Unit 12 notes PDF

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UNIT 12: MARKETS, EFFICIENCY, AND PUBLIC POLICY: When market-determined prices induce people to account for the full effects of their actions on others, outcomes are efficient. When prices do not capture significant effects, markets fail, and other remedies are needed. 12.1: MARKET FAILURE: EXTERNAL EFFECTS OF POLLUTION: When markets allocate resources in a way which is not pareto-efficient this is called market failure. Market allocation is unlikely to be Pareto efficient if the decisions of producers and consumers affect others in ways that are not considered. This is another cause of market failure. When we analyse gains from trade, we not only consider the consumer and producer surplus, but also the costs or benefits that other partiers (that are neither buyers/sellers) may experience. For example, the superbug which emerges due to overconsumption of antibiotics affects people who were not involved in the sale of the antibiotic. An example of gains from trade in the case where the production of a good creates an external cost, is pollution. This is called an external effect, or externality. Imagine there is an island where a pesticide called Weevokil is used. The marginal cost of producing bananas for the growers is labelled as the marginal private cost (MPC). It slopes upwards because the cost of an additional tonne of bananas increases as the land is more intensively used, requiring more Weevokil. Diagram below also shows marginal social cost (MSC), which includes the costs borne by fishermen who waters are contaminated by Weevokil. MPC is upward sloping as cost of producing additional tonne increases as land is more intensively used MEC – marginal cost imposed by the banana growers on fishermen, this is the cost of the reduction in quantity and quality of fish caused by each additional tonne of bananas Adding together MPC and MEC gives full marginal cost of production, known as marginal social cost (MSC). Shaded area shows the total cost imposed on fishermen by plantations using Weevokil. It is the sum of differences between the marginal

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social cost and marginal private cost. Shows that MSC is higher than MPC

Consider the case in which the wholesale market for bananas is competitive and market price is $400. If owners wish to maximise their profit, they will choose their output so that price = their marginal cost (marginal private cost). Although 80,000 tonnes maximise profits for banana producers, this does not include the cost imposed on the fishing industry, so it is not pareto efficient. Suppose plantation owners produce one tonne less  The fishermen would gain $270, the plantation would lose hardly anything, their revenue would fall by $400, but their costs would fall as well  If fishermen paid plantation owners any amount between $1-$270 then both would be better off with 79,999 tonnes.  Fishermen’s benefits are maximised when price = marginal social cost, at quantity of 38,000, so this is the pareto-efficient level. 

Pollutants like Weevokil have negative external effects, called environmental spillovers. They bring private benefits to those who use them, but damage the environment, so impose external costs on others that rely on environmental resources For society as a whole, this is a market failure: compared with the pareto-efficient allocation, the pollutant is overused, and too much of the associated good is produced. 12.2: EXTERNAL EFFECTS AND BARGAINING: The solution whereby the fishermen paid the banana owners to reduce output is called private bargaining and is sometimes preferred over government intervention. Let’s look at how a private bargain might solve the pesticide problem. If the banana owners and fishermen do not come to an agreement, they would result to their reservation option, where plantation owners choose to produce 80,000 tonnes. Assume one individual from each group negotiates, and that only banana output can be negotiated. Both sides should realise that by reducing output to pareto efficient level, they can both gain. 

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Gain for fishermen equals loss of profit +net social gain, when output is reduced from 80,000 to 36,000 Reducing output reduces profit for banana owners Net social gain is the gain for fishermen minus loss for plantations

Since gain Is greater for the fishermen, they would be willing to pay banana growers to reduce output if they had funds to do so. Minimum acceptable offer from the fishermen depends on what the plantations would get in the existing situation, which is their reservation profit (labelled loss of profit). If they agreed to minimum acceptable offer, fishing industry would gain, whilst plantations would be no better off. The maximum the fishing industry would pay is determined by their fallback (reservation) option. It is the sum of the blue and green areas. If this occurred, plantations would get all the net social gain while fishermen would be no better off. The compensation they agree on, between the max and min level is determined by their bargaining power. You may view the pareto efficient level as unfair, as fishermen pay for plantation owners reduce pollution. However, this happens as we assume the plantations have the legal right to use Weevokil. An alternative legal framework may give the fishermen a right to clean water. In this case, plantation owners wishing to use Weevokil could propose a bargain in which they would pay fishermen to give up their right. A pareto efficient allocation would result, however the two cases different in the distribution of the benefits. Practical obstacles to bargaining may prevent the achievement of pareto efficiency:    

Implications of collective actions: private bargaining may be impossible on both sides of parties, as they need to find someone, they trust to bargain for them Missing information: devising payment scheme requires measuring the cost of weekvokil, for each fisherman. Need to find who is responsible for pollutant, plantation by plantation. Enforcement: bargain involves relying on the legal system if plantation owner does not reduce output as agreed Limited funds: Fishermen may not have enough money to pay the plantations to reduce output

12.3: EXTERNAL EFFECTS: POLICIES AND INCOME DISTRIBUTION:

Government can intervene to reduce output of bananas through:   

Regulation of the quantity of bananas produced Taxation of the production or sale of bananas Enforcing compensation of fishermen for the costs imposed on them

Regulation: Government can cap total banana output at 38,000. However, if the plantations differ in size and output, it may be difficult to determine and enforce the right quota for each one. This policy would reduce the costs of pollution for fishermen, but would lower the plantations profits. Taxation: If government puts a tax on each tonne produced, equal to $400 - $295 ($105, the marginal external cost) then the after-tax price received by plantations is $295. 

