1.4. Market Failure

Syllabus Content

• The meaning of market failure - Market failure as a failure to allocate resources efficiently
• The types of market failure - the meaning of externalities; Negative externalities of production and consumption; Positive externalities of production and consumption; lack of public goods; Common access resources and the threat to sustainability; asymmetric information and abuse of monopoly power

Triple A Learning - Market failure questions

Triple A Learning - simulations & activities

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 socially 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 (HL)
• Inequality (HL)

The meaning of externalities

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 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.

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

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.

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

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).

SC = PC + XC

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.

Negative Externalities of Production/External Costs of Production

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Negative Externalities of Consumption/External Costs of Consumption

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Figure 3: Negative Externalities of Consumption

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.

The main measures that governments can take include:

1. Direct provision of goods and services - this means the government providing the good or service themselves, perhaps through state-owned or nationalised industries.
2. 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.
3. Taxes and subsidies - where an activity causes negative externalities it could be taxed and where there are positive externalities, it could be subsidised.
4. Tradable 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.
5. Regulation, legislation and direct controls - this involves setting legal limits or regulations to prevent negative externalities or perhaps to reduce their impact.

1: 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.

Nationalised 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.

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 privatisation, 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.

2: 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.

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 internalised 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 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.

3: Taxes

The use of taxes 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).

Figure 6 Negative externalities - dumping of waste

Figure 7: Carbon tax on fossil fuel

Issues arising from the tax 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.

4: 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

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!

5: 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 tradable 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.

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.

Positive externalities of Production/External Benefits

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Figure 9: Positive externalities of Production

Positive externalities of Consumption/External Benefits

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Figure 10 Positive externalities of Consumption

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?

2: 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.

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.

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 heroin 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.

Figure 11 Over-consumption of a demerit good

Government responses - demerit goods

Possible government responses to correct market failure arising from demerit goods

Figure 12 Negative advertising campaign

Figure 13: Imposition of a tax

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 criminalised 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.

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 maximise 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 under-provided by the market, it would be useful at this stage to summarise 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.

• Types of Goods in an economy

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-excludability.

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.

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.

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.

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

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
• 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

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 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

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.

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.

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.

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

Task

1: Suppose there is a neighbourhood crime watch in which people volunteer to patrol the street where you live. If you do not participate in the patrol, but your neighbourhood is safer because of the crime watch, are you a free rider? Why? What can your neighbours do to eliminate the free-rider problem?

2: Public education is not a public good, but it has external effects. Explain.

3: Suppose that people value the continued existence of dolphins in the Pacific Ocean, but that tuna-fishing fleets kill large numbers of these mammals. Draw a graph showing this externality. Describe two alternative approaches to remedy the externality.

4: Property rights over the world’s oceans are not well defined. Recently, experts have noted that stocks of fish are declining as the seas’ resources are over-used.

(a) Explain, in economic terms, why this might have happened.

(b) Commercial fishing firms all over the world are complaining about the decline in their industry. The response of many governments has been to subsidize the fleets in their countries. Explain why this is an example of government failure.

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.

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.

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.

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.

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.

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 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

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.

Cap and Trade Schemes

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.

Promoting Clean technologies

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.

Carbon taxes versus cap and trade schemes

As market-based methods to reduce emissions, both carbon taxes and cap and trade schemes incentives to firms to switch to less polluting forms of energy. However, they differ in how they attempt to do this. Carbon taxes fix the price of the pollutant in the form of a tax on carbon and allow the quantity of carbon emitted to vary, depending on how firms respond to the tax; cap and trade schemes fix the quantity of the permissible pollutant, and allow its price to vary, depending on supply and demand.

Most economists prefer carbon taxes to cap and trade schemes for a variety of reasons:

· Carbon taxes make energy prices more predictable. Price predictability is important for businesses and consumers

· Carbon taxes do not offer opportunities for manipulation by governments and interest groups. Politicians often prefer cap and trade schemes to carbon taxes, and it is believed that this may be because it is easy to manipulate the distribution of permits for the benefit of preferred groups and supporters, without affecting the impacts on the environment (because of the cap). Carbon taxes do not allow for such manipulation.

· Carbon taxes do not require as much monitoring for enforcement. Cap and trade schemes require monitoring of emissions, otherwise firms may try to cheat by emitting more pollutants than they are permitted. Carbon taxes are easier to monitor as they only involve payment of a tax depending on the type and quantity of fossil fuels purchased.

· Cap and trade schemes face strong political pressures to set the cap too high. If the cap on pollutants is set too high, it would have a very limited or no impact on reducing carbon emissions.

· Carbon taxes are less likely to be used to restrict competition between firms. A possible disadvantage of tradable permits over taxes is that some firms could buy up more tradable permits than they actually need, thus driving up their price in an effort to keep new firms from entering the market (as a result restricting competition).

There are also some arguments against carbon taxes

· Carbon taxes may find it difficult to target a particular level of carbon reduction. Since carbon taxes cannot fix (or cap) the permissible level of carbon emissions, they lead to uncertain carbon-reducing outcomes. Cap and trade schemes work by fixing the total amount of the permissible carbon emissions.

· Carbon taxes are regressive. A regressive tax is one where the tax as a fraction of income is higher for low-income earners than it is for higher-income earners, and go against the principle of equity

Asymmetric information (HL)

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
• 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.

Abuse of monopoly power (HL)

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.

Inequality (HL)

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 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!

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