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Market failures

I’ve got a bit lax at posting at this website because the student response has not been very strong. I’ll try again in a different format in the future.

The last week we completed an introduction to the topic of ‘market failures’.

Free markets generally work well – they deliver efficiency – if competitive conditions obtain and consumers must pay to consume and firms must pay all the costs they impose.

With externalities this last condition is not satisfied. If a firm imposes external costs (e.g. pollution) then it will produce more than what is socially optimal. If external benefits are provided (e.g. science and development work that delivers for free cost reductions to other industries) then a firm will produce too little.

We saw that governments can intervene with tax/subsidy policies to achieve economic efficiency. Alternatively property rights can be defined on the resource giving rise to the externality and bargaining used to achieve efficiency – this solution involving private actions is due to Ronald Coase. Coase showed that efficiency would obtain regardless of how property rights were assigned.

Bargaining does not always yield efficient outcomes as the example of wars and strikes show so it may not be possible to rely on it to resolve externalities.

Then we may need to impose taxes/subsidies or use regulations that limit production or pollution. These regulations may produce inefficiency if we do not know the costs of pollution abatement among firms – we may otherwise force firms with high costs of abatement to do lots of cleanup. The nice thing about regulations however is that pollution levels themselves can be accuratetely specified and pursued.

One way to hit exact pollution targets but to do so in a cost-efficient way is to impose regulations on firms by assigning them pollution quotas and then making these quotas tradeable. Firms with high costs of pollution abatement will buy quotas and those with low costs will sell their quotas and clean up themselves.

Finally we discussed public goods as goods which were non-excludable and non-rival in consumption. These will be underprovided by free markets since free-riders will consume the goods without paying for them. Moreover we wouldn’t want to price them anyway since their consumption is non-rival – extra consumers add nothing to cost. Public goods (such as defence) are often provided by government rather than in markets and funded by taxes.

Common property resources are non-excludable but rival. Examples include some ocean fisheries. Individuals account for their own costs in accessing such resources but not the costs they impose – use is rival – on others. Hence use is excessive. Here you do wish to price because of the non-rivalry but currently cannot. A solution might be to try to impose ownership or to regulate the use of such resources.

Finally, we discussed club goods where consumption is excludable but use is non-rival. Here pricing would lead to excessively low use since consumption is non-rival. A solution is to levy a fixede membership fee for accessing the resopurce but then to allow unlimited use at a zero price. An example would be pricing access to a pay-TV service or to something like a golf club.

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