Market Failure - Policies

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Negative Externalities of Production

Government regulations

• Rely on “command” approach, using authority to enact legislation and regulations in the public’s interest
• Regulations can be used to prevent or reduce the effects of production externalities
• In the case of the polluting firm, regulations can forbid the dumping of certain toxic substances into the environment
• More commonly, regulations do not totally ban the production of pollutants, but rather attempt to achieve one of the following
  1. Limit the emission of pollutants by setting a maximum limit of pollutants permitted
  2. Limit the quantity of output produced by the producer
  3. Require polluting firms to install technologies reducing the emissions
• The impact is to lower the quantity of the good produced and bring it to the optimal supply curve by shifting MPC up to MSC
• Pollutant and output restrictions achieve this by forcing the firm to produce less.
• Requirements to install technologies reducing emissions achieve this by imposing higher costs of production due to the purchase of the non-polluting technologies.
• Ideally, the higher costs of production would be equal to the value of the negative externality.
• The government’s objective is to make the MPC curve shift upwards until it coincides with the MSC curve, in which case Qopt is produced, price increases from Pm to Popt, and the problem of overallocation of resources to the production of the good is corrected.
• If polluting firms do not comply with the regulations, they would have to pay fines.

Market Based Policies

• Governments can also pursue policies relying on the market to correct negative production externalities.
• The government could impose a tax on the firm per unit of output produced, or a tax per unit of pollutants emitted.
• the tax results in an upward/downward shift of the supply curve, from S = MPC to MSC (=MPