CHAPTER 5 :

MARKET FAILURE
 CHAPTER 5.1
The meaning of market failure : al locative efficiency
The failure to achieve at locative efficiency

free competitive market when the price of good adjusts to make Qd quantity
' '
in a a Qs the equilibrium reflects the best
-
-
, -
,

or optimal allocation of resources to the production of the good

→ all ocative efficiency is achieved when MB =
Mo (when social surplus is Max )

↳ achievement of these outcomes depend on very strict t unrealistic conditions that are practically never met in the

real world

↳ in reality, the free market fails to achieve all Ocative efficiency

-
study of market failure focuses on the free market 's inability to realize al locative efficiency in a variety of circumstances
-
market failure doesn't lessen the market 's significance as a mechanism that can advance the well-being of societies ; it

suggests that for markets to realize their potential they must be supported by appropriate govt
, policies
-
all oiative efficiency is a concept used by economists to identify real
-

world situations that differ from the Ideal of a perfect

allocation of resources

→ once these are identified , it is possible to design govt policies aimed at reducing the extent of the inefficiencies

-
market failure : the failure of the market to allocate resources efficiently
→ results in at locative inefficiency : too much or too little of goods 1 services are produced + consumed from the point of

view of what is socially most desirable

-
over provision of a good : too many resources are allocated to its production lover allocation)
-
under provision : too few resources are allocated to its production (under allocation)
-
Test your understanding 4.1 -

1 .
P consumer Allocate efficiency is achieved at the point Of equilibrium where MB
,
-
-
Mo At this
.
point of

, surplus
MG
production , the sum of consumer and producer surplus ( social surplus ) is maximized with

ion:::: : : ::: ::: : : :: is::: : : :: ::iii : sittin:: ::*: : :::: :tint: ::: ::::
'

' "

ptfoducelr service thatis most desired preferred through optimal resource allocation
t I .

sur pm ! MB
-
O
Qe Q

z .
Market failure is the inability of a market to achieve all ocative efficiency due to over provision or under provision -
causing

too much or too little of the good to be produced and consumed than what is socially desirable .
 CHAPTER 5.2
Externalities : diverging private and social benefits and costs
The meaning of externalities

understanding externalities
-

consumer buns = derives some benefits

-
firm sells =
Incurs costs
-

sometimes the benefits hosts spill Over

, onto other consumers / producers who have nothing to do wi consuming , producing
the good → there is an externality
-
an externality occurs when the actions of consumers , producers give rise to negative l positive side effects on other

people who aren't part of these actions t whose interests aren't taken into consideration
-
other ppl feeling the effects of an externality are third parties
-

If the side
-
effects on third parties involve benefits , there arises a positive externality
→
also known as external 1 Spillover benefit
-
it they involve costs in the form of negative side effects , there arises
-
a negative externality
→ external , spillover costs

-
externalities can result either from consumption activities Icon sumption externalities ) or from production activities
( production externalities )

marginal private benefits t costs and marginal social benefits t costs

-
marginal (private) benefits :
benefit consumers receive for consuming one more unit of the good
-
marginal (private) lost : cost to producers for producing one more unit of the good
-
no externalities -
-
MPB +
Mpc determine an equilibrium price x quantity that reflect a social optimum where there is a 110 cative

efficiency
→ social optimum : a best situation from the point of view of all Oca five efficiency
it there's an externality , additional benefits hosts affecting third parties arise and

!
-
.
p
mm Msc

g-
the full benefits I costs to society differ from the private ones
-
-

pop ? Yasu! Trim'm Irri ?! Bafana!7th determined by the intersection of MPB '
-

Mpc is

t no longer a social optimum bi al locative inefficiency is introduced by social

D= MPB MS B
-

I -

t benefits hosts that differ from private ones

#
o
Qopt Q -
social benefits =
MSB =
full benefits to society from consumption of a good
at locative efficiency
is achieved social costs MSC full costs to society of producing the good
-
-
- - -

-
MSB MSG
-
-
→
social optimum -7
all Native efficiency
FIGURE 5.I Demand , supply , and atlocative
efficiency w/ no externalities

-
marginal private costs (Mpa refer to costs to producers of producing one more unit of a good
-

marginal social costs (MSC) refer to costs to society of producing one more unit of a good
-

marginal private benefits ( MPB) refer to benefits to consumers from consuming one more unit of a good
-

marginal social benefits ( MSB) refer to benefits to society from consuming one more unit of a good
-
al locative efficiency is achieved when Mso -
-
MSB

wi no externality , the free market leads to an outcome where MPC MSG MPB MSB
-
- -
- - -
-

w/ externality , the free market leads to an outcome where MPB -

-
MPC but where MSB -4 MSC -
indicating
all Ocative inefficiency
-
an externality creates a divergence between Mpc -1 Msc or MPB t MSB

-
all negative externalities create external costs where Mso > MSB at the point of production
-
all positive externalities create external benefits where MSB > Mso
-
an production externalities create a divergence between private +
social costs where Mp of MSC
-
all consumption externalities create a divergence between private t social benefits where MPB -4 MSB

-
Test your understanding 5.2 -

1 .
lat An externality occurs when the actions of consumers or producers give rise to positive or negative external

side effects
-
on unrelated third parties that is not reflected in the final cost or benefit of a good 1 service .
 (b) Externalities lead to market failure because it creates a divergence between private costs 1 benefits and social costs 1

benefits since additional benefits costs affecting third parties arise

I and the full benefits I costs to society differ from

private ones Therefore the equilibrium price

. and quantity determined by the intersection of marginal private

benefit and marginal private cost is no longer the social optimum because marginal social cost is not equal to

marginal social benefit -

indicating the presence of al locative inefficiency .

2 .
la , marginal private benefit is the benefit from consuming one more unit Of a good for consumers while marginal
,

social benefit is the same but to society as a whole .

(b) Marginal private cost is the cost of producing one more unit of a good to producers while marginal social cost
, is

the same but to society as a whole .

3 . when there's an externality the condition of MPB

,
-
-
MSB -
-
Mpc
-
-
Msc is violated since MPB -4 MSB or MP OF MSC -

leading te al locative inefficiency since the private costs 1 benefits don't reflect the social costs 1 benefits that 're

considered to be the social optimum .

 CHAPTER 5.3
Negative externalities of production -1 consumption
Negative production externalities ( external or spillover costs )

Illustrating negative production externalities

-
refer to external costs created by producers
-

common ex : environmental pollution created as a side effect of production activities

-

→
cement factory that emits smoke into the air t disposes its waste by dumping it into the ocean
→ there are additional costs that spill over onto society due to the polluted air -1 ocean above the firm 's private costs

of production
→ negative consequences for local inhabitants , swimmers , sea life , the fishing industry -1 the marine ecosystem

Mso for each level Of output Q , social costs of producing cement are greater than the

)
p
-
,

firm 's private costs ( Ms 07 MPG )

popt YI!"mpc -
be the externality only involves production demand , curve represents both MPB

ggg ya,Bµ
p

l
,
, on, , , me , determined by µ, www..no , mm , mp , ,µµ ,,,n ,
I
l D : MPB MSB t -
-
in ( Qm Pm) .

#
o
Qopt Qm Q -
social optimum outcome is given by the intersection of msbtmso -

resulting in

FIGURE 5.2 Negative production externality ( Q opt , Popt)

-
when there's a negative production externality , the free market over allocates resources to the production of the good and

too much of it is produced relative to the social optimum

→
shown by Qm > Qopt and MSG ) MSB at the point Ot production Qm
The welfare loss of negative production externalities
-
welfare loss
→
whenever there's an externality there's , a welfare (deadweight) loss involving , a reduction in social benefits due to

the misallocation of resources

(a) Welfare loss (b) Welfare loss in relation to consumer -1 producer surplus (supplementary material)
Msc Msc
welfare p

✓
p

✓
loss
,

l
! simp
"

Ii
"

!
a
e
pom y Mpo pop, y ,
- - - - -
- - -
.

pm pm

' '
' '
t I D= MPB
-
- MSB / I D= MPB
-
- MSB
l l
o
# o
#
Qopt Qm Q Q opt Qm Q

FIGURE 5-3 Welfare loss (deadweight loss ) in a negative production externality

→ Figure 5.3191
↳ for all units of output greater than Qopt , Mso > MSB
-
meaning society would be better off it less were

produced
↳ welfare loss : difference between Mdot MSB for the amount of output that's overproduced ( Om Qopt) -

→ loss of social benefits due to overproduction of the good caused by the externality

↳ it externality were corrected so that the economy reaches the social optimum , the loss of benefits would disappear
-
welfare loss in relation to consumer 1- producer surplus (supplementary material )
→
Figure 5.3lb)

↳ In market equilibrium :

o ) consumer surplus = at b t C Id -

) producer surplus ft g th
-

o -

e) value of external cost Ltd t et 9th

-
-

↳ difference between MSC t Mpc curves up to Qm

total social benefits consumer t producer surplus external cost ( atbtctd ) -11ft 9th ) ( ( tdte -19 th ) = at b tf
-

o) e
- - - - -
-
 ↳ at the social Optimum ( Q opt , Popt )
) consumer surplus a
-

o -

e ) producer surplus b tf -
-

e ) external cost O
-
-

total social benefits at b tf

=
o )

↳ total social benefits are smaller at the market equilibrium by area e ( welfare loss '

correcting negative production externalities

-
Government regulations
→ rely on the command approach
→ govt uses its authority to enact legislation t regulations in the public 's interest

→ can be used to prevent I reduce the effects of production externalities

→ ex on the polluting firm : regulations can forbid the dumping of certain toxic substances into the environment ( rivers ,

oceans , etc ) .

→ regulations don't totally ban the production of pollutants but rather attempt to :

↳ limit the emission of pollutants by setting a Max level of pollutants permitted

↳ limit the quantity of output produced by the polluting firm
p Msc

✓l
↳ require polluting firms to install techs reducing the emissions
^

impact : to lower the quantity produced bring it closer to Q opt by

+
→
pope - - - -

y s Mpo
-
-

:*:::ii:::: ::::: ::::#nine.mn: ::in:p

s "

. .. .. '
I
l l MSB
requiring firms install techs impose higher costs of production D MPB
- -

↳ to - -

due to the purchase of non polluting techs -

Qopt Qm Q

↳ ideally higher costs of production = Value of the negative

FIGURE 5.4 Government regulations to correct negative
externality production externalities

govt's objective to make the Mpc curve shift upwards until it coincides w/ the Msc curve , in which Qopt is
=
→

produced price , increases from pm to popt , and the problem of over allocation of resources to the production is
corrected
→ polluting firms have to pay fines if they don't comply
-

market -
based policies
→ govt can also pursue policies relying on the market

(d) Imposing an indirect tax on output (b) Effects on external costs Of a (c) Tradable permits
or on pollutants tax on emissions ( carbon tax)
Pf s of tradable

PI PI MSC Mpo + tax

/ permits
-

Msc M pot tax

- -
-

of if #
gtfo's tnsimpc
"
s Mpo Pa - -

pi Pope
- - - -
.

,
- - - - -
- - -

n
l l l
l l
l l l l
D= MPB MSB - l D= MPB MSB -
D1
l 1
- -
, i
,
# #
O
OT
O Qoph Q ! Qm
O -

Qopt ①m -
ptz
Q, Q

FIGURE 5.5 Market based policies to correct negative externalities

-

→ Imposing a tax to correct the negative production externality

↳ govt could impose a tax on the firm per unit of output produced or a tax per unit of pollutants emitted

↳ Figure 5.5cal
o ) tax results in upward shift from S MPC to MSC
-
-

o
) optimal tax policy is to impose a tax that's exactly equal to the external cost so the Mpo shifts upwards

until it overlaps w/ Mso

o ) after tax equilibrium is the intersection of Msa t D= MPB MSB resulting the lower optimal quantity
-

in
-
- -

produced ( Qopt) t higher optimal price (Popt)

o
) Pope .
=p, =
price paid by consumers
 o) tax incidence is shared between consumers x
producers
→ Distinguishing between a tax on output t a tax on pollutants (emissions )
↳ a tax per unit of output is intended to work by directly correcting the overallocation of resources -
resulting

in Q opt

↳ a tax per unit of pollutants is intended to work by creating incentives for the firm to buy fewer polluting resources

( ex : fossil fuels) 1- to switch to less polluting techs (alternative energy sources )

↳ ex : carbon tax (tax per unit of carbon emissions of fossil fuels ) to deal w/ climate change
o
) fossil fuels don't all emit the same amounts of carbon when burned

e) calculated based on how much carbon the fuel emits

a ) more carbon emitted =
higher tax
o ) bc of the tax , firms must pay a higher price to buy fossil fuels =
higher costs of production

e) Figure 5.5cal : S
-
-
MPG Shifts towards MSO

e) increase in the price of high carbon fuel creates incentives for firms to switch to substitute energy
-

sources w/ lower carbon emissions / no carbon emissions ( not fossil fuels )

ol Q opt will increase bc the external costs of producing the output will become smaller ( from Qopta to Qopta)
e) Figure 5.5lb) : MSC curve shifts from MSG to MSG -
indicating that the external costs are lower due to

the use of less polluting resources and taxes are lower

↳ a tax on emissions has the effect of creating incentives for producers to reduce the amount of pollution they

create by purchasing less polluting resource

↳ this reduces the size of the negative externality + increases the optimum quantity of output
↳ a tax on the output of the polluter only reduces the amount Of Output produced
→ Tradable permits
↳ also known as Capt trade schemes

↳ Involves permits to pollute issued to firms by a govt or an international body

↳ permits can be traded ( bought t sold ) in a market

↳ govt grants firms who pollute a number of permits to produce a particular level of pollutants over a given

time period
↳ price of permits when traded are determined by supply t demand

↳ It a firm can produce its product by emitting a lower level of pollutants than the level set by its permits , it can

sell its extra permits in the market

↳ It a firm needs to emit more pollutants than the level set by its permits , it can buy more permits in the market
↳ Figure 5.510 )
o
) supply of permits is perfectly inelastic , since it's fixed at a particular level by the govt / international authority
e) fixed supply of permits is distributed to firms
o ) demand curve determines equilibrium price
e) as an economy grows + firms increase their output levels , the demand for permits is likely to increase
( rightward shift of demand from Da te Dz ) t price of permits increase from Pa te p,

↳ tradable permits are like taxes on emissions in that they provide incentives to producers to switch to less

polluting resources for which it is not necessary to buy permits

↳ reduce emissions -
-
sell permits = increase profit
↳ Permits intend to reduce the quantity of pollutants emitted -
reducing the size of the negative externality

+ increasing the optimum quantity of output produced by shifting the MSC curve downward toward Mpo
- correction of negative production externalities involves shifting the Mpo curve upward toward the Ms o curve through

govt regulations or market based -

policies
-
for al locative efficiency to be achieved , the quantity of the good produced t consumed must fall to Qopt as price increases

µ Popt

Evaluating govt regulations -1 market -

based policies
-
Advantages of market -

based policies

→ economists prefer market based solutions over govt regulations to deal w/ negative production externalities
-

→ both taxes -1 tradable permits have the effect of internalizing the externality , meaning the external costs are
 made internal bc the b 're now paid for by producers t consumers who are parties to the transaction
↳ consumers share the tax incidence paying for external production costs
-

→
taxes on emissions are superior to taxes on output
↳ taxes on output only provide incentives to producers to reduce the quantity of output produced w/ a given tech

1- polluting resources but , not to reduce the amount of pollution then create 1 to switch to less polluting

resources

→
taxes on pollutants emitted provide incentives to firms to economize on the use of polluting resources (ex : fossil fuels) t

use production methods that pollute less

→ firms don't all fall the same costs of reducing pollution
↳ low cost = more likely to cut pollution emissions to avoid paying the tax

↳ higher cost =
least likely to cut their pollutants : will pay the tax

→ taxation leads to lower pollution levels at a lower overall cost of reducing pollution

→ tradable permits creates incentives for firms to cut back on their pollution If they can do so at relatively low cost

↳ relatively low cost for a firm to reduce its pollutant emissions = cut emissions -
-
sell excess permits
↳ firms that can only reduce pollution at high cost will be forced to buy additional permits
→ both taxes 1- tradable permits are methods to reduce pollution more efficiently at a lower cost
-
Disadvantages of market based policies -

→ although taxes -1 tradable permits are simple in theory . in practice the b 're faced w/ numerous technical difficulties
→ taxes
↳ difficulties when designing a tax equal in value to the amount of pollution

↳ an effective tax policy needs to answer :

o ) what production methods produce pollutants ?

