Mic 14

Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
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CHAPTER

14
Market Failures

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DEFINITION OF EXTERNALITIES

Cost of benefit arising from any activity which
does not accrue to the person or organization
carrying the activity.
Two types
–External costs
–External benefits

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EXTERNAL COSTS
Damage to other people or the
environment, for example, by radiation,
river or air pollution, or noise, which does
not have to be paid by those carrying on
the activity.

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EXTERNAL BENEFITS

Effects of an activity which are pleasant or
profitable for other people who cannot be
charged for them, for example, fertilization
of fruit trees by bees, or the public
enjoyment of views of private buildings or
gardens.

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CAUSES OF MARKET
INEFFICIENCY
Externalities cause markets to allocate
resources inefficiently.
We will examine various ways in which private
individuals and government may diagnose this
type of market failure.

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POSITIVE EXTERNALITIES
Benefits to society more than the provider.
For example, education.
When population is educated, it leads to more
productive workers, lower crime rates,
encourage developments and dissemination of
technology, higher productivity and wages for
everyone.
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POSITIVE EXTERNALITIES (CON’T)
Education and Social Optimum

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POSITIVE EXTERNALITIES OF
EDUCATION AND SOCIAL OPTIMUM
The demand curve does not reflect the social
value of the good due to the fact that the social
value is greater than the private value. The
social value curve lies above the demand
curve.
The optimal quantity: The social value curve
and the supply curve (which represents cost)
intersect.
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EDUCATION AND SOCIAL
OPTIMUM EXPLANATION
Hence, the social optimal is greater than the
quantity determined by the private market.
In case of market failure, the government can
correct the market failure by inducing market
participants to internalize the externality.
Market equilibrium move closer to the social
optimum, a positive externality requires
subsidies from government.
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NEGATIVE EXTERNALITIES
Costs to society is larger than cost of
production.
For example, rubber factories emit pollution.
For each unit of processed rubber produced, a
certain amount of smoke enters the
atmosphere. This smoke creates health
problems for those who breathe the air.
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NEGATIVE EXTERNALITIES
(CON’T)
Social Cost of Producing Rubber

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SOCIAL COST OF PRODUCING
RUBBER
• The equilibrium quantity of rubber is larger
than the social optimal quantity.
• This inefficiency is due to the fact that the
market equilibrium reflects only the private
costs of production.

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SOCIAL COST OF PRODUCING
RUBBER (CON’T)
• In this market equilibrium, the marginal consumer
values aluminum at less than the social cost of
producing it.
• So at QMarket, the demand curve lies below the
social-cost curve.
• As a result, reducing rubber production and
consumption below the market equilibrium level
raise total economic well-being.
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SOLUTIONS TO
EXTERNALITIES
Government actions are always the
best to solve externalities and to
achieve the allocation of resources
closer to social optimum.

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OTHER TYPES OF SOLUTIONS
1. Moral codes and social sanctions: To take
account of how our actions affect other people.
For example, why most people litter, although
there are laws against littering, but these laws
are not fully enforced.
2. Charities: Colleges and universities receive
gifts from corporations, alumni and foundations
to internalize externalities.

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OTHER TYPES OF SOLUTIONS
(CON’T)

3. Self-interest of the relevant parties: For
example, a corn grower and a housekeeper are
located next to each other. Both parties confer
positive externalities on each other.
4. Enter into contract: A contract between two
parties in the form of integrating different types
of businesses.

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HOW EFFECTIVE IS THE
PRIVATE MARKET IN DEALING
WITH EXTERNALITIES?
A famous economist, Ronald Coase came
up with a theory called Coase Theorem
which suggests that if the private parties
can bargain without cost over the allocation
of resources, they can solve the problem of
externalities on their own.
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WHY PRIVATE SOLUTIONS DO
NOT ALWAYS WORK?
The Coase Theorem is only workable if both
parties have no trouble coming with and enforcing
on the agreement.
The transaction cost incurred during the process of
agreeing and following through on a bargain.
Sometimes bargaining can simply break due to
labour strikes, war and natural disaster.

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PUBLIC POLICIES TOWARD
EXTERNALITIES
In order to solve the inefficient allocation of
resources in the market, government can respond
in two ways:
Command and control policies
Regulations that prohibits certain act altogether
such as dumping poisonous chemicals into the
water supply.

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PUBLIC POLICIES TOWARD
EXTERNALITIES (CON’T)
Pigovian taxes and subsidies: Taxes enacted
to correct the effects of negative externalities
through monitoring level of pollution and tax
incentives.
Market-based policies
Tradable pollution permits:
Agreeing to reduce its emission by certain level.
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DIFFERENT KINDS OF GOODS
Excludable: Can people be prevented from
using the good?
Rival in consumption: Does one person’s use
of the good reduce another person’s ability to
use it?

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FOUR CATEGORIES OF GOODS
Private goods: Both excludable and rival in
consumption. For example, a burger is
excludable because it is possible to prevent
someone from eating the burger—you just
do not give it to him.
Public goods: Neither excludable nor rival
in consumption. For example, tsunami alert
system.
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FOUR CATEGORIES OF GOODS
(CON’T)

Common resources: Rival in consumption
but not excludable. For example, fish in the
ocean.
Natural monopolies: Excludable good but
not rival. For example, ambulance service.

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EXAMPLES OF GOODS IN EACH
CATEGORY
YES RIVAL NO

Private Goods Natural Monopolies
YES
• Burger • Cable TV
• Shirts • Fire protection
EXCLUDABLE
Common Public Goods
Resources • Tsunami siren
• Fish in the ocean • National defence
NO • Environment
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PUBLIC GOODS
Not excludable.
For example, big screen cinema: It is possible
to prevent someone from seeing the screen,
and it is not rival in consumption because one
person’s enjoyment of watching the movie does
not reduce anyone else’s enjoyment of
watching the movie.

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PUBLIC GOODS (CON’T)

Because certain goods are not excludable,
people have an incentive to be free riders.
A free rider: A person who receives the benefit
of a good but does not pay for it.

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IMPORTANT PUBLIC GOODS

• National
It is neither excludable nor rival in consumption.
• Basic Research
One person’s use of theory does not prevent
any other person from using the theory.

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