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If plantations maximise their profit, they will choose the point after-tax price equals MPC and produce 38,000 tonnes The tax corrects the price message, so that plantations face the full marginal social cost of their decisions When plantations are producing 38,000 tax is equal to the cost imposed on the fishermen- this is known as Pigouvian tax.

Also works in the case of positive external effect. If MSB is greater than MPB, this becomes Pigouvian subsidy, which can ensure the decision-maker takes this external benefit into account. The taxation results in cost of pollution being reduced for farmers, but the reduction in banana profits is greater, since plantations have to pay taxes as well as reducing output, and the government receives the tax revenue. Enforcing compensation: The government may require the plantation owners to pay compensation for costs imposed on the fishermen. Compensation per each tonne will equal the difference between the MSC and the MPC. 

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After this is implemented the marginal cost is MPC+ the compensation, which is equal to the MSC For plantations to maximise their profit they will choose the point P2 and produce 38,000 tonnes The shaded area shows the total compensation paid As a result, the fishermen are fully compensated for pollution, and the plantations profits are equal to the true social surplus of banana production

This is similar to the effect of a tax, but the fishermen benefit more, as rather than the government they receive the payment from the plantations.

The market failure occurred because the price of the pesticide did not incorporate the costs inflicted on the fishermen, so it sent the wrong message to firms. In this case, a policy requiring plantation owners to compensate the pollution caused, incentivises them to find production methods that cause less pollution, and so are more efficient. BUT other 2 policies of tax and regulation of banana production would not do the same. As it would be better to tax and regulate the use of pesticides and not bananas. There are limits to how well government can implement Pigouvian taxes, regulation and compensation:   

Government may not know the degree of harm suffered by each farmer Marginal social costs are difficult to measure The government may favour the more powerful group

12.4: PROPERTY RIGHTS, CONTRACTS, AND MARKET FAILURES: Private costs and benefits are effects on the decision maker. Whilst, the total effects inflicted on others are social costs and benefits. Costs inflicted on others (such as pollution) are termed external diseconomies (negative externalities), whilst uncompensated benefits on others are external economies (positive externalities). Market failures may occur because the external benefits and costs of a person’s actions are not owned by anyone. For example, you don’t have a contract with incinerator companies specifying at what price you are willing to accept fumes. Here we have ‘incomplete, missing, or unenforceable property rights’, simply incomplete contracts. Another way to express the problem is to say there is no market within which these external effects can be compensated. So the term missing markets is used. In the case of the weevokil example:  

Fisherman’s property rights were incomplete: they did not own a right to clean water There was no market for clean water

Reasons why uncompensated external costs and benefits occur:  

Some information is non-verifiable, there is asymmetric information. As a result, there can be no contract ensuring that external effects are compensated

12.5: PUBLIC GOODS: Goods such as irrigation projects may not be provided efficiently in the market. These are known as public goods. When one farmer pays the costs to provide the irrigation, all farmers benefit. This creates a social dilemma. If farmers act independently, they are incentivised to free-ride, so good will not be provided. By finding a way to work together they can benefit from the good. Characteristics of public goods:    

Inclusive - If its available to one person it can be available to everyone at no additional cost These include national defence, weather forecasting, knowledge Services typically provided by the governments Non-rival goods – marginal cost of making it available to everyone is zero

For some public goods additional users can be excluded even though the cost of their use is zero. For instance, satellite TV, copyrighted books, it costs no more if more people view it, but owner chooses to restrict it. Public goods for which it is feasible to exclude others are called artificially scarce goods/club goods. Goods that’s are not public are called private goods. They are both rivalrous and excludable. A 4th type of good that is rivalrous, but NOT excludable, is common-pool resource. For example, a fishery is open to all- what one fisherman catches cannot be caught by anyone else, but anyone who wants to fish can do so.

Markets typically allocate private goods. Markets for other kinds of goods are either not possible or likely to fail.  

When goods are non-rival, marginal cost is zero. Setting P=MC, is not possible unless producer is subsidised When goods are not excludable there is no way to charge a price for them

So public policy may be required to allocate them. For instance, national defence is the responsibility of governments generally. Governments also adopt a range of policies to address the problem of knowledge as a public good, through issuing patents to give firms an incentive to undertake R&D. 12.6: MISSING MARKETS: INSURANCE AND LEMONS: Hidden actions and moral hazard: One form of asymmetric information is a hidden action. This is when some action taken by one party is not known by the other. For example, case of the employee whose choice of how hard to work is hidden from the employer. This causes a problem called moral hazard. There is a conflict of interest because the employee prefers to not work as hard as employer would like. Moral hazard refers to a situation whereby one party decides on an action that affects the profits or wellbeing of the other but which the affected party cannot control. Hidden attributes and adverse selection: Problem of hidden attributes occurs when some attribute of a person in an exchange is not known to other parties. For example, an individual purchasing health insurance knows her own health status, but insurance company does not. Adverse selection refers to the problem faced by parties to an exchange in which the terms offered by one party will cause some exchange partners to drop out. Such as asymmetric information in insurance, if price is high, only people who seek to purchase medical insurance are people who know they are ill (insurer does not). This will lead to further price rises to cover costs (hidden attributes problem). Hidden attributes cause adverse selection. Another example is buying a car. Buyers have no information about the quality of any car that is for sale, they only known the true value of the cars sold the previous day. The most prospective buyers are willing to pay is average value of cars sold yesterday. Suppose average value is $4,500 but one owner’s car is worth $9000. Prospective buyers will not pay this price, so seller will not sell. Average value of sale keeps decreasing over time, and only worthless cars are left for sale- adverse selection as only lower quality cars sold. Adverse selection in the insurance market: Suppose that you are born and do not know whether you will have a health problem. There is a health policy available for all at the same premium- set at the average expected medical costs. Most people would be happy to purchase, because serious illness imposes high costs. However, assumption that you do not know anything about your health status is unrealistic. Points to consider:   

People are more likely to buy insurance if they know that they are ill This information is asymmetric: person buying insurance knows if they are ill or not, but provider does not know Insurance companies will be more profitable only if they charge higher prices

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This leads to adverse selection: price will be high enough that only people who knew they were ill would purchase the insurance This leads to even higher prices Healthy people are then priced out of the market

This is another example of a missing market: many people will be uninsured. Moral hazard in the insurance market: There is also the problem of hidden actions. Buying an insurance policy may make buyers take risks that are now insured. Insurers typically place limits on the insurance. But the insurer cannot enforce a contract on everything, such as how fast you drive, these actions which are hidden from the insurer because of asymmetric information. There is a moral hazard and principal-agent problems. The agent (insured person or employee) chooses an action that matters to the principal (the insurance company) but cannot be included in the contract because it is not verifiable. 12.7: INCOMPLETE CONTRACTS AND EXTERNAL EFFECTS IN CREDIT MARKETS: Borrowing and lending is a principal-agent problem where the use of the borrowed funds; hard work to ensure the success of the project for which the funds were borrowed; and the repayment of the loan cannot be secured by means of an enforceable contract. As a result, the decisions of the borrower have external effects on the lender. What the borrower does affects the profits of the lender, but is ‘external’ to the contract. This is not included in the contract as details on how hard the borrower works, etc is not known- moral hazard. The problem in the case of credit is that because the borrower may not repay the loan, they will take risks that they would have avoided if she had to bear the full cost of a bad outcome. This means the project is more likely to fail, imposing costs on the lender. This will make the lender reluctant to make loans unless the borrower can be given an incentive not to take undue risk, either by investing some funds (equity) or by providing collateral to the lender (security). This means a person with little wealth may not be able to get a loan, even for a productive project.

So poor borrowers may be credit-constrained or credit-excluded, an example of market failure. Credit market failures also occur for another reason. When a bank makes a loan, it takes account of the possibility that it may not be repaid: If the interest rate it can charge is sufficiently high, even quite high-risk loans may be a good bet. However, the bank is also worried about what might happen to its profits should most of its borrowers be unable to pay, as would happen if it had extended mortgages for home purchases during a boom in housing prices, and then the housing bubble burst. The bank could fail. If owners of the bank would bear all of the costs of a bankruptcy, then they would make strenuous efforts to avoid it. But owners are unlikely to bear the full costs for two reasons:  

Bank will typically have borrowed from other banks, so costs will be borne by other banks that will not be repaid ‘too big to fail’ if the bank is sufficiently important, then the government may bail it out by subsidising it with tax revenue

The bank owners know that others will bear some of the costs of their risk-taking. So they take more risks that they wouldn’t otherwise. Excess risk-taking by banks and borrowers is a negative external effect leading to market failure. 12.8: THE LIMITS OF MARKETS: Why are some goods and services allocated in markets, while firms, families and the government allocate others?

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Some kind of activities are better carried out by them. For example, raising children could be carried out by firms or markets. But a combination of families and governments does the job in most societies. Firms exists because for some things, ‘in-house’ production is more profitable, than acquiring the same thing by purchase. Repugnant markets: marketing some goods and services, such as organs or human beings violates ethical norms and undermines dignity Merit goods: some goods and services should be available to people independently of their ability or willingness to pay

Repugnant markets: Virtually all countries ban the sale of human organs for transplant. One reason for this is because the sale may not be truly voluntary, because poverty may force people to enter this transaction which they may later regret. Moreover, putting a price on a baby or body part violates the principle of human dignity. Merit goods: Some goods and services are considered special in that they should be made available to all people regardless of their ability/willingness to pay. They are provided by the government. An example, is primary education in most countries. It is provided free to all children and financed by taxation. Other examples include basic healthcare, and personal security (fir...