↳ different production methods create different pollutants
↳ necessary but hard to identify
01 Which pollutants are harmful ?

↳ necessary but hard to identify

↳ there's much controversy among scientists over the extent of harm done by each type of pollutant

o) what is the value of the harm ?

↳ necessary to attach a monetary value to the harm

↳ how much is the harm done by each pollutant worth ?

↳ raises questions w/ no easy answers : who I what is harmed ? how is the value of harm to be measured ?
↳ there's also a risk that even if taxes are imposed some polluting firms ma b not lower their pollution levels -

continuing to pollute even tho they pay a tax

→ tradable permits
↳ face all the listed technical limitations Fae

↳ require the govt International body to set a Max acceptable level for each type of pollutant , called a cap
o ) this demands technical info on quantities of each pollutant that 're acceptable from an environmental

point of view which , is often not available

o ) to high Max level =

won't have the desired effect on cutting pollution levels (inefficient)
o ) too low mall level =
costly permits =
harder for firms to buy
↳ to date , it's only been developed for coz , SO ,

↳ a method must be found to distribute permits to polluting firms in a fair way

o) issues of political favoritism

o ) guts can give preferential treatment to their friends + supporters

↳ in practice best case scenario :

.
-

o) shift of MPC curve towards Msc

o) some reduction in the size of the externality

o) but it's unlikely to achieve optimal results

-
Advantages of govt regulations
→ simpler than market based solutions -
 → can be implemented more easily

→ technical difficulties of market -

based policies make it more practical to impose regulations limiting the amounts of

pollution firms can emit

→ regulations force polluting firms to comply t reduce pollution levels (which taxes may not always do )

→ more commonly used to limit negative externalities of pollution

-
Disadvantages of govt regulations
→ don't allow the externality to be internalized

→ create no market -
based incentives
→ unable to make distinctions between firms that have a higher I lower costs of reducing pollution
→ unable to provide incentives for firms to use less polluting resources

↳ unable to lower the size of the externality

→ pollution is reduced at a higher overall cost

→ Sutter from similar limitations as the market -

based policies : lack of sufficient tech inte on types + amounts of

pollutants emitted

↳ can only be partially effective

→ costs of policing t problems w/ enforcement

Test your understanding 5.3

-
-

1 la ) Msc lb) the equilibrium quantity determined by the market ( Q m) is greater than the

if
p µ, welfare

✓
.

loss
optimum quantity from society 's point of view ( Q opt)
^

in
.

"

in:*: ::: insist: tinea: : :: ::::: ::: :::: :*:::: .in: :*: ::*:
' " " "

l l
l
l 900 d .

I
I D= MPB MSB
-
-

'
I Idl The welfare loss indicates a reduction in social benefits due to the
o
#
Qopt Qm 0 misallocation of resources that lead to an Ove production of the good

relative to the social optimum .

2 . Environmental pollution ( air pollution , water pollution ) noise pollution from factories ,

3 .
Environmental pollution : government regulations that ban the dumping of certain toxic substances on the environment

or require polluting firms to install technologies to reduce emissions i imposition of carbon tax or

an indirect tax on output pollutants i tradable permits that limit the production of pollutants

Noise pollution : government regulations that limit the working time of the firm or require firms to employ technologies to

reduce the noise pollution

4 .
la ) Ibl Msc
P
P1

Pym ✓
MSC M pot tax
-
-

^
im "
Pimp
-
-
mm

pp - - - - -
f l
l l
l l l
D= MPB = MS B
l l o
#
1 , D= MP B MSB -
-
Q opt Qm Q
#
O
Om Q
Qopt
(c) Taxes internalize the negative externality , as external costs are paid for by producers and consumers (tax incidence is

shared ) who are parties to the transaction Taxation also creates incentives for firms to reduce the quantity of output
.

produced or switch to better alternative methods -

reducing the size of the externality at a lower overall cost .

However there are many technical difficulties when designing

,
a tax equal to the size of the externality There is also the .

risk that firms may not lower the externality even though then pay the imposed tax Government regulations are
.
simpler
and hence can be implemented more easily They also force the firm 's compliance .
-

ensuring that the externality is

reduced However government regulations don't internalize the externality and create
. , no market -
based incentives -

making them unable to lower the size of the externality This means that the externality is removed
.
at a higher overall

cost There are also

. additional costs of policing and problems with enforcement .

5 . Tradable permits creates incentives for firms to cut back on the production that has negative externalities or to switch to
alternative methods in which it's unnecessary to buy permits This. allows the firm to sell excess permits whilst simultaneously
 reducing the site of the externality .

6 . Cal internalizing the externality involves making the external costs internal by encouraging the parties involved to take
responsibility by paying for such costs This lessens the gap between private costs and social costs This can be done through
. .

taxation and tradable permits , as both encourage the parties involved to pay for the external costs that they've created -

internalizing the negative externality .

(b) Economists prefer market based methods because it creates incentives for firms to reduce the size of the externality
- -

encouraging them to take responsibility by internalizing the externality instead of forcing it upon them Command methods .

also tend to reduce the externality at a higher overall cost -

disadvantaging the firms extremely because it doesn't

take into account the firm's stage of development Command methods also tend to involve additional costs of .
policing
and tend to have problems in terms Of enforcement .

(c) There are many technical difficulties involved when implementing market -
based policies For taxes it's hard for
.
,

governments to design a tax equal in value to the size of the externality There's also
.
a risk that even if taxes are imposed
some firms ma b not lower the size of the externality despite paying the tax .
in the case of tradable permits , they

require the government to set a maximum acceptable level for each type of pollutant which demands technical ,

Information on the quantities of each pollutant that 're acceptable from an environmental perspective that's hard to
find They also
. require the government to establish a method to distribute permits to polluting firms in a fair way since ,

issues like political favoritism often arises .

7 .
ca ) Taxes on emissions and tradable permits are similar , as they provide incentives to producers to switch to less

polluting resources in order to avoid taxation or the buying of extra permits They both reduce the size of the negative
.

externality by internalizing the externality .

(b) They differ since taxes on output are intended to work by directly correcting the overallocation of resources -
shifting

the Mpo curve closer te Mso so that the equilibrium quantity produced can decrease to be closer to the social

optimum quantity They don't create incentives for the firm to buy fewer polluting resources or to switch to less
.

polluting technologies -

thus only reducing the amount of output produced and not the site of the externality .

(C) a tax on emissions because taxes on output only provide incentives to producers to reduce the quantity of output

produced with a given technology and polluting resources , but not to reduce the amount of pollution then create or

to switch to less polluting resources -

only reducing the amount Of output produced and not the externality A tax on .

emissions reduces the size of the negative externality and increases the optimum quantity of output .

Negative consumption externalities (external 1 spillover costs )

Illustrating negative consumption externalities

-
refer to external costs created by consumers

-
ex : when consumers smoke in public places , there are external costs that spill over onto society in the form of costs te non -

smokers due to passive smoking

↳ smoking related diseases
- =
higher than necessary healthcare costs = additional burden to society
-
MPB doesn't reflect social benefits
-
Figure 5.6

¥1
JMP
P o MSc
-
-

→ external costs :
negative benefits
Pm - - -

↳ cause the MSB curve to lie below the MPB curve

ii.
7. arin:: :: omni:: me:: :b'm'T?
room mm
-' " " mm

l l
l
l
l
l MSB → social Optimum (Q opt Pop t) ,

.
o . --

Q opt Qm Q ↳ Intersection of MS B t MSC

FIGURE 5.6 Negative consumption externality

-
more ex :

↳ heating homes +
driving oars by use of fossil fuels that pollute the atmosphere

↳ partying w/ loud music until the early hours of the morning +

disturbing the neighbors
-
free market over allocates resources to the production of the good t too much of it is produced relative to what is

socially optimum
→ shown by Qm 7 Q opt and MSC 7 MSB at Q m

→ negative externalities ( production + consumption) lead to allocate've inefficiency arising from an overallocation of
 resources to the good 1- N its over provision

The welfare loss of negative consumption externalities

( at welfare loss lb ) Welfare loss in relation to consumer +

producer surplus (supplementary material)
p p
5- MPC : MSC
Pm S MPO MSC
-
-
-
-

we
Harne loss a welfare loss

art
a.mn.
' ' '
l
l l
l
MSB l
l MSB
l l
l l l l
O O
- -

Q opt Qm Q Q opt Qm Q

FIGURE 5.7 Welfare loss (deadweight loss ) in a negative consumption externality

-
welfare loss

→ the reduction in benefits for society due to the over allocation of resources to the production of the good

→ for all units of output greater than Qopt ,

MSG ) MSB

↳ indicates that too much of the good is produced

→ difference between MSC 1- MSB for the amount of output that's overproduced relative to the social optimum ( Q m Qopt) -

→ loss of social benefits from overproduction due to the externality

↳ it corrected , society would gain the benefits represented by the shaded area

-
welfare loss in relation to consumer + producer surplus ( supplementary material )

→ in market equilibrium
↳ consumer surplus = at b

↳ producer surplus :
Ot d tf

↳ cost of externality at d te
-
-

↳
total social benefits =
Consumer surplus producer surplus external cost ( at b) tlotdtf ) lat d let :b to tf
-
e
- -

-1 - - -

→ at the social optimum

↳ consumer surplus = by a

↳ producer surplus f
-
-

↳ external cost -
- O

↳ total social surplus

-

consumer surplus t producer surplus b to tf

-
- -

→ total social benefits at market equilibrium ( total social benefits at the social optimum

↳ smaller by area e ( Welfare loss )

The case of demerit goods

-
goods that are considered to be undesirable for consumers
-
over provided by the market
-
ex : cigarettes alcohol gambling
. .

-
reason for over provision is that the good may have negative consumption externalities in which case the market over allocates

resources to its production

↳ another reason : consumer ignorance 11h difference about its negative effects : consumers may not be aware of the harmful

effects upon others of their actions 1 they may not care

correcting negative consumption externalities

-
Government regulations
→ can be used to prevent I limit consumer activities that impose costs on 3rd parties
→ ex: legal restrictions on activities as smoking in public places
→
has the effect of shifting the DE MPB curve towards the MSB curve until Dz overlaps w/ MSB

→ would eliminate the externality , WI production +

consumption occurring at Qopt t price falling to Popt
-
Advertising
→ ads t campaigns by the govt can be used to persuade consumers to buy fewer goods w/ negative externalities
→
ex : anti
-

smoking campaigns , campaigns to reduce the consumption of goods based on fossil fuel use : campaigns to use

public transportation to economize on petrol use t to improve home insulation to reduce oil consumption for heating
→ objective : to try to decrease demand for such goods
 → same effect as govt regulations : MPB shifts to be where it coincides w/ MSB t where Qopt is produced t consumed t

price falls from Pm to Popt

-
Market based policies
-

→ involve the imposition of indirect ( excise ) taxes

→ indirect takes can be imposed on the good whose consumption creates external costs in order to achieve all Olathe

efficiency
↳ ex : cigarettes , petrol , gasoline
→
effects :
↳ decrease in supply : upward shift of the supply curve from MPC to M Pot tax

↳ It tax external cost , the Mpo t tax curve intersects MPB at the Qopt level of output -1 quantity produced +
consumed
-
-

drops to Q opt
↳ Qopt is the socially optimum quantity t price increases from pm to Po
-

correction of negative consumption externalities involves either decreasing demand +

shifting the MPB curve toward the MSB

curve through regulations ( advertising ; or decreasing supply t shifting the Mpo curve upward by imposing an indirect tax

Both demand decreases -1 Supply decreases can lead to production -1 consumption at ① opt 1- the achievement of allocating

efficiency
-

price paid by consumers falls to pop+ when demand decreases -1 rises when supply decreases

(a) Government regulations + advertising (b) Market based : imposing

-
an indirect tax lot Imposing a tax on consumers (supplementary material)

#¥#m=mpB :/
p p MPO -1 tax P
5- MPC Msc
-
-

tax : Po
EETs
- - -

1
- - -

M" M"
ftp..ms
-
-

a
pm
-

,
-

pm . - -

Pop Pp pp
-

extpamampbst
l l l l D= MPB , l
l l bi MSB
-
! I MSB l l
Dr MPB tax
-

-
-

0
# 01-1
Q opt Qm Q Qopt Qm Q opt Qm Q

FIGURE 5.8 Correcting negative consumption externalities

- objective of policies to correct negative consumption externalities t solve the over provision of demerit goods : to decrease

consumption , since demerit goods are undesirable

A tax on producers or consumers ? ( supplementary material )

-
shift in supply -1 shift in demand produce identical market outcomes
-
Figure 5.8lb)
→ Indirect tax is imposed on the good causing the negative externality = Mpo shifts upwards
→ at the new equilibrium Q opt will , be produced t sold at Price Po (price paid by consumers )

→
pp : price received by producers
-
H tax is imposed on consumers , which they pay directly to the govt demand will shift downwards from Da to Dz ( Figure 5.8107)
,

→ reason for shift : for each quantity consumers are willing t able to buy , the price they pay Includes price of good -1 tax per
unit -
meaning for each quantity , the price of the good must be lower by the amount of the tax

→ new equilibrium is determined by the intersection of bat supply -

giving rise to Qopt

→ when consumers buy Qopt , they pay the tax per unit +
pp =p,
→
pp is received by producers
-
Figure 5.8lb) VS figure 5- Slot
→
identical market outcomes

→
Qopt is achieved , consumers pay pot producers receive pp Po tax
-
-
-

→ tax incidence is shared between producers -1 consumers

→ only difference : who pays the tax

↳ in practice , excise taxes are paid to the govt by firms bc its administratively easier for the govt to collect taxes this
way

Evaluating market based -

policies govt regulation t advertising 1 persuasion

.

economists prefer market based solutions to the problem of negative consumption externalities
-

→ indirect taxes are the preferred measure , as they internalize the externality
 -
indirect taxes create incentives for consumers to change their consumption patterns by changing relative prices ; the good that's

taxed becomes relatively more expensive -1 consumption is reduced

-
difficulties w/ market
-
based policies

→ measuring the value of the external costs : assessing who +

what is affected

→ inelastic demand of demerit goods

↳ % t in Qd C % Tin P due to the tax

↳ increase govt revenues while not significantly decreasing Qd

↳ means that In order to achieve a opt, a very high indirect tax would have to be imposed ( politically unacceptable )
-
advertising t persuasion are simpler
-
disadvantages of advertising -1 persuasion
→ cost to the govt of advertising campaigns, which are funded out of tax funds -
meaning less funds available to use

elsewhere in the economy ( op cost )

→ may not be effective
-
govt regulations

→ can be v effective in reducing the external costs of smoking

→ cannot be used to deal w/ other kinds of negative consumption externalities
↳ ex : v difficult to regulate petrol consumption (easier to impose indirect taxes)

- wi all policies . It's only possible to move the economy in a direction towards of correction of the externality rather than

achieving a precise allocation of resources where Qopt is produced t consumed

-
Test your Understanding 5.4 -

1 lat lb) The equilibrium quantity ( Om) determined by the market is more than

¥1
JMP
.
p amso

the socially optimum quantity ( ① opt)

Pm - - -

co, since Qm > Qopt the market over allocates resources

, to the production of

hair how a negative production externality

fhneeyqjg.edu?rovina
Port causes allocate've
. MPB

l l
l l MSB ( d) The welfare loss indicates a reduction in social benefits due to the
o . . --

Qopt Qm Q misallocation of resources that lead to the over provision .

2 . passive smoking traffic congestion vehicle pollution noise pollution from neighbors
. . ,

3 . passive smoking : legal restrictions enacted by the government when smoking in public places i anti smoking campaigns ; -

imposing indirect taxes on cigarettes I cigar

Traffic congestion : campaigns to use public transportation imposing indirect taxes

-

. on vehicles ( oars motorcycles , etc ) ; legal

, .

regulations that limit the number of private vehicles owned or that limit the type of private vehicles

that can operate per day (based on license plate or setting a minimum number of people per vehicle )
vehicle pollution campaigns to : use public transportation ; imposing indirect taxes on petrol 1 gasoline; legal restrictions

that limit the number of private vehicles owned per family mouse

Noise pollution : legal regulations that prohibit loud music I partying from and to a set / pre determined time frame
-

'EE¥¥
la)

p.pt#*..mpp, !
4 lb) 10) MPO -1 tax

!
'

P D p
g Mpo Msc g. Mpo Msc
- -
-
- -
-

tax :

pm -
i'Eos
'

pm -
E a -

film'm .ms .

pop mp, ppm

l l l l l l b MPB
-
-

l l l l
l bi MSB l bi MSB
l
-
l
-

, i MSB
# #
o o
① opt Qm Q Q opt Qm Q Qopt Qm

Idl Government regulations can be very effective in reducing the external costs of smoking , however it's not very effective
when dealing with other kinds of negative consumption externalities Advertising and persuasion
.
are simpler to

implement than any of the other measures however there's always the risk that it may not be effective They also
, .

involve additional costs to the government which . are funded out of tax funds -
meaning the government will have

less funds available to use elsewhere in the economy Indirect taxes are the .
preferred measure , as they internalize the

externality They also create incentives for consumers to change their consumption patterns by changing relative
. prices ;
the good that's taxed becomes relatively more expensive and consumption is reduced However , there .
are difficulties when
 measuring the value of the external costs ( assessing who and what is affected ) There's .
also a problem due to the
inelastic demand of demerit goods which means that the indirect tax will increase government revenues while not
,

significantly decreasing quantity demanded This .

means that In order to achieve the socially optimum quantity ,

a very high indirect tax would have to be imposed which is politically unacceptable , .

5 . lat Demerit goods are goods that have negative spillovers and are considered to be undesirable for consumers from society 's

point Of view They also tend to be over provided by the market Examples include cigarettes
.

.
. alcohol and gambling
. .

(b) The over provision can be corrected by imposing indirect taxes on the goods , through campaigns that educate the public
-

on the negative effects ; or through government regulations that limit production and consumption Through regulations .

or advertising , demand decreases -

shifting MPB closer to Msa .
Imposing an indirect tax will shift the Mpc curve upwards -

decreasing supply All these measures can lead to

.

production and consumption at the socially optimum quantity to opt) -

correcting the over provision and achieving all ooative efficiency .

6 .
A negative consumption externality refers to spillover costs created by consumers due to the consumption of certain goods and

services while a negative production externality refers to external costs created by producers due to the production of goods

and services A negative consumption externality creates

. a gap between MPB and MSB , as it involves the demand curve while .

a negative production externality creates a gap between Mpo and Msc as it centralizes on the supply curve .

7 . (at Market based solutions like imposing

-
an indirect tax on the good with the negative consumption externality .

(b) There are difficulties when measuring the value of the external costs , which is needed in order to know the value of the

tax There's also

.
a problem due to the inelastic demand of demerit goods which makes the tax Ineffective since the ,
goods
are not price sensitive -
meaning an increase in price due to the tax will not significantly reduce the quantity demanded .

This means that In order to achieve the socially optimum quantity ,

a very high indirect tax would have to be imposed .

Real world Focus -

could a tax On chocolate help fight obesity ?
i.
It is referring to negative consumption externalities , since it involves external costs that

¥1
JMP
p o mso
-
-

arise from the consumption of chocolate These external costs include the additional healthcare
.

Pm - - -

costs that burden society due to the high rates of heart disease and diabetes within the

non nai '

::::::'m:n: ::::: :c::: :::::::: :::* : : :*:: ::::: mini:::::: :

mm
- " " "

.
l l
l l
l l MS B
. .
o --

Q opt Qm Q

z .

p Mpo + tax if the excise tax on chocolate is imposed on producers Mpb will shift upwards by the amount
, of

tax : the external cost At the new

. equilibrium where Mpo intersects MPB , Q opt will be produced
Pc Imai po
-
-
Msc (which is less than the over provided market quantity Qm ) and consumers will pay Pclwhich

I ionium:::: .in: in::c:: ::: :::::÷:: .mn::::: ::::

" " aimed at discouraging me
an

l l b MPB -
-

l l
l l MSB

Qopt Qm

p the excise tax is imposed on consumers (meaning they have to pay directly to the government)

t
it ,

Po -

MPB will shift downwards from D , to Dz by the amount of the tax which ideally should
T
- - - -

g. mpg : Msg
i be equal to the external cost At the new equilibrium which is the intersection between Dc
pm
. ,
-

y
- - - - - - - - -

t.xtiin.i.io : :: : iii. :roam:::::: :: :'m:m: :: : : :: : int::::i::c :: ::c.int:: ::::::

" " "
.
an
l l
l l
l '
Dz MPB tax
-

-
-
meant to discourage the consumption of chocolate .

o
-
Q opt Qm Q

¥
3 .
P
sa : M pot tax since the demand for chocolate tends to be inelastic consumers , are not price sensitive

µx
when consuming chocolate -
meaning the quantity demanded for chocolate is not
"
Po
extern?'m%
-
-

" responsive towards changes in price Thus a .

,
tax on chocolate must be very high in

iiiiiiiiiiiiiiiiiiteiii:ii.iii.iii.iii.iii. iii.iii.in:: : :::: iii.iii.in

.

I MSB
l l

! I mpb
more ways to generate revenue , a tax on chocolate may be very desirable However, .

#
o
Qopt Qm Q
to consumers the extremely high tax due to the inelastic demand of chocolate makes the
.

undesirable , as consumers have to pay a high price of Pc for a comfort food .

 CHAPTER 5.4
positive externalities of production + consumption
positive production externalities ( external or spillover benefits)

illustrating positive production externalities

-
refer to external benefits created by producers
-
ex : if a firm engages in research +
development , and shoe eds in developing a new tech that spreads throughout the

economy , there are external benefits bc not only the firm but also society benefits from the widespread adoption

↳ social costs of research 1- development are lower than private costs

Figure 5.9

!
-

P s Mpo -

Witten
-

external benefits negative

.at
'
→ = costs

pm - - - - -

y l Mso → market gives rise to equilibrium ( Qm , pm ) determined by the intersection

,

pop -

l l
→
got raypobptinmpom
, , a. µ , pop, , determined by µ , inter, on o, mgp , m, ,
l l
l l
→ since Qml Qopt the
, market under allocates resources to research t
l l
l l D MPB MSB
-
-
-
-
development activities that lead to new techs , and not enough of them
-11
o
Qm Qopt Q are undertaken

FIGURE 5.9 Positive production externality

-
when there's a positive production externality the free .
market under allocates resources to the production of the good : too

few resources are allocated to its production t too little of it is produced

↳ Shown by QMLQ opt t MSB ) MSG at Om

- more ex :

→ firms train workers who later switch jobs -1 work elsewhere : external benefits are created as the new employers 1- society

benefit from the trained workers

→ a pharmaceutical company develops a new medication that benefits not only its users but also those around them

from the improved quality of life t increased life expectancy

The welfare loss of positive production externalities

-
welfare loss
→ be of the under provision

→ difference between MSB + MSG for the amount of output that's under provided relative to the social optimum ( ① opt -

Qm)

→ involves external benefits for society that are lost bc not enough of the good is produced
→
It the externality were corrected , society would gain the benefits represented by the shaded area
-
welfare loss in relation to consumer + producer surplus (supplementary material )

(at welfare loss Ibl Welfare loss in relation to consumer -1 producer (supplementary material )

! it
p p
s MPC S MPC
- -
- -

external external
l l
benefits benefits
/ mga , mga

n
: it
.
it
.

I
l f l
l
l l l l

↳nmse
' '
' '
' ' ' '
' '
' '
ME
Qm Qopt Q Qm Qopt Q

FIGURE 5.to welfare loss (deadweight loss) in a positive production externality

→ at market equilibrium

↳ consumer surplus a
-
-

↳ producer surplus bye

-
-

↳ external benefits o tf
-
-

↳
total benefits = consumer surplus t producer surplus -1 external benefits = at lb te) tutti
-
- at b te t
Ctf
 →
at the social optimum
↳ consumer surplus
-
-
atbtotd

↳ producer surplus :
etf -19

↳ external benefits O
-
-

total benefits consumer surplus -1 producer surplus atbtotdtetftg

-

↳ -
-
-

→ total benefits at social optimum > total benefits at market equilibrium

↳ at the social optimum there , are additional benefits dtg

↳ amount of welfare loss at market equilibrium due to the under allocation of resources arising from the positive production

externality

correcting positive production externalities

(a) Direct government provision (b) Granting a subsidy

÷i÷i÷m
P s Mpo
P
S MPC
-
-
- -

/
, ""
""""" I

' ' '

i
' ' '
'
' '
' l
' ' '
'
' '
' '
l l
l
l l D : MPB i D= MPB
'

# #
O o
Qm Qopt Q Qm Qopt Q

FIGURE 5.11 Correcting positive production externalities

-
Direct government provision
→ ex : govt often engage in research '
-

development ( Rt D) for new tech , for medicine + pharmaceuticals etc , .

→
govt can also directly provide training for workers

→
govt pay for such activities w/ govt funds , raised through taxes
→ Figure 5 Illa )
-

↳ when govt intervenes by providing goods 1-services itself , Mpo shifts downwards towards Mso so that the opt

quantity of the good ( Qopt) will be produced w/ price falling from Pm to Popt
-

subsidies
→ can correct allocating inefficiency by correcting market failure
→ Figure 5.11lb)
↳ it subsidy external benefit MPC shifts downwards I rightwards until it coincides
-
- , w/ Msc

↳ increases quantity produced to Qoptt lowers price from Pm to Poppy

↳ problem of under allocation of resources -1 under provision is corrected tallooative efficiency is achieved
→ direct govt provision subsidies+ have the same market outcomes

-
correction of positive production externalities involves shifting the MPO curve downward toward the Msc curve through direct govt

provision or by subsidies
-

For allooative efficiency to be achieved , the quantity produced toonsumed Must increase to ① opt as price falls tepopt
-
Test your Understanding 5.5 -

1 . (al
p g. mpg (b) The equilibrium quantity determined by the market is smaller than the socially optimum

tlgebtfhf:f
's auantitblQMCQor.tl .

::i:i::::i:::::::i: 'm:O:*: :c::::i:::i÷:c::::i :* :i: :*

" '

. .

I 1 the good .

I l
l
l
l
l
id ) The welfare loss represents the external social benefits that are lost due to the
l l
l l D MPB - MSB
-
-
misallocation of resources that leads to under provision Of Goods ( not enough of the
-11
o
Qm Qopt Q good is produced) .

2 .
projects to reduce deforestation ; construction and operation of an airport : investing in research and development ; firms

training workers

} ,
projects to reduce deforestation : Direct government provision in which the government will run these projects themselves through
 government funds and by asking for volunteers ; granting subsidies to these kind of programs knowing

how it benefits society as a whole Both will reduce the external benefits
.
-
shifting MPG towards Msc

in order to achieve al locative efficiency .

Airport : Governments can directly provide airports (making it a public property instead of a private one ) or grant subsidies by funding

private firms that are willing and able to construct and operate the airport Both will reduce the external benefits .
-

gradually
reaching at locative efficiency .

Research and development : Governments can engage in their own R&D program and find new technologies or they can subsidize

private firms to engage in R&D Both will shift the Mpo .

curve towards MSG
-
reducing the size of the

externality .

worker training : The government can directly provide the training themselves or they can subsidize the firm to train its workers Both .

will correct the externality -

possibly achieving all Ooative efficiency .

Positive consumption externalities (external or spillover benefits )

illustrating positive consumption externalities

-
external benefits created by consumers

ex :
-

→
consumption of education benefits the person who receives the education , but in addition gives rise to external benefits ,

involving social benefits from a more productive workforce lower unemployment higher rate of growth more economic
, , ,

development , lower crime rate , etc .

→
consumption of health care services benefits not only the person receiving the services but also society -1 the economy bo a

healthier population is more productive enjoys .

a higher standard of living -1 may have a higher rate of economic growth
-

Figure 5.12
pl

µ
→
socially optimum quantity Qopo given by the point where MSB Msc
, ,
-
-

g : mpg Msg
-
-

→
quantity produced by the market is given by MPB :
MPC
Pope - - - - -

since
→
Qopt > Qm , the market under allocates resources + too little
1 I
,

rmns.rs - wneont.it:7?Yaispo7iIiduIYonsumpiionexternaii - n' the tree market

l benefits
/
l
l underallocates resources to the production of the good 1- too little of it is
l l
l
l
p Mpb -
- produced relative to the social optimum -
shown by Qm l Q opt
o
#
Qm Qopt Q -
In general , positive externalities whether (production consumption) lead

to an under allocation of resources and therefore to under provision .

FIGURE 5.12 positive consumption externality

The welfare loss of positive consumption externalities

( at welfare loss lbs welfare loss in relation to consumer -1 producer surplus ( supplementary material)

if§
p p

§iii.
s Mpc MSC s Mpc MSC
- -
- -
- -
- -

welfare welfare
loss a loss

I if

:
I
#
D= MPB
Ms B
l
l
l
'
l
l

l
l
l
l
'

#
G l
l
l
'
iii.
l
l

l
I
,
l
'
'

D= MPB
MSB

O o
Qm Q opt Q Qm Q opt Q

FIGURE 5.13 Welfare loss ( dead weight loss ) in a positive consumption externality
-
welfare loss

→ difference between Mlb -1 MSG curves for the amount of output that is under produced relative to the social optimum
IQopt -

Qm)
→
represents loss of social benefits due to underproduction of the good
→ It this externality were corrected , society would gain the benefits represented by the shaded area

-
welfare loss in relation to consumer -1 producer surplus ( supplementary material)

→ in market equilibrium
↳ consumer surplus btd
-

-
 ↳ producer surplus g -
-

external benefits ate

-

↳ -

↳ total social benefits

-
-
consumer surplus -1 producer surplus -1 external benefits -_ btdtgtate

→ at the social optimum

↳ consumer surplus atbtc
-
-

↳ Producer surplus -
-
dtetf -19
↳ external benefits :O

↳ total social benefits : consumer surplus -1 producer surplus : atbtotdtetftg

→ total social benefits at social optimum are greater by areas off

↳ o it
-

is the welfare loss that arises when production occurs at market equilibrium as a result of an

under allocation of resources due to the positive consumption externality

-
negative externalities ( production -1 consumption where Qop+LQm
-
-
welfare loss triangle points to the left

positive externalities ( production -1 consumption) where Qopt > Qm

-

-
welfare loss triangle points to the right

The case of merit goods

-
goods held to be desirable for consumer + under provided by the market
-
reasons for under provision :
o) The good may have positive externalities
→ too little is provided by the market
→ ex : education immunization programs ( benefit
. not only those who have received them but also the broader

population by wiping out a disease )

01 LOW levels of income -1 poverty
→ some consumers may want certain goods nervine but can't afford to buy them due to their low incomes
→ since they're willing but unable to buy their Mdiv demand , is not accounted for -
making market demand too low
→
ex : healthcare services medicines , education -1 , recreational facilities

o) consumer Ignorance

→ consumers may be better off if they consume certain goods -1 services but they may be ignorant of the benefits -150

don't demand them

→ ex : preventive healthcare ( immunization , annual health check ups ) can prevent serious diseases but lack Of
-

knowledge
about the benefits may lead consumers to demand too little of these services

correcting positive consumption externalities

(al legislation or advertising lb) Direct government provision

f
p p
5. MPC MSC
-
-
5- MPC MSC
-
-

Stgovt provision

':
l
l
l
i
l
l

l
l

g
l
l
l
¥÷÷÷: Di MPB
-
-
Po - - - - - - - -
l

t
l
l
l
- - - - -
l
l
l
y
l D MPB
-
-
MSB

, l
l l
#
O o#
Qm Qopt Q Qm Qopt Q

101 Granting a subsidy

¥¥÷xiet
i
P s mpoimsc Legislation
-
- -

→ can be used to promote greater consumption of goods w/ positive

Mpo
-

subsidy externalities

%:p::: nptnesanaieienisamgtiontnatmaneseaucaiion
→

l l
R - - - - - - -
f - - - -
to MSB
↳ demand for education increases
l l D MPB
-

Figure 5.14cal :D , MPB shifts to the right ' upward

-

↳
-

l l
-

#
Qm Qopt Q ↳ Ideally it will shift until it reaches the MSB curve , where

FIGURE 5.14 correcting positive consumption externalities Dr : MSB -1 Qoptis produced -1 consumed
 -
Advertising
→ govt I can use advertising to try to persuade consumers to buy more goods w/ positive externalities
→ ex : govt s can try to encourage the use of sports facilities for improved health
→
objective : to increase the demand for such services

→ Figure 5.14 la ) :
D , shifts to b z
-
-
MSB Q opt is , produced t consumed while price increases to popt
↳ same as WI legislation
-

Direct government provision

→ govt are frequently involved in the direct provision of goods +
services w/ positive consumption externalities
→
ex : public provision of education t healthcare in virtually all countries in the world

↳ education t healthcare are merit goods w/ external benefits so large that it's widely believed that they mush 't

be left to private sector provision alone

↳ In most countries where there's govt provision of healthcare t education , there is also private sector provision of these
services
→
Figure 5.14 Cbl : increases supply -
shifting s rightwards / downwards to St govt provision

↳ to achieve the social Q opt the , new supply curve must intersect MPB at the level of Output Qopt

↳ at the new equilibrium price falls to

, Po , Q opt is produced t al locative efficiency is achieved

↳ Pc ¥ Popt ; it lies below the Popt

-
subsidies
→ has the same effect as direct govt provision
→ Figure 5.14 lol : results in increasing supply t shifting the supply curve rightward I downward

↳ same as Figure 5.14lb)

↳ it subsidy =
external benefit , the new supply curve is Mpc -

subsidy t it intersects MPB at the Popt level of output

↳ price falls from Pm to Po , Qopt is produced t all ooative efficiency is achieved

-
correction of positive consumption externalities involves either increasing demand t shifting the MPB curve towards the MSB
curve through legislation , advertising ; or increasing supply t shifting the Mpo curve downward by direct govt provision
or by granting a subsidy
-
Both demand increases t supply increases can lead to production t consumption at Qopt -1 the achievement of al locative

efficiency
-

The price paid by consumers increases when demand increases t falls when supply increases
-
All methods are intended to increase the amount of the good produced t consumed , as increased consumption of such

goods is held to be desirable for society

Evaluating policies to correct positive production +

consumption externalities
-

Direct govt provision -1 subsidies

→
widely used to deal w/ positive consumption externalities t to a lesser extent also, w/ positive production externalities
→ v effective in increasing the quantity of the good produced t consumed

→ have the added advantage of lowering the price of the good to consumers (although Popt is not achieved )
→ difficulties in achieving the optimum results where Mso : MSB
↳ involves the use of govt funds that rely on tax revenues

↳ govt have many possible alternative uses for these funds each , of which has an op cost

↳ it's not possible for the govt to directly provide I subsidize all goods t services w/ positive externalities -
hence ,

choices must be made on :

(at which goods to support

( b) by how much they should be supported

↳ Ideally , choices should be made on the basis of economic criteria which would specify the amount of social
,

benefits expected in relation to the cost of providing -

the objective being to maximize the benefits of

each good -1 service to be provided dubs i dined for a given cost

↳ in practice , it's rlly difficult to measure the site of the external benefits -
I therefore to calculate precisely which

goods -1 services should be supported t

the level of support they should receive

→ often highly political in nature , as different groups compete w/ each other over who will receive the most benefits

↳ govts are often susceptible to political pressures -1 sometimes make choices based on politics rather than econ criteria
 → In the real world it's very unlikely that govt s are able to shift the MPC
. or MPB curves by the amount necessary to

correct the positive externalities

-
Legislation -1 advertising

→ subject to similar limitations concerning calculating the size of external benefits

→ can only be effective sometimes
→ can only help shift the MPB curve in the right direction rather than achieve a demand increase that will bring

the economy to the Q opt level Of output

→ can have v positive effects in certain oases
↳ ex : legislation requiring schooling up to a min ago , advertising on the importance of good nutrition
→ in other cases , can be ineffective

↳ ex they can 't on their own increase

:
consumption of health care services + education to the optimum level
→
have the further effect of raising the price of the good to consumers , which may make the good unaffordable

for some consumer groups

→ can be used more effectively it they're implemented together w/ direct provision -1 subsidies

↳ ex : compulsory schooling up to a certain age l legislation) goes together w/ direct govt provision
-
Test Your understanding 5.6 -

1 ( al ( b) The equilibrium quantity determined by the market is less than

pi
.

the socially optimum quantity ( Q m C Q

welfare S : MPC Msg opt )
-
-
.

> loss

÷÷÷÷÷÷i÷÷÷÷÷÷:÷÷÷÷÷:::::*::::c:::::
"

..
l l l external Id ) The welfare loss represents the external social benefits that are lost
l l
benefits
l
l
l l
l
due to the misallocation of resources that leads to under provision Of
l
D MPB l -
-
goods ( not enough of the good is produced) .

o
#
Qm Q opt Q

z .
Consumption of education (going to university ) healthcare services ( going to annual checkups , getting vaccinated when needed )
,

3 .
Consumption of education : Governments can subsidize private schools or directly provide public schools -
increasing the supply of

education and decreasing the price of education for consumers Governments can also enact .
a

legislation that makes education , compulsory up to a certain age or it can advertise schools -

increasing the demand for education by informing and educating the consumers , although

this increases the price of education Both these methods

.
can lead to al locative efficiency it

production and consumption is done at Q opt and the external benefits are fully eliminated .

consumption of healthcare services : Governments can directly provide healthcare services ( public hospitals , free vaccination programs ,

small public clinics, programs that out costs for low income consumers ) or subsidize
-
private ones -

lowering the cost for consumers whilst increasing supply Governments also .
can advertise the

use of healthcare services or enact laws that make them compulsory ( vaccinations , annual

checkups) -
increasing demand although increasing the price of such services for consumers .

Both these methods can lead to al locative efficiency it production and consumption is

done at Q opt and the external benefits are fully eliminated .

4. a positive consumption externality refers to spillover benefits created by consumers due to the consumption of certain goods and

services while a positive production externality refers to external benefits created by producers due to the production of goods
and services A positive consumption externality creates
.
a gap between MPB and MSB , as it involves the demand curve while .

a positive production externality creates a gap between Mpo and Msc as it centralizes on the supply curve .

5 .
(a) Merit goods are goods held to be desirable for consumers and are usually under provided by the market due to

various reasons Some of these reasons include consumer ignorance on the benefits of the
.
good i low levels of Income and

poverty that prevent low income consumers from acne sing and buying the good ; and the presence of positive externalities that
-

create spillover benefits that discourage the supply and demand for such goods .

(b) The underprovision can be corrected by enacting laws or advertising to encourage the consumption of such goods -
increasing

demand by shifting MPB closer to Msb It can also be corrected by direct government provision of such goods and services
.
or

by granting subsidies to increase the supply of such goods All these measures can lead to .
production and consumption
 at the socially optimum quantity to opt) -

correcting the over provision and achieving all ooative efficiency .

6 . Governments can enact laws to make the consumption of a good (service compulsory in order to increase demand and reduce the

external benefits Governments also can directly

.
provide such good S1 services in order to increase supply and take responsibility of

the external benefits Moreover governments also can grant subsidies to create incentives for firms to
.
, produce more of such goods 1

services -
increasing supply and letting the subsidy accommodate for the external benefits .

7 .
Legislation can have very positive effects in certain oases ( example : legislation requiring schooling up to a minimum age , .

However, they can also be ineffective sometimes , as they can only help shift the MPB curve in the right direction rather than

achieve a demand increase that will bring the economy to the Q opt level of output They . also have the further negative effect
of raising the price of the good to consumers , which may make the good unaffordable for some consumer groups Hence . ,

they can be used more effectively it they're implemented together with direct government provision and subsidies Direct .

government provision and subsidies are very effective in increasing the quantity of the good produced and consumed They .

also have an additional advantage of lowering the price of the good to consumers (although Popt is not achieved ) There . are

also difficulties when achieving optimum results ( M SB MSC) , since it's

:
not possible for the government to directly provide or

subsidize all goods and services with positive externalities -

forcing them to make choices with opportunity costs These .

choices tend to be highly political in nature , as governments tend to be susceptible to political pressures and sometimes make

choices based on politics rather than economic criteria It's .

also really difficult to measure the site of the external benefits

and to calculate precisely which goods and services should be supported and the level of support they should receive .
 CHAPTER 5.5
Lack of public goods
Market failure and public goods
public goods vs private goods : rivalry t exo Iud ability

-
a private good has 2 characteristics

o) Riva Irons :
→ its consumption by one person reduces its availability for someone else

→
ex: your computer textbook . -1 clothes are rival rous bo when you buy them , another person can 't buy the same ones

0 ) EXO Md able

→ it's possible to exclude ppl from using the good

→ exclusion is usually achieved by charging a price for the good

→ if someone is unwilling I unable to pay the price he is he will not have the benefit
, of using it

-
a public good has 2 characteristics

o) Non rival vous : its consumption by one person doesn't reduce

-

consumption by someone else

o ) Non exam da ble : it's not possible to exclude someone from using the good
-

pure public goods are non rivalroust non ex und able - -

-

→
ex : a lighthouse , police force , national defence flood control , , non -

toll roads , fire protection

public goods and the tree rider problem
-

case of excl Uda ble goods

→ possible to prevent ppl from buying t using it by charging a price for it

those who don't pay the the price don't buy it don't get to use it
→ +

→ private firms have an incentive to provide ex and able goods bc they can charge a price for them 1- therefore can cover

their costs
case of non excl Uda ble goods
-
-

→ it produced by a private firm ppl could , not be prevented from using it even though they wouldn't pay for it
→
no profit maximizing firm would be willing
-

to produce a good it can 't sell at some price

→
market fails to produce goods that are non -
ex and able -
giving rise to resource misallocation , as no resources are allocated

to the production of public goods

-
public goods illustrate the tree rider problem occurring when people can enjoy the , use of a good w/o paying for it
-
free rider problem arises from non -
exo Iud ability : people can 't be excluded from using the good
-
public goods are a type of market failure be due to the tree rider problem private firms don't produce these goods : the
,

market fails to allocate resources to their production

Quasi public goods ( public goods that are not pure )
-

-
not private but not public
-
can be considered to be impure public goods

- are non rival rolls (public) t exc Md able

-
( private )
-
ex : public museums that charge an entrance fee + toll roads

→
exo ' ud able be consumers must pay to use them
-
since the price system can be made to work to exclude potential users , they could be provided by private firms
→ but they all have v large positive externalities -
justifying the need for direct govt provision
correcting the market 's failure to provide public goods

implications of direct government provision

-
bo market fails to allocate resources to the production of public goods , the govt must step in to ensure that public goods are

produced at socially desirable levels

-
public goods are directly provided by the govt , financed out of tax revenues -1 are made available to the public free of charge

( nearly free of charge )

-
govt provision of public goods raises some issues of choice about :

(a) Which public goods should be provided

(b) 1h What quantities they should be provided

 -
limited govt funds force choices on what public goods to produce
→ each choice has an op cost in terms of other goods that are foregone I sacrificed

-
govt must use economic criteria to decide which public goods will provide the greatest social benefits for a given amount of

money to be spent on providing the goods

-
govt face a major additional difficulty in calculating expected benefits in the case of public goods
→ w/ private goods that are provided I subsidized by the govt it's possible to make estimates of expected benefits by using .

the market price of the good

↳ market price reflects the benefits consumers receive -

revealing its value to consumers

↳ govt can use the market price of private goods w/ positive externalities to estimate benefits + their value to consumers

→ w/ public goods there's no market price bb they 're not produced by the market t have no price
-
govt must try to estimate the demand (privet of public goods through votes surveys
-
asking how much of a good would be

worth
→
Into is used in cost -
benefit analysis : compares the estimated benefits to society of a particular good w/ its costs

→ If the total benefits expected to arise from a public good 7 total costs of providing it =
good should be provided
→
benefits C costs -

-
good shouldn't be provided

→ It cost benefit analysis

-

indicates that a public good should be provided , MB t Mc are compared to decide the degree of

provision : public good should be provided up to the point where MB Mo -

-

-
costs of provision of a public good are easy to estimate
-
difficulties in estimating benefits :
→ difficulty arising w/ surveys : ppl who rlly want something tend to exaggerate its value
→ cost benefit analysis is
-
a v rough t approximate method used to make choices about public goods

-
Test Your understanding 5.7 -

1 .
la ) RivaIrons refers to the characteristic of a good Iser vice in which its consumption by one person reduces its availability for others .

