Government Policies to Reduce Market Failure

If you've watched the news recently, you guys should know that the government are considering changing the packaging on cigarettes to discourage new smokers. Use this as a case study in your exam to demonstrate government policy to reduce market failure caused by demerit goods (See notes on Negative Externality and Market Failure. These notes specifically apply to negative externalities, but it is relevant because the consumption of demerit goods causes negative externalities, e.g. second hand smoke).

The new plain branding is being considered to deter youths from starting to smoke, but critics say that the branding will make no difference to those who are already in the habit of smoking. What is your view? Good idea? Tell the examiner!

Negative Externality

There is a great video for those of you who are unsure about negative externalities conducted by my favourite person when I was studying my A-Levels, Paj Holden! To watch the video, please click here.

Please also look at my post on negative externalities as this will also help you.

Tuition fees

Hi everyone, I would first like to apologise for the inactivity on my blog.

Second, I've just read something intriguing about universities and tuition fees. This article here, from The Independent, explains that universities have appealed to the Offa (Office for Fair Access), the universities watchdog, to try and amend the agreement they made earlier this year, to try to reduce their fees.

27 universities have appealed, possibly suggesting a price war in the higher education market. Is this a case against the market provision of higher education?

This is a good example of a possible price war that is currently occurring and a good example to use in the exam.

Externalities and market failure

An externality is when a public good (properties of public good: non-excludable and non-rival) is “dumped” on to third parties outside the market, see here for more. They occur from the consumption and production of goods and services. Those receiving the externalities are not compensated for in any way.

Externalities can be a form of market failure because market failure occurs when the wrong quantity of a good/service is provided at the wrong price.

A negative externality is when the…

marginal social cost  >  marginal private cost

The extra cost borne by society resulting from the last unit of output consumed/produced is greater than the extra cost to the individual/firm.

The socially optimum level of output (where MSB=MSC) is Q1, and price P1. The privately optimum level (where MPC=MPB) of output is Q2 and price P2.When there is a negative externality, the market produces at the privately optimum level at point X, therefore there is over-production. The shaded area represents the welfare loss and the MEC.

If a firm, a factory for example, produces electricity, they also create a negative externality which is pollution. If the firm fails to recognise and act against reducing the pollution, market failure occurs. The incentive function of price breaks down (see word of the day) because the firm is only charging consumers for the output of the good produced in the factory and not the output produced as a negative externality. Therefore the good is under-priced, over-consumed and over-produced.

A positive externality is when the…

marginal social benefit  >  marginal private benefit

The extra benefit borne to society resulting from the last unit of output consumed/produced is greater than the extra benefit to the individual/firm.

If a factory produces a positive externality, for example increased fish stocks in a lake that result from more warm water being discharged into it, fisherman are able to exploit the fish without having to pay the factory owner. The fisherman free rides. Market failure occurs because the good is under-priced and under-produced.

See here for more on public goods and the free rider problem.

Public Good

A good that possesses the following characteristics:

• Non-excludable: You cannot stop anyone from using the good.
• Non-rival: If you use the good, it is equally available to others who want to use it as well.

Examples: Street lights, national defense

How public goods are a form of market failure

If a public good is provided to a market, e.g. national defense, the social benefits are greater than the private benefits, creating a positive externality (notes on positive externalities can be found here, as are the notes on merit goods which cause positive externalities of consumption, or you can take a look at separate merit goods notes. Also, you can take a look at negative externaility if you want, only try not to confuse yourself! See here). This means that people know that the benefits to them if they join the army is that the country can be at an advantage during war. However this is the same benefit people will receive if they don't join the army, so people are inclined not to join the army because the cost is too high (risk of death) and there are mutual benefits to those who have joined with those who haven't. This is called the free-rider problem. People benefit from goods/services that they haven't paid for. This is market failure because there is no market incentive for people to join the army, or for the private sector to provide national defense.

Public goods can be a form of market failure if the price mechanism breaks down. If the provision of street signs and road signs requires people to pay (i.e market provision), some people will pay and some people won't (free rider problem). Businesses providing road signs will not check who has and hasn't paid because too many people are benefiting from them (due to the properties of a public good, see above). Thus by the creation of a positive externality, the private sector does not see it profitable to continue providing road signs, leading to market failure.

Solution

Government provision of public goods financed through taxation. This ensures everyone pays for it and everyone benefits from it.

Merit Good

A merit good is one where the marginal social benefit is greater than the marginal private benefit of consumption. Merit goods lead to market failure because the wrong quantity of goods is sold at the wrong price. The diagram below explains more.

Consumption of a merit good leads to a positive externality. Remember that social benefit maximisation is when MSB = MSC and private benefit maximisation is when MPB = MPC. Therefore if the free market were to provide merit goods, it would provide at Q1 to maximise private benefit. However, the socially optimum level of consumption is at Q2 thus leading to under-consumption and under production of merit goods (hence market failure).

Marginal External Benefit is MSB – MPB. It is the extra benefit incurred from producing the positive externality.

Public Bad

A good that people want to remove (e.g. rubbish). Society would rather pay to remove the good rather than leave it there.

Negative Externality

A negative externality is when the…

marginal social cost  >  marginal private cost

The extra cost borne by society resulting from the last unit of output consumed/produced is greater than the extra cost to the individual/firm.

The socially optimum level of output (where MSB=MSC) is Q1, and price P1. The privately optimum level (where MPC=MPB) of output is Q2 and price P2.When there is a negative externality, the market produces at the privately optimum level at point X, therefore there is over-production. The shaded area represents the welfare loss and the MEC.

If a firm, a factory for example, produces electricity, they also create a negative externality which is pollution. If the firm fails to recognise and act against reducing the pollution, market failure occurs. The incentive function of price breaks down (see word of the day) because the firm is only charging consumers for the output of the good produced in the factory and not the output produced as a negative externality. Therefore the good is under-priced, over-consumed and over-produced. Externalities are a form of market failure.