CHAPTER 7

MARKET FAILURE: A situation in which the free market mechanism does not lead to opitmum allocation of resources.

the market fails to bring the best result for society and this arises because the market settles in a position where MSC does not equal MSB

EXTENALITY: A cost/benefit that is external to a market transaction and is thus  not reflected in market prices. In the presence of an externality price doesnt equal MC

costs/benefits are borne by a 3rd party = decisions are not in the best interests for society

consumption E affects the consumption side and a production E effects the production side

E cost = too much produced

E benefit = too little produced  

INFO FAILURE: both parties need to have good info in order to make rational decisions or the market can't allocate resources effeciently.

• consumers need to understand the benefit gained from consumption
• produces need to understand the market in order to supply the correct amount of g/s

SOCIAL COST = PRIVATE COST + EXTERNALITY

EXTERNAL COST: A cost that is associated with an individual production which is borne by a 3rd party & isn't reflected in price

MARGINAL SOCIAL COST: The cost to society of producing an extra unit of a good

INTERNALISING THE EXTERNALITY: An attempt to deal with an externality to bring an external c/b into the price system

LABOUR IMMOBILITY: If labour is flexiable there is good resource allocation and the wage rate can provide a good incentive ; the economy can expand to attract labour

COMMODITY MARKETS: have inherrent instability due to voliate demand and prices. The market mechanism may not function effectively as current prices aren't reliable to guide market conditions

1) POLLUTION: negative externality

• unregulated market = too much produced + difficult to enforce property rights
• global issue that needs to be tackled with global cooperation
• Solution: internalise externality (impose costs on producers)

2) TRANPORT: negative externality

• congestion imposes consts on users
• Solution: congestion charge = ensures drivers bare some costs

3) HEALTH: positive exernality

• vaccine reduces the risk of people getting it + stops spreading

4) EDUCATION: positive externality

• helps to improve future earnings + more productive
• educated group more productive together

A process of evaluating the worth of a project by comparing the c/b, including the external c/b

think of the long term and not only focus on financial c/b

come to reasonable balance between current and future interests

1) Identify c/b (external ones too)

2) give these a monetary value

shadow prices: An estimate of the monetary value of an item that doesn't carry a market price

3) discount the future - future g/s need to bee expressed by their present value

discounting: a process were future values of c/g are reduced to provide an estimate of their current value

net present value: the estimated value in the present of a discounted future net benefit

Pollution is a negative externality and it is too costly to reduce it to zero

1) Firms pay a tax equal to the externality, which will reduce their output

this is effective if the gov. has good info about the MB & MC

different firms given different rates = flat rate causes inappropriate incentives (firms using efficient tech will reduce output)

2) Set enviromental standards with place a cap on the amount of emissions - issue permits allowing firms to pollute different amounts

1997: Kyoto conference iniated a global attack on global warming

many developing countries agreed to take action to prevent

2001: USA withdrew from Kyoto - fear of harming their economy (25% of emissions)

178 other countries agreed to Kyoto + adopted trade pollution system

System was demanding to Japan who were already clean

Doha 2012: some progress was made but China refused to go past Kyoto (soon to be biggest emitters

A syndrome under which people are happy to support the construction of an unsightly/unsocial facility as long as it doesn't effect them

The legal system enforces property rights & provides set of rules under which the market must operate

failure to enforce property rights = failure of market

difficult to enforce them where they haven't been enforced before

if individuals are given control of PRs compensation will vary - makes it impossible to internalise the externality

the gov enforces PRs on the behalf of residents- they act as a collective enforcer

COASE  THEOREM: When conflicting PRs occur, bargaining between parties will led to efficent outcomes, as long as the transanction costs associated with the bargaining are negliable