Ex andable is also a characteristic of a good Her vice wherein it's possible to exclude certain consumer groups from using it .

(b) public goods (pure ones ) are both non -

exo Iudable and non rival vous -
meaning it's not possible to prevent people from using it

and availability doesn't decrease as consumption increases Quasi . public goods are ex dudable and non -

rival rout -
meaning
they can exclude possible users since they have a price yet their availability doesn't decrease
, with an increase in consumption .

Private goods are excl Uda ble and rivalrous -

meaning they can prevent people from using it due to the price charged on

potential users and availability may decrease with every additional consumption .

2 .
Examples of public goods include non -

toll roads lighthouse flood control national defense etc All these goods are pure public good S1
, . , , .

services since it's not possible to prevent someone from using them , since they're free of charge (non ex and able) and their
.
-

consumption by a person doesn't reduce their availability for others (non -

rival roust

3 . la ) Quasi public goods are impure public goods that lie in between pure public goods and private goods -
not really falling into

any Of these 2 distinctions (not public but also not private goods )

(b ) Quasi public goods are ex andable like private goods , as they have a charge ( price -
preventing certain consumer groups from using

them ( usually low income consumers) They're also non rival to us like public goods , since their consumption by one person doesn't
-
.
-

reduce consumption by others .

4 .
la ) public goods are a type of market failure because private firms don't produce these goods due to the tree rider problem .

The tree rider problem occurs when consumers can enjoy the benefits of a good without paying for them This is .
due to the

non -
exoMd able characteristic of public goods , where people can 't be prevented from using a good As.
a result , no

profit maximizing firm would be willing

-

to produce a good it can 't sell at some price -

meaning they don't have the

incentive to provide these goods Hence the market . ,

fails to produce goods that are non -
ex and able -
causing resource
misallocation , as no resources are allocated to the production of public goods .

5 . (at The government responds through direct provision -

meaning they directly provide for these goods by financing for them through

tax revenues They're also made free of charge I or at most charged very cheaply ) for the public to use
.
.

(b) Since the government 's funds are limited it's .

not possible to provide for all public goods Hence the government must make choices
. . on

which public goods to provide and in what quantities . Each choice has an opportunity cost of other alternative public goods that are

sacrificed . Such choices can also be highly political in nature , as governments tend to be susceptible to political pressures -
preventing

them from making choices based on economic criteria It's also very difficult for governments to calculate the expected benefits
.

that may arise from the provision of such public goods, since they don't have a market price Hence governments must try to
. ,
estimate the demand for public goods through votes surveys by asking how much a good would be worth This is then used in
.

cost -
benefit analysis to determine which public good to provide If the cost benefit analysis indicates that
.
-
a public

good should be provided , marginal benefit and marginal cost are compared to decide the degree of provision There .
are

many faults in this method since . it's merely a rough estimate and there's always the possibility of people exaggerating the

value of a public good due to their personal desire and need for such good .
 CHAPTER 5.6
common access resources and the threat to sustainability
common access resources 1- environmental sustainability

common access resources t market failure

-
The meaning of common access resources
→
resources that aren't owned by anyone

→ don't have a price

→ available for anyone to use w/o payment

→ ex : clean air, lakes, rivers , fish in the open seas, wildlife , hunting grounds , forests biodiversity fertility
, .
of soil that occurs in nature ,

open grazing land , ozone layer, stable global climate , etc .

-
why common access resources are a type of market failure
→ differ from any other kind of good 1 resource
→ possess a special combination of characteristics : rivalroust like private goods ) t non exo Iud able I like public
-

goods)
→ riva Irons

↳ Its use by some people reduces availability for others

↳ most goods are rival rous

↳ examples

o) If we use up clean air , there's less left over for others to use

o ) when we catch fish in the open sea , there are fewer fish left over for others to catch

o ) If we destroy the stability of the global climate it will not be available for use
, by future generations

→ non -
exo Md able

↳ not possible to exclude anyone from using it

↳ most good St resources are ex ol udable bc they have a price

↳ open access resources differ bc they have no price t anyone can use them w/o payment

→
The rivalry t non -
ex and ability characteristics of common access resources pose serious threats to the environment

→ Rivalry means that consumption by some reduces availability for others

→ Non exo Iud ability means that consumers 1- producers use them abundantly t often overuse them bb they have no price
-

→
overuse of common access resources

↳ When factories, home , or cars use fossil fuels that emit pollutants into the atmosphere or into oceans rivers -1 lakes, they
,

overuse a portion of these natural resources w/o paying for them

↳ some of these activities result in 07 one depletion . w/ harmful effects on life from the sun 's radiation (they overuse

part of the ozone layer )

↳ they also give rise to global warming w/ possibly devastating effects on agriculture , health -1 ecosystems

(overusing the benefits provided by a stable global climate )

↳ when fish are overfished , the fishing industry uses up an excessive amount of the global steak of fish t possibly
disrupts the marine ecosystem

↳ when forests are cleared to create land for use in agriculture 1 for the sale of timber by the lumber industry, there are

huge consequences in terms of loss of biodiversity 1- threats to wildlife t the ozone layer
↳ land is being overgrazed due to excessive grazing

↳ arable land is lost blot soil erosion 1- satin isation

↳ wildlife is endangered be of the destruction of natural habitats due to the en roach ment of settlers t agriculture
→ in all these cases , common access resources are used w/o payment, leading to serious environmental degradation -1 depletion
sustainability and common access resources
-
The meaning of sustainable
→ refers to the ability of something to be maintained I preserved over time

→
joint preservation of the environment +
the economy

↳ for the environment, it refers to environmental preservation ( lack of destruction)

↳ for the econ it refers to the preservation of humankind 's ability to

, provide goods t services to satisfy heads +
wants

in the future
 → problem of sustainability arises boot conflicts between environmental t economic goals
↳ economic goals involve efforts to increase the quantities of output produced t consumed

↳ to busing on economic goals while disregarding the environment may result in its irreversible destruction

↳ environmental goals involve the preservation of the environment

↳ focusing on environmental goals while disregarding the economy may result in humankind 's inability to satisfy needs + wants

→ sustainable development : development that meets the needs of the present w/o compromising the ability of future generations

to meet their own needs

↳ involves striking a balance between environmental t economic goals so that both can be satisfied into the future

↳ this means that societies should pursue economic growth that doesn't deplete Ide grade natural resources so that future

generations will not have fewer flower quality natural resources to satisfy their own needs
-

→ sustainability refers to maintaining the ability of the environment 1- the economy to continue to produce t satisfy needs -1 wants

into the future

→
sustainability depends crucially on preservation of the environment over time
-
The maximum sustainable yield of common access resources ( supplementary materials)

( at lb)
18 a

#
• constant decreasing absolutely
•
=
16 u average average decreasing
+ . I yield yield yield
S o
S 14 constant decreasing I

affiliating
.
..
age.mg
.
era.
¥
. .

:/
X S
O
g •
I
I o
sustainable unsustainable
¥ resume
" "
tiene
I
-

° O
1234567T #
maximum sustainable yield
number of fishing boats
number of users of open access resources

FIGURE 5.15 Illustrating sustainable t unsustainable resource use

→ fish in the open seas are a common access resource that anyone has access to w/o payment

→ yield refers to the amount of output

→
Figure 5. Il la )

↳ constant avg yield : boats 1,213 each batch 4 tonnes

↳ decreasing avg yield : each boat brings back a smaller amount of fish than the previous one

o ) 4 boats have caught 15 tonnes w/ an avg yield of 3.75 tonnes

o) 5 boats total of 17 tonnes w/ an avg yield of 3.4 tonnes

o ) 6 boats total of 19 tonnes w/ an avg of 3.2 tonnes

↳ absolutely decreasing yield : as more t more boats go fishing the total

, amount of fish they bring back becomes less +
less

↳ the fish were plentiful for the first 3 boats but w/ the addition of the 4th , fishing became more
,
difficult bc it began to
put pressure on the supply of fish in the ocean

↳ as the supply of fish was more t more depleted , it became increasingly difficult to catch fish , so the avg quantity of fish

brought back fell w/ the addition of each boat

↳ WI the addition of the 7th boat , the fish supply was overused ; the fish population was no longer able to reproduce itself -1

therefore the quantity of fish in the ocean began to drop

→ Figure 5.15lb)
↳ point of Max yield of a common access resource
-
-
resource 's Max sustainable yield : the Max use that can be made of the

resource that is also sustainable in that the resource can . reproduce itself

↳ all points to the left of Max sustainable yield indicate sustainable levels of use

↳ all points to the right indicate unsustainable use -

meaning that the resource is being depleted I degraded

↳ the further to the right the greater the resource depletion degradation
,

→ In the real world , many open access resources are used un sustainably (to the right of their Max sustainable yield )
→ sustainable resource use means that resources are used at a rate that allows them to reproduce themselves , so that they
 don't become degraded / depleted
-
Test your understanding g.S -

I .
Fish in the open seas : when the fishing industry overfishes and overuses the global stock of fish -

disrupting the stability of the

marine ecosystem

stable global climate : when factories cars pollute the environment , they overuse the benefits of a stable global climate -
giving
rise to climate change and global warming

Forests : when forests are cleared too excessively (deforestation ) to create land for agriculture , to expand infrastructure or for the .

sale of timber -
leading to the loss of biodiversity and threatening the ozone layer and wildlife

open grazing land : when land is being overgrazed due to excessive grazing

2 .
(as common access resources are rivalvous like private goods , but non -
exandable like public goods Their .
use by some people

reduces availability for others ( rivalvous ) , and they're often used abundantly because they're free of charge (non ex ol U da ble) -

(b) Their lack of a price allows anyone to use and overuse -

justifying why they're non ex and able ,
-

since it's not possible to

exclude certain consumer groups when they're available for anyone to use without payment .

(c) The lack of a price allows people to overuse such resources -

possibly leading to the degradation and depletion of the

environment if they're used excessively The lack of a price fails to limit the use of these resources
.
-
posing a threat to the

environment

3 .
Common access resources are a type of market failure , since the lack of a pricing mechanism for these resources means that they

may be overused 1depleted I degraded as a result of the various activities of producers and consumers who don't pay for the resources

they use This poses

.
a serious threat to sustainability Hence , the market fails to prevent the environmental degradation and depletion
.

caused by the excessive use of common all less resources due to the lack of a pricing mechanism to deal with their non -

exclnotable

and rivalrow characteristics .

4 .
Sustainability refers to the maintaining the ability of the environment and the economy to continue to produce and satisfy humanity 's

many needs and wants into the future It involves the.

joint preservation of the environment and the economy in order to not

jeopardize the ability of future generations to satisfy their own needs and wants since sustainability highly depends
. on

environmental preservation over time .

5 . la ) open access resources tend to be overused since they're free of charge This is due to the
. activities of producers and consumers

that are driven by their own selfish desires -

prioritizing their own private benefit and not considering the repercussions or

social costs of their actions Our self interested behavior drives us to overuse such resources
.
-
-

possibly leading to shortages in

key resources essential to human survival

(b) Cutting down a small amount of forest accentuates the small scale of the activity and how it isn't overdone or done

excessively In addition to that it being done over

.
, an extended period of time allows the forest to regrow in its own pace -

again highlighting how this isn't done excessively nor frequently .

Distinguishing between the ' pollution of affluence 1 and the ' pollution of poverty
'

-
pollution of affluence

→ environmental degradation that is the by-product of production t consumption activities resulting from increasing quantities of

output produced t consumed ( economic growth )

→
arises mainly from industrial production I
-
high income consumption patterns
-

→ involve the heavy use of fossil fuels , using up open access resources like clean air , rivers , takes
→ lead to climate change

-
pollution of poverty

→ occurs mainly in developing countries

→ arises from production t consumption activities that are due to poverty
→ due to economic activities pursued by v poor people in an effort to survive

High income production and consumption based

-
on fossil fuels as a threat to sustainability
-
the overuse of common access resources and their degradation depletion are the external costs of industrial production t high income
-

consumption activities , both based on the use of fossil fuels

-
involves negative production externalities -
difference between M Po t m so can be interpreted as :

→ the social cost arising from a factory 's overuse of clean air, water, sea life , and ozone layer on account of its dependence on

fossil fuels
→ the cost to society of causing global warming ( destroying the stability of the global climate)
 -
the burning of fossil fuels creates external costs in terms of overuse of common access resources

-
if it were possible to make the factory ( parties involved ) pay for the overuse of these resources, the producer wouldn't necessarily stop

its polluting activities entirely I wouldn't stop using common access resources
-

→ however, it would stop them from overusing such resources -

thus leading to a sustainable use of common access resources

-
Figure 5.2 : the overuse of any common access resource as a negative production externality

→ ex : Mpo represents the private costs of a fishing firm that fishes in the open seas

→ external costs : depletion of the stock of fish environmental damage due to disruption of the marine ecosystem , or the common
.

access resources that the fishing firm has overused but not paid for

-
Figure 5.6 : overuse of common access resources can also result from negative consumption externalities
→
ex : Mpb represents the demand for heating oil
→
MSBL MPB : external cost like the overuse of clean air

poverty as a threat to sustainability

-
Brundtland Report coined the term sustainable development ' '

-
according to the Brundtland Report , poverty is the most important cause of environmental destruction , due to the overexploitation by
poor ppl of their soar be environmental resources

-
poor ppl lack modern agricultural inputs t being too poor to buy inputs that preserve the soil 's fertility , they deplete the soil 's natural

minerals -
making soils less productive
-
poor ppl usually have higher birth rates t higher population growth -
creating pressures for them to open up new lands for agriculture
-
w/ suitable agricultural land becoming increasingly scarce , they cut down forests ( deforestation in search of new farmland ; they

move to fragile lands in mountains t hills -

causing soil erosion ; and they overgraze animals on pasture lands -
depleting nutrients
-
poor ppl have limited abilities to borrow to finance the purchase of inputs

→ this works against their ability to make improvements in sanitation irrigation improved agricultural inputs
, . t land improvements

→ this prevents the reverse 1 reduction of environmental degradation

-

Figure 5.2 : the production t consumption activities of v poor ppl that endanger the environment t sustainability can be interpreted as

negative externalities involving the overuse of common access resources

→ ex : Mpo represents the farmer's private costs of farming

→
difference between mpotmso : the overuse of forests that have been cleared for agriculture or the overuse of soil leading to

depletion of nutrients
-
the threat to sustainability lies in the increased scale of economic activities around the world which , may be due to economic growth

based on the use of fossil fuels ; or it may be due to the increasing numbers of v poor ppl who engage in environmentally destructive
activities in an effort to survive

-
whereas the pollution of poverty occurs mainly in developing countries this isn't to say that , developing countries aren't guilty of

creating '
'
some pollution of affluence

→
increasingly the pollution , of affluence arises also in developing countries that grow by engaging in industrial production t

consumption activities w/o regard for the environment

A note on renewable t non -

renewable resources + sustainability
-
non -

renewable resources : resources that don't last indefinitely bc they have a finite supply
→ they need tens of thousands of years to reproduce themselves

→ ex : metals minerals , fossil fuels ( oil natural gas , coal )

,
.

