluate the possible effects on the Australian economy of
implementing the Emissions Trading Scheme (ETS)

79