→
many of these resources I except fossil fuels ) don't get destroyed to their use , and so through effective recycling could be

made to last indefinitely

→ by contrast , fossil fuels are destroyed when used

↳ have devastating effects on the earth's atmosphere the global climate ,

, t the ozone layer

-
renewable resources : resources that can last indefinitely if they 're managed properly ( not overused ) bb they're reproduced over

relatively short periods of time by natural processes

→ ex : forests , wildlife , fish biomass , , water resources, geothermal power , soil fertility biodiversity
,

-
sustainable resource use applies mainly to renewable resources
→
given appropriate management , these resources can be made to last forever

→ through mismanagement I overuse these resources become depleted . t

degraded -
indicating ansustainability
 -
sustainable resource use doesn't apply to non -

renewable resources like fossil fuels

→ it resources are non -

renewable they could be used sustainably only if they weren't used
, at all

→ sustainability is relevant to fossil fuels when referring to the negative production externalities that are created by their use

- Test your understanding 5.9 -

l .
The increasing scale of production and consumption activities threaten the environment , which may be due to the economic growth

based fossil fuels ( ' pollution of affluence ) ; increasing population site

'
on the use of or it may be due to the of poor people that

continue to engage in environmentally destructive activities in effort to survive l pollution of poverty ) Industrial production and
' '
an .

high income consumption activities based on the use

-
of fossil fuels both involve the overuse of common access resources that can

lead to environmental degradation and depletion Burning . fossil fuels lead to global warming , climate change , acid rain air pollution , .

etc .
-

destroying the Earth 's stable global climate by emitting greenhouse gases into the atmosphere and depleting the ozone layer .

increasing rates of poverty also lead to the overexploitation of common access resources that can lead to environmental destruction .

Their activities done to survive can lead to soil erosion , deforestation overgrazing etc . , .
-

as they lack the finances and agricultural

inputs to sustainably develop .

2 .
The overuse of common access resources can be interpreted as negative Negative production externalities :

f-
externalities arising from both production and consumption activities It .
P M so

can be interpreted as a negative production externality For example , it .

MPO represents the private costs of the mining industry then the , pom -
stettnnpo

a.:::::c:: :::: :: ::::::: ::::::: :::S:::::::*: :: it:c

it "

. mi . .
l l
contaminations of the soil , groundwater, and surface water environmental ,
l l
D MPB MSB l
pollution , acid rain , climate change , deforestation
- -

The overuse l
- -

, etc . can also

#
o
negative consumption externality For example : it Mpb Qopt Qm Q
be interpreted as a .

represents the demand for diesel cars , the external costs represented by the Negative consumption externalities :

!
difference between MPB and Msc ( MPB ) MSB ) be the environmental

X
can p
s MPO : MSC
-
-

impact of the overuse of diesel or cars in general The overuse

. can lead to

air pollution and can even lead to climate change due to the emission of 002
pm - - - - - - - -

mwoYYaheofitsmsofagygmgo-ad.fi?mtinfe!
thinning the ozone layer and robbing the ma ,
pop

I f D= MPB
l
l
l Ms B
#
o
Q opt Qm Q

Government responses to threats to sustainability

Legislation
-
laws 1- regulations intended to limit threats to sustainability

typically involve emissions standards , quotas , licences permits , , or outright restrictions

-
examples :

→ restrictions on emissions from cars

→ requirements for oars to use catalytic converters to reduce air pollution

→ restrictions on emissions from factories + industrial production

→ requirements for steel mills t electricity generating plants to install smokestack scrubbers to reduce emissions

→ banning the use of harmful substances (ex : asbestos )

→ restrictions regarding hunting seasons t hunting areas

→ issuing licences or permits for particular activities I like hunting)

→ prohibiting construction ( like housing ) or industry or agriculture in protected areas

→ restrictions on quantity of logging

→ restrictions in the form of quotas for fishing Imax permissible quantity of fish that can be caught) or in the form of the size of

shipping fleets . or total bans for specific areas or specific times of the year

→ establishment of protected areas for the protection of biodiversity +

endangered ecosystems
 -
advantages
→
simple to put into effect and oversee

→
can be quite effective
↳ ex : restricting car emissions banning the use of harmful substances restrictions
, ,
on hunting logging
,
-1 fishing and
,

establishment of protected areas

↳ In the case of emissions of industrial production , they avoid the technical difficulties that arise in the use of market -

based solutions t force polluters te out emissions

-
limitations
→
in the case of emissions of pollutants , they don't otter incentives to reduce emissions to increase energy efficiency , , t to

switch to alternative fuels ; and they can 't distinguish between high t low cost polluters , which would limit the overall

cost of reducing pollution

→
involve costs of monitoring t supervision to detect possible violations
-
overall the effectiveness must be assessed in relation to the particular use for which it is intended , as
. it can be more effective

in some situations than in others

carbon taxes versus cap + trade schemes

-
the single most pressing t complex threat to the global ecosystem is global warming
→ caused by the emissions of greenhouse gases

→ most important : CO2

→
gases emitted by manmade processes specifically by the burning ,
of fossil fuels toil , coal , natural gas I

→
tremendous uncertainty in calculating the precise contribution of each of the manmade greenhouse gases to the increases

in global temp

-
measures to deal w/ carbon dioxide emissions :

⑦ carbon taxes

② Capt trade schemes

-
carbon taxes
→ a method to reduce emissions of CO2 , emitted when fossil fuels are burned
→ aims at taxing the use of fossil fuels in accordance w/ the amount of carbon each one emits

→ fuels that emit more carbon are taxed at a higher rate than those emitting less carbon

→ since the tax varies wi carbon emissions , fossil fuel users face the incentive to switch to fuels that emit less carbon 1 no carbon

(non fossil fuel energy sources)

-

→ Figure 5 5lb)
-

↳ external costs become smaller as a result of using less polluting fuels

↳ optimum quantity of the good produced increases

→ some countries have introduced carbon taxes

↳ Denmark Finland , France , Ireland Netherlands , Poland , Sweden

, .

↳ some States in Canada t us

-
cap and trade schemes

→ refer to tradable permits

→ impose a cap Imax amount) on the total amount of 002 that can be released by producers into the atmosphere
→ permits to release co , are distributed to producers 1- they can be bought t sold in a market

→ may be set up in a country or within a group of countries ( European union Emissions Trading system) or globally ( Kyoto Protocol)
-
Evaluating carbon taxes t cap and trade schemes

→ as market
-

based methods both provide incentives to firms to switch to less polluting forms of energy
.

↳ carbon taxes fix the price of the pollutant in the term of a tax on carbon t allow the quantity of carbon emitted to

vary depending on how firms respond to the tax

↳ cap +
trade schemes fix the quantity of the permissible pollutant t allow its price to vary depending on supply t demand

→ most economists prefer carbon taxes for various reasons :

o) carbon taxes make energy prices more predictable

↳ fossil fuel prices in global markets fluctuate according to demand 1- supply

↳ under Capt trade schemes , the price of fossil fuels might fluctuate even more due to fluctuations in the price of carbon
 ↳ since carbon taxes fix the price of carbon emissions , the price of fossil fuels is likely to be relatively more predictable
↳ price predictability is important for businesses that need to plan their costs ahead of time

o) carbon taxes are easier to design t Implement

↳ cap I trade schemes are difficult to design t implement as they involve complicated decisions : setting the cap at the
-

right level t distributing the permits among all interested users

↳ carbon taxes may be simpler to design t use

o ) carbon taxes can be applied to all users of fossil fuels

↳ cap -1 trade scheme proposals often target one particular industry Is mall group of industries

↳ carbon taxes can be applied to all users of fossil fuels, including all producers t consumers

o ) carbon taxes don't offer opportunities for manipulation by governments + interest groups
↳ politicians often prefer Capt trade schemes bc it's easy to manipulate the distribution of permits for the benefit of

preferred groups 1- supporters w/o affecting the impacts on the environment Ibo of the cap )

↳ carbon taxes don't allow for such manipulation

o ) carbon taxes don't require as much monitoring for enforcement

↳ Capt trade schemes require monitoring of emissions , otherwise firms may try to cheat by emitting more pollutants

than they 're permitted

↳ carbon taxes are easier to monitor as they only involve payment of a tax depending on the type -1 quantity of fossil

fuels purchased

o ) Capt trade schemes face strong political pressures to set the cap too high

↳ It the cap on pollutants is set too high it would have

. a very limited I no impact on reducing carbon emissions

01 Carbon taxes are less likely to be used to restrict competition between firms

↳ some firms could buy up more tradable permits than they actually need
-
driving up their price in an effort to

keep new firms from entering the market (as a result restricting competition )
→ arguments in favor of Capt trade schemes

o ) carbon taxes MAY be too low

↳ govt s may be unwilling to set carbon taxes high enough for these to provide the necessary incentives for users to

switch to less polluting energy sources

o) carbon taxes can 't target a particular level of carbon reduction

↳ since carbon taxes can 't fix ( or Capt the permissible level of carbon emissions they lead to uncertain carbon ,
-
reducing
outcomes

↳ cap t trade schemes work by fixing the total amount of the permissible carbon emissions

01 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 high
- -

income earners t go against the principle of equity

↳ a carbon tax on a firm is an indirect tax whose burden ( incidence ) falls on both producers 1- consumers

↳ a carbon tax will affect lower Income consumers more than higher income consumers
-
-

01 Carbon taxes must be adjusted for inflation

↳ during periods of Inflation ( rising price level ) , the market will automatically result in rising prices of tradable permits

according to supply + demand , which is an advantage

↳ in the case of carbon taxes , an upward adjustment would have to be decided on by the govt ( or international body)

which could be politically +

administratively more difficult

Funding for clean technologies

-
The need for clean technologies

→ clean techs aim toward a more responsible t productive use of natural resources which also reduce negative environmental

impacts
→ include wind power, solar energy , biofuels , geothermal energy nuclear power , energy storage (development
. of fuel cells ) , fuel

efficiency ( less waste in use of energy) , recycling , etc .

→ many of these techs are alrdy available to reduce carbon emissions

↳ using more efficient use of fossil fuels (avoiding waste in their use )

↳ use of low or no emission power generation methods : wind power solar power
-
-
,
 → v large potentials of these approaches aren't realized
→ there aren't enough appropriate policies that promote their use

↳ regulatory t market based-

policies
↳ a more rational use of subsidies
→ despite the increase in the use of the existing techs they ,
can 't bring carbon emissions to acceptable levels on their own

↳ there is an urgent need for the development of new techs that can be adopted by countries around the world on a large

scale to prevent unacceptable increases in global temps

-
Funding for clean technologies
→ govt t private firms need to be involved in activities leading to innovation t development of low -
emissions techs t

environmentally friendly sources of energy

→ funding for these activities is barely sufficient

→
according to the World Bank 's "
World Development Report
"
2010 :

↳ "
today 's global efforts to innovate t diffuse climate smart techs fall far short of what is required for significant
-

mitigation t adaptation in the coming decades "

↳ "
Investment in research development demonstration,
. ,
+
deployment (RbDt b) is lacking
"

↳
"
neither public nor private funding of energy related research is
-

remotely close to the amounts needed for transitioning

to a climate smart world

-
"

govt energy RD lb budgets have declined since the early 19805 falling by almost half from 1980 to 2007
"
↳ " global -
,

→
govt spending on energy RD t b as a % of govt spending on total Rbtb tell from over 20% in 1980 N less than 4010

in 2007

→ private sector spending on energy Rbtb estimated at , $40 billion to $60 billion a year, is far greater than public sector (govt)

spending of about $7 billion a year ( in 20071

↳ within the private sector spending . on energy Rbtb isn't a high priority as it represents
, a mere 0.5% Of revenue ,

compared w/ solo of revenue spent on Rb -1 D in the electronics industry t '

5% of revenue in the pharmaceutical

sector

→ boot the far greater resources at their disposal , developed countries have been playing a leading role in climate smart
-

tech development
→ some developing countries have begun to play a more active role

↳ they contribute 230 lo of new investments in energy efficiency t renewable energy in 2007 compared to 13010 in 2004

↳ most of these investments were concentrated in 3 countries only : Brazil , China , India

→ funding for clean techs clearly has op costs

↳ however , given its urgency govt should make

, a greater effort to allocate resources to tech innovations in this area . t

should also make efforts to promote private sector funding 1- participation

Eliminating environmentally harmful subsidies

-
when environmentally damaging production activities are subsidized they , result in greater production -
leading to greater

environmental damage
-
subsidies to industrial forestry encourage commercial logging -
resulting in the destruction of forests

-
subsidies to the production of fossil fuel energy result in greater amount of fossil fuel production
-
consumption subsidies are commonly imposed on fossil fuel energy , agricultural inputs (fertilizers -1 pesticides ) t water

-
both production t consumption subsidies are often the result of policy failures -
involving the pursuit of a policy for one purpose

that creates problems in another area (environmental destruction)

-
subsidies should therefore be studied for their environmental impacts +
changed I eliminated accordingly
-
In the case of fossil fuels subsidies
. are often granted to :

→
promote the industrial sector by keeping costs down

→
promote international competitiveness of industrial products I make them less expensive in international markets through

lower costs of production)

→
support domestic fuel production to ensure adequate domestic supply

→ reduce reliance on foreign energy sources (for countries that are fossil fuel producers )
→
keep fuel prices down for consumers
-

effect of subsidies are entirely inconsistent w/ the pursuit of sustainable development

 figure 5.16

.g /, MfW
-

350 -
d → subsidies are concentrated mainly in developing countries since developed
,

300
countries have for the most part eliminated energy t petroleum subsidies
250
the world ma " " " " " nd' " und

!! !wn: ha! Ya often:YgYd

→
' te" innovation

joy
-

50

o. f
€ -

World World World

subsidies to subsidies to public
energy petroleum funding for
products energy Rtb
FIGURE 5.16 World govt spending on energy t petroleum
subsidies ton energy research t development

The role of international co -

operation
-
policies are made mainly by national govt

-
the overuse of common access resources often has international repercussions

→
this is why cooperation among govt is crucially important as a method of controlling t preventing negative consequences on certain

resources , such as global climate t the ozone layer

-
cooperation among govt is v important for the development t diffusion of new technologies intended to deal w/ global environmental

issues
-

cooperation may be global or regional

-
ex : the ozone layer has suffered ozone depletion . leading to reduced protection against the sun 's ultraviolet radiation
→ resulted from human activities involving the production of nitrogen oxides t chlorofluorocarbons ( CFCs)
→
the ozone layer is an open access resource : no one owns it t no one can claim damages for its destruction
→
the responsibility for its destruction lies w/ polluting activities within virtually every country t the consequences for its destruction
are felt globally
→ same applies for the global climate
-

Montreal Protocol

→ one of the most successful examples of international collaboration for the environment

→ signed in 1987 I
-

came into effect in 1989

→ intended to phase out substances that have caused depletion of the ozone layer

→ by 2009 all member States of the US had ratified agreement

. t significant progress has been made in the area of phasing out ozone -

depleting substances
-
Kyoto Protocol

→ less successful , major international collaborative agreement for the environment

→ 1997 -
2012

→ objective : to make signatory countries commit themselves to reduce emissions of 002 t other greenhouse gases over a period of 15

years to slow down the problem of global warming t climate change

→ also contained provisions for the development of a market of tradable emissions permits , according to which each participating
country was to be assigned certain pollution permits which it would be able to trade I buy -1 sell) w/ other countries

→
came under a lot of oritoism + hasn't been implemented in full

→ many environmental specialists argued that even if it were implemented , the agreed reductions in emissions were too small to have

a sufficient impact on the problem of global warming

→
there have been numerous discussions to the Kyoto Protocol , but nothing has emerged as of summer 2011

European union Emissions Trading system ( EU ETS )

→ a successful ex of a regional collaborative agreement

→ European union 's cap t trade scheme for carbon

→ initiated in Jan 2005

→ covers the sectors of power t heat generation oil refineries, metals pulp t paper, energy intensive industry
,
,

→ In this system , one permit , or EU Allowance IEUA) permits the holder to release one tonne of CO2

→ each emitter of carbon is allocated EU As which , are traded in a rapidly growing carbon market
-
Test your understanding 5.10 -

I
.
la) In the case of legislation ( restrictions and regulations) they're simple to , enact and oversee , as they avoid the technical difficulties faced

by market based policies by directly enforcing the regulation restriction They

-
. can also be very effective when dealing with some cases

( restricting car emissions hunting , logging fishing ; banning the use of toxic substances ; etc ) However this effectiveness highly depends
, .
. .

on the case 1 scenario , as they can be ineffective when dealing with some oases because they don't offer incentives to the parties

involved to change their ways and develop For example , in the case of
. emissions of pollutants , they don't offer incentives to reduce

emissions or to switch to alternative energy sources -

and they can 't distinguish between high and low cost polluters which could 've
-

limited the overall cost of reducing pollution Legislation also involves additional costs of monitoring and supervision to detect possible
.

violations -
which is an extra burden on government budget .

(b) Advantages of carbon taxes include the fact that they provide users with the incentive to switch to alternative energy sources ( non
-

fossil fuel energy sources ) which can increase the optimum quantity of a good produced by decreasing external costs When . compared

to cap and trade schemes carbon taxes have the advantage of making energy prices more predictable ( prevent price fluctuations of
, fossil
fuels ) , are easier to design and implement , can be applied to all users of fossil fuels ( both producers and consumers ) , prevent government

manipulation don't require

. as much monitoring ( easier to monitor as they only involve the tax payments , and are less likely to be misused

to restrict competition between firms which can cause unwanted repercussions However they .
,
also have the disadvantage of possibly

being ineffective it governments aren't willing to set a high tax to properly incentivize users They also .
can 't target a particular level of

carbon reduction -
leading to uncertain carbon reducing emissions ; are regressive (take -
a proportionally greater amount from those of

lower incomes ; and they also must be

-

adjusted for inflation by the government which . can be politically and administratively difficult .

lol cap and trade schemes create incentives for firms to cut back on the production that has negative externalities or to switch to

alternative methods in which it's unnecessary to buy permits This . allows the firm to sell excess permits whilst simultaneously
reducing the threat to sustainability It . also fixes the total amount of the permissible carbon emissions by setting a cap .
cap and trade

schemes also automatically adjust for inflation according to supply and demand However they can cause the already volatile
. , prices

of fossil fuels to fluctuate even more -

making it hard for firms to predict prices and plan costs ahead of time They also require .

the government to set a maximum acceptable level for each type of pollutant which demands technical information . on the quantities
of each pollutant that 're acceptable from an environmental perspective that's hard to find They also rewire the government .
to

establish a method to dis I tribute permits to polluting firms in

-
a fair way , since political favoritism often comes into play They're . also

limited to one particular industry and require additional costs of monitoring -

making them harder to implement .

2 . Most economists prefer carbon taxes because they make energy prices more predictable . are easier to design and implement can be .

applied to all users of fossil fuels , do not offer opportunities for manipulation by governments and interest groups , do not require as much

monitoring for enforcement and are less likely , to be used to restrict competition between firms .
Moreover , cap and trade schemes

also table strong political pressures to set the cap ( maximum acceptable level of emissions) too high, which will eliminate or reduce

the efficiency of this market -

based policy On the other hand , some also prefer cap and trade schemes because carbon taxes may
.

be set too low cannot target

.
a particular level of carbon reduction due to the lack of a cap that leads to uncertain carbon reduction

outcomes , are regressive loving against the principle of equity) , and they must be adjusted for inflation (making it harder administratively) .

3 . la ) It's crucial for both the public ( government) and private sector to allocate sufficient funds for the research and development of

clean technologies that will deal and reduce the many threats to sustainability , since clean technologies aim toward a more

responsible and productive use of natural resources which can significantly reduce negative environmental impacts Knowing the .

continuous deterioration of our planet , there's an urgent need for the development of new clean technologies that can be

adopted by countries around the world on a large scale in order to prevent the unacceptable increases in global temperatures

and to slow down the rate of climate change and global warming Hence given this urgency it's absolutely necessary for .
, ,

the government to allocate more resources to technological innovations in this area and to encourage and promote private sector

funding and contribution .

(b) The underfunding may be due to the lack of awareness on the urgent need for clean technologies -
meaning the very large

potentials of these approaches aren't realized It may also be due . to the lack of appropriate policies that promote their use

and encourage their development It's also due to the presence of .

opportunity costs that arise from their funding , as the government

and private firms prefer to use their funds elsewhere that will give them instantaneous results -
and that will be more beneficial

( private benefit) to them .

4 . Since the overuse of common access resources often has international repercussions that affect the entire global population,

international cooperation is crucially important as a method of controlling and preventing negative consequences on certain

resources , such as global climate and the ozone layer . International cooperation is necessary for the development and
 diffusion of new technologies intended to deal with global environmental issues For example the ozone layer has suffered ozone .
,

depletion that resulted from human activities involving the production of nitrogen oxides and chlorofluorocarbons ( CFCs) Since the .

ozone layer is an open access resource , the responsibility for its destruction lies with polluting activities within every country and

the consequences for its destruction are felt globally Hence , international cooperation is necessary to prevent I reduce the continuous
.

depletion of the ozone layer .

Real world Focus -

Business leaders in Australia debate carbon taxes versus cap and trade schemes

1 MSC M pot tax Both a carbon tax and a cap and trade scheme will raise the price consumers must pay ,
pp
-
. -

x /
as they too share the burden of the price increase in fossil fuels Due to the carbon
MM"
Y! ptypto
t" '

)
.

Po
tax and cap and trade scheme , product prices rise from Pm to
-

Po (Pm pm) due to the

i increase in the costs of production isin ve firms have to pay the tax or pay to buy the
Pm - -

necessary amount of permits, this wi , , affect Australia ,

.
international compeminences ,
l l
l as the increase in the firm 's costs of production that translate to an increase in
,
l
l D= MPB MSB -

product prices makes it hard for Australian firms to compete with the lower product
-
l l
#
O
Q opt Qm Q prices of other firms from other countries in the international market .

2 . ( at A carbon tax can help out carbon emissions by internalizing the externality The .
carbon Tax :
increase in the price of carbon fuel due to the tax increases the firm 's costs Pl Msc M pot tax
-
-

/
#
of production -
creating incentives for firms to switch to substitute, alternative (z

)T
energy sources with lower carbon emissions or no carbon emissions This will
. 5- MPC

cause the Msc curve to shift downwards to Msc , -

indicating that the external i i
Pm - -

costs of production are lower due µ +he use of us , pumping resources .

This also
l l
means that the tax is lower and Q opt will increase from Qopti to Qoptz as the l l
l
l
l l l D= Mp B MSB
site of the externality is reduced
-
-

.
l l l
#
O -

Qopt Qopt Qm Q
I 2

(b) cap and trade schemes : A cap and trade scheme also works by internalizing the externality setting .
a maximum level of

Pl s of tradable permissible carbon emissions creates incentives for firms to reduce their emissions or even te out
permits
/ it completely by prompting for alternative energy sources if they don't want to buy more

4¥
-

Pz - - -

permits that ill strain their budget and increase their costs of production The possibility to sell .

permits also creates incentives for firms to cut carbon emissions so that they can sell their

::::: :: : : :::::: aim:::iii.iii. iii. ai:::::i: :::c::mint::::::::: ::: :

" it " " "

. .

D 't
p,
-
and also try to cut emissions to gain profit from the selling of permits These permits .
out
÷
Q, Q carbon emissions by setting a cap and by encouraging producers to reduce or even substitute their

carbon emissions .

3 .
Some Australian business leaders may prefer cap and trade schemes because as long as the firm 's carbon emissions stay under or up to

the cap they don't have to pay additional costs It buy extra permits ) unlike taxes which
, , require them to pay regularly -
continuously
increasing their costs of production .
They also may prefer permits because in the long run , when it's possible for the firm to switch to

alternative energy sources they can sell their unused permits for profit They also may prefer cap and trade schemes since it can be
, .

more effective than taxes , knowing how the etteoienoy of taxes rely on demand and since the demand fer petrol is inelastic they may .

not be as effective in the long run .

 CHAPTER 5.7
Asymmetric Information
-
the competitive market mechanism presupposes that all firms t all consumers have complete info regarding products , prices , resources and methods
, of

production
-
however the real world is full
, of examples where firms, consumers , t resource owners are in situations where info is missing
-
asymmetric info refers to situations where buyers 1- sellers don't have equal access to into

→ usually results in an under allocation of resources to the production of goods -1 services

Examples where info is available to sellers but not buyers

-
sellers often have info about the quality of a good 1 service that they don't make available to consumers

-
sellers of used cars have info about the car 's quality that they're unlikely to reveal to potential buyers it the car has a defect

-
In a free t unregulated market, sellers of food could sell products that are unsafe for human consumption
→ possibly heading to illness t even death

-
sellers of meds could sell unsafe meds that could be ineffective 1 dangerous to human health

-
Indi vs claiming to be doctors , some of whom have little 1 no training could practice meds t even surgery ,
-
resulting in huge costs in terms

of human health t safety

-
in a tree unregulated market , the result is usually to underallocate resources to the production of the good 1service

→
consumers are likely to be aware of possible dangers to themselves + will be cautious about buying the good service -
resulting in a

lower demand t less production

-
H consumers are unaware of possible hidden dangers , such as w/ unsafe food 1 toys , there could result an over allocation of resources to the

production of these goods t services

possible government responses

-
Regulation
→ govts can pass laws -1 regulations that ensure quality standards t safety features that must be maintained by producers + sellers

of goods t services

↳ ex : food , meds , private schools , toys buildings , , t all types of construction

→ difficulties

↳ legislation t regulation are time consuming , bureaucratic procedures , which sometimes work to slow down economic activities
-

↳ ex : it takes a long time to test new meds t certify their safety -

t is also a v costly process
↳ regulatory t quality control activities have v large opoosts

↳ ex the case of
:
food safety control
↳ Involves not only food t beverage but also hygiene in restaurants

↳ there are a huge # of products -1 service providers involved who require regulation 1- monitoring from the level of the farm

( regarding the kinds -1 amounts of chemical inputs ) to the moment the food reaches the table
-
provision of information
→
govt can directly supply info to consumers I force producers to provide into -
thus protecting consumers in their purchasing
decisions
→
may include info about the quality of medical care by different providers about communicable diseases crime
, , rates by

neighbourhoods , health hazards related to different activities 1 products 1 substances , nutritional labelling on foods etc
, .

→ in some countries ( Europe) , govt provide fee so hods for services ( such as legal , medical , architectural ) to ensure that consumers

receive a particular quality of services for a particular range of prices

→ difficulties

↳ when the govt is the provider of info :

↳ collection x dissemination of all the necessary info to consumers

↳ accuracy of info

↳ opoosts in providing the info

↳ when a private seller , producer is the provider of info :

↳ serious questions whether info regarding all hazards in products 1 substances , materials used , and quality of services

(whether legal , medical financial etc ) is accurate t complete

, , .
 -
it is sometimes not possible to eliminate an info asymmetry between sellers -1 buyers , bo no matter what regulations t into are provided ,

there's still some room for the seller to hide some info from the buyer
→
in the areas of healthcare t law , doctors t lawyers have specialized technical info about their
, clients that the clients themselves
don't possess

→ doctors t lawyers often use this info for their own private gain by selectively revealing into to their clients that causes them to

demand more services than necessary

leads to supplier induced demand : demand that's created by the supplier which wouldn't have appeared if the client had equal
' '
→
-

access to info
-

Licensure
→ in the case of doctors , most countries have laws requiring doctors to be licensed

↳ a license can only be obtained upon proof of adequate medical competence

→
licensing is similarly required for many other professions in many countries

↳ ex : teachers , lawyers , plumbers , electricians

→ some economists criticise licensing
↳ It may work to limit the supply of people in a profession

↳ raise the price of their services t increase their incomes at the expense of consumers who must pay higher prices
Examples where info is available to buyers but not to sellers
-
often arises in the area of insurance services : buyer of insurance has more info than the seller

-
another ex occurs in the labor market

The problem of moral hazard t possible responses

-
Explaining moral hazard

→ refers to situations where one party takes risks but doesn't face the full costs of these risks

→ usually arises when the buyer of insuraranoe changes his/her behavior after obtaining insurance , so that the outcome works

against the interests of the seller of insurance

→ ex :

↳ buyers of our theft insurance may be less careful about protecting their car against theft bc they 'll be reimbursed it someone

steals their car

↳ some buyers of medical malpractice insurance ( doctors ) may be less careful about avoiding malpractice bc of the knowledge

that malpractice costs will be covered by the insurer

↳ unemployment insurance may lead some people to be less hesitant about becoming unemployed in the knowledge that .

their insurance will provide them w/ some income

→ in all those bases , the buyers of insurance have info about their future intentions that's not available to the sellers of insurance
→ in a free, unregulated market the result of , a moral hazard is to underallocate resources to the production of insurance services .

as sellers of insurance try to protect themselves against higher costs due to the risky behaviour of the buyers of insurance

→ many economists have argued that the financial crisis of 2008 was partly a case of moral hazard

→
It's possible that many financial institutions would be more careful about making risky loans t engaging in other highly risky

financial transactions if they didn't believe that the govt would support them in the event of difficulties

↳ not a strict matter of taking out an insurance policy

' '
↳ a sort of insurance

↳ the govt provides a kind of assurance of protection in the event that financial institutions face difficulties due to poor

loan repayments
→ moral hazard doesn't refer to unethical 1 immoral behavior

↳ simply a historical remnant of a v old insurance term

↳ originally meant subjective ' '

-
Evaluating responses to moral hazard

→
problems are usually dealt w/ by the provider of insurance
→
often done by making the buyer of insurance pay for part of the cost of damages

↳ known as lout of pocket payments'

-
-

↳ intended to make the insurance buyer face the consequences of risky behavior -
thus leading to less risky behavior
 → problem : out Ot pocket payments have different effects depending on the income level of insurance buyers
- -

↳ private insurance companies usually offer a range of policies from which buyers can choose : the lower the cost of the

insurance , the higher the out Ot pocket payments

-
-

↳ lower income earners usually choose low cost policies w/ high -

out of
- -

pocket payment bc they 're more affordable

↳ higher income earners choose the opposite

↳ lower income earners are more likely to change their risky behavior bb they're offered less insurance protection

↳ higher income earners are less likely to change their risky behavior

→
In the financial area , moral hazard is dealt w/ through govt regulation of financial institutions

↳ intended to oversee t prevent highly risky behavior

↳ raises issues regarding the types t degrees of govt regulations that are required if these are to be effective

The problem of adverse selection t possible responses

-
Explaining adverse selection
→ arises when buyers of insurance have more info about themselves than the sellers of insurance

→ arises most often in the area of health insurance

→
buyers of health insurance know more about the state of their health than sellers of insurance

↳ those w/ health problems are unlikely to tell the full truth to the insurance company

→
In a tree , unregulated market adverse selection results in
. an underallocation of resources to health insurance services

↳ insurance company reduces the supply of insurance to protect itself against having to provide insurance coverage

te v high risks 1 people who are more likely to become ill

→ also leads to high insurance costs for insurance buyers
-
Evaluating possible responses to adverse selection

→ private insurance companies usually protect themselves against adverse selection by offering a range of policies where the

lower cost of the insurance , the higher the out Ot pocket payments - -

↳ this offers people choice

↳ those who believe they have a low risk of getting sick can buy a low cost -
policy w/ higher out of pocket payments
- -

↳ higher cost policies w/ lower out Ot- -

pocket payments can be selected by people who believe they have high levels of

health risk

↳ in practice . it doesn't work out this way

↳ lower income earners choose low cost policies w/ high out of pocket payments bo these are more affordable Ias in the
- -
- -

case of moral hazard ) , regardless of the state of their health

↳ from the perspective of equity I fairness . this is undesirable bait discriminates against those on low incomes

↳ in trying to protect themselves against high risks , insurance companies usually refuse to insure ppl above a certain age ,

as elderly ppl generally have a higher chance of becoming ill

↳ those who mostly need need health insurance coverage -
poor ppl who can 't afford to buy healthcare in the private

market t elderly ppl who are more likely to be ill - are left w/ little 1 no insurance coverage

→
govt responses
↳ direct provision of healthcare services

↳ at 10 W/ zero prices to an entire population

↳ financed by tax revenues

↳ ensures that the entire population has healthcare insurance coverage (as in countries w/ a National Health service ,

↳ social health insurance

↳ may cover a country 's entire population ( as in many European countries )

↳ or which selectively covers only certain vulnerable groups of the population ( as in the US )

↳ problem

↳ difficulties in controlling costs of providing healthcare

↳ growing burdens on the govt ( social health insurance budgets

The problem of safety in the workplace t possible responses

-
safety in the workplace
→
employers 1 buyers of labor resources are generally interested in providing some workplace safety

→
be a v unsafe working environment disrupts production
 → itis possible that the level of safety chosen by some employers isn't sufficient from the perspective of workers

→ some employers may be interested in hiding info from potential employees regarding unsafe working conditions w/ negative

consequences for the safety of the workers they employ

→
represents market failure due to asymmetric info in the labor market
-
Evaluating possible responses to safety in the workplace
→ govt can provide info to workers about safety conditions in various firms
↳ provision of info might be more effective

↳ difficult to provide info on all types -1 levels of dangers in the workplace

↳ ex : labor unions often provide info to their members but they usually cover only some particular trades t professions in
particular industries
→
or they may require employees to provide info to prospective workers about hazards t safety conditions

→ or they may set min safety standards in the workplace that all employers must abide by

↳ most commonly used approach

↳ govt set safety standards
-

↳ difficult for the govt to cover all possible safety t hazard eventualities bo of the v different working

environments of different industries +

types of works
-
Test Your Understanding 5.11 -

l .
Asymmetric Information which is when buyers and sellers don't have equal
,
access to information -
usually resulting in a misallocation

of resources to the production of goods her vices

-

causes an imbalance of power A lack of equal information causes

. economic imbalances

that result in adverse selections and moral hazards .

2 .
(at sellers of unused cars , toys, medicine , or food are likely to not provide the complete information / disclaimer regarding the quality of their

product to consumers
-
especially when their product has detects or has the potential to be harmful to human health by using
materials that are unsafe .

(b) Governments can legislate or regulate in the form of laws and regulations in order to set standards for the quality of a good 1

service produced and to set safety features that producers must maintain when producing their product Governments also .
can

directly provide information or force producers to provide information to consumers in order to ensure that consumers have all

the necessary information needed to make a fair decision Governments also

. can require all producers hellers 1 workers to have a

license that is granted through strict considerations 1 examinations -

restricting a certain practice and the use of an occupational

title This will ensure that all producers / sellers 1 workers are professionals and all practices are government approved which -

.
,

supposedly will ensure the quality of goods 1 services that consumers purchase .

(c) Regulation : His usually very effective , as laws and regulations force producers to comply . However, legislation and regulation

are time consuming to establish

-
and enact They can also slow
.
down economic activities and can be very costly -

burdening government budget Since the government has limited funds it's not possible to regulate
.
, all cases of asymmetric

information -
leading to opportunity costs that tend to be very large They also can be somewhat ineffective when there is
.

still some room for the seller to hide some information from the buyer , since it's not possible to completely eliminate

asymmetric information in some cases -

heading to supplier induced demand that
-
will burden consumers They are also.

hard and costly to reinforce as the government also has to establish

. a system to sanction and detect violations .

provision of information : This reduces the imbalance of power caused by the lack of equal information between buyers and

sellers -
protecting consumers in their purchasing decisions by supplying the necessary information when .

the government's the provider of information , there are difficulties in the collection of all the necessary

information and when ensuring the accuracy of the information In addition

. to that , governments also face

opportunity due to this provision of information When the private seller is the provider it's hard to ensure
. .

whether the information regarding all hazards in products 1 substances , materials used , and quality of services

is accurate and complete like regulation this method .

,
can also be ineffective when there's still some room

for the seller to hide some information from the buyer -

knowing how it's not possible to completely

eliminate asymmetric information in some cases This leads to supplier induced demand that disadvantages
.
-

consumers .

Licensure : it ensures the competence and quality of producers 1 workers and the goods 1services they're selling However it may .
, work to

limit the supply of people in a profession -

leading to a shortage in the labor market that may increase the price

of their services and increase their incomes at the expense of consumers who must pay higher prices It also .
 leads to unemployment for those who can't afford to pursue the education / vocational training required to get a license

(unless the government provides the vocational training for free or subsidizes the training run by private firms) .

3 . ( at It often arises in the area of insurance services where the buyer of insurance has more information
. regarding his/her health
than the seller It also arises in the labor market where the buyers of labor (employers ) have more
.
information on the work

environment and what the job entails than the sellers ( workers ' potential employees ) .

(b) Governments can regulate by setting certain criteria quota, ,

or restrictions in order to prevent the highly risky behavior of consumers

-
preventing moral hazards Governments also can
. directly provide services l healthcare) or establish a social health insurance at low or

no prices to the entire population or to certain vulnerable groups of the population in order to correct the underallocation of resources

caused by adverse selection .

( o) Government regulation Although it may be effective when done right it raises issues regarding the types and degrees of government
: ,

regulations that are required if these are to be effective It's also costly and
. quite hard to enforce especially
.

when detecting violations -

causing a burden on government budget .

Direct government provision : It solves the under allocation and under provision at a low or even no cost to consumers However there
.
,

are difficulties in controlling the costs of providing healthcare and it leads to growing burdens
on the government or social health insurance budgets .
 CHAPTER 5.8
Abuse of monopoly power
The meaning of monopoly power
-
monopoly : a type of market structure where there is a single firm dominating the market for a product t where high barriers to entry

( factors making it difficult for other firms to enter the industry ) ensure that the monopoly position of the single seller can be preserved
-
monopoly power 1 market power : the ability of a firm / a group of firms to control the price of the product they sell

→ can be exercised by monopolies t oligopolies ( few large sellers )

-
monopoly power is considered to be socially undesirable bb it leads to :

→
welfare loss , as social surplus is less than Max

→ all Oca ti ve inefficiency : MB > mo t therefore there's an under allocation of resources to the good
→
productive inefficiency : production doesn't take place at the lowest possible cost

→
lower output t higher price of the industry than the output 1- price of a competitive market

possible government responses

legislation
-
legislation in the form of anti -

monopoly laws can be used to prevent the development of substantial monopoly power 1 the exercise

Of monopoly power
-
ex : often used to prevent collusion (agreement to fix prices ) among oligopolistic firms +
to encourage competition between them
-
used to break up monopolies or near monopolies that have been found to engage in monopolistic practices into smaller units that 'll
-

behave more competitively

-
used to prevent mergers between firms that would result in too much monopoly power

-
in general used to encourage competitive behavior in the economy
.

Regulation
govt s usually regulate natural monopolies
- ' '

-
natural monopoly : a single firm that can produce enough output to satisfy the entire market at a lower cost of production than

Ht firms
-
ex : utilities (gas water electricity ) , postal services
.
,

-
bb of the natural monopoly 's low costs of production it may
, not be in society 's interests to break it up into 2 It smaller firms
-
the natural monopoly is likely to engage in the usual practices resulting w/ undesirable social effects
-
govts regulate natural monopolies -
forcing outcomes that are more favorable to consumers : prices can be set at lower levels t

quantities produced at higher levels than the unregulated monopolist

Nationalization
-
refers to a transfer in ownership of a firm away from the private sector t toward government ownership
-
nationalized firm = govt owned firm -

-
sometimes pursued as an alternative to govt regulation of privately owned natural monopolies
-
historically preferred in most European countries but not us I tended to prefer regulation of natural monopolies)

-
objective : to ensure that prices are lower 1- output greater than the results of an unregulated monopoly
→ similar to the objective of govt regulation
-
govt ownership
-
since the 1980 , there has been
, a trend to privatise govt owned firms
-

→ opposite of nationalization

→ involves a transfer of ownership away from the public t toward the private sector
-
nationalization vs regulation

→ within the Eu , where a# of natural monopolies had been under govt ownership , prices of a # of services (telephone 1- electricity)

were substantially higher than the us where similar services were regulated but not under govt ownership

→ bc the higher costs of the producers were passed on to consumers in the form of higher prices
→ within the Eu many formerly nationalized industries have been privatized
.

↳ same applies for many economically less developed countries

Trade liberalisation
-
involves the removal by the govt of barriers to international trade 1 the buying -1 selling of goods 1-services between different countries
 -
It a firm within the domestic economy exercises substantial monopoly power , it faces limited competition from competitor firms
-
has the effect of increasing imports (goods purchased from other countries ) t therefore increasing the competition faced by the

domestic firm
-
as a result of increasing competition the monopoly power
,
of the domestic firm Is , is reduced

Test your understanding 5.12

-
-

I .
(at The abuse of monopoly power is socially undesirable because monopolies face fewer incentives to be efficient due to the lack of

competition -
resulting with productive efficiency Monopolies also tend to raise prices by lowering the quantity of output
.

produced and since they have control over the market with little to no competition consumers have
, no choice but to pay the

higher price due to the lack of alternatives -

making demand inelastic This allows the monopoly to manipulate prices and
.

quantities of output produced as they will -

producing less output at a higher price than the competitive market .

(b) The abuse of monopoly power leads to welfare loss as social surplus is less than maximum due to the decline in consumer surplus
, .

It also results in all locative inefficiency since marginal benefit is greater than marginal cost indicating that there's an
-

underallocation of resources to the good

2 .
Governments can legislate in the form of anti -

monopoly laws to prevent the development of substantial monopoly power ; regulate

natural monopolies (since society may not want to break the monopoly into separate firms due to its low costs of production ) by
' '

forcing outcomes that are more favorable to consumers (setting prices at lower levels and quantities produced at higher levels than

the unregulated monopolist) ; nationalize the monopolist by transferring the ownership of a firm away from the private sector and

towards government ownership in order to ensure that prices are lower and output greater than the results of an unregulated monopoly ;

and liberalize trade by removing the barriers to international trade in order to increase imports and competition which can reduce

monopoly power .

Type of market failure The market's impact on resource allocation Responses

Negative production externality over allocates resources govt regulation , market based policies (taxi permit 1

Negative consumption externality over allocates resources govt regulation advertising market based policies
-

, ,

positive production externality underallocates resources direct govt provision , subsidies

positive consumption externality under allocates resources It , legislation advertising

,

Demerit goods overallocates resources govt regulation advertising market based policies
-

, ,

Public goods under allocates ( allocates no resource Direct govt provision

overuse of common access resources overallocates resources legislation , Capt trade , carbon tax

Asymmetric information Under allocates resources ( usually , regulation into provision , licensure
,

Monopoly power underallocates resources legislation regulation , nationalization trade liberalization

, .

TABLE 5.1 Market failures -1 their impacts on resource allocation

 CHAPTER 5.9
The problem of government failure ( policy failure)
-

govt intervention in markets is essential to ensure that market work effectively t -

failures are corrected
-
govt intervention doesn't always improve the operation of markets

-
govt intervention in markets that worsen the allocation of resources : indirect taxes subsidies , . price controls

→ economists don't favor price controls bc these intensity problems of resource misallocation
↳ but they're often used bo 90 Vts are driven by various objectives not all of which involve improving the functioning of the
,

economy

→ perverse subsidies

↳ subsidies for fossil fuels

↳ encourages fossil fuel production t consumption -

contributing to environmental pollution t reducing incentives for the development

of alternative , non polluting energy sources

-

govt I policy failure occurs when govt intervention in markets result in less efficient outcomes than those that would 've arisen w/o the

intervention
-
occurs for the following reasons :

→ govts respond to political pressures created by the influence of powerful interest groups t the sometimes narrow interests of their

supporters
↳ the use of price supports to support farmers ' incomes in many developed countries

→
govts don't always have all necessary info to formulate appropriate policies
→ intervention in markets is complex t may often lead to unintended consequences

↳ a policy intended to correct a problem in one area may lead to the unintended creation of a problem in another part of the

economy

→ govt policies have a certain inertia that's sometimes difficult to change

↳ once laws 1 rules 1 regulations have been established , they can 't be changed easily boot inflexibility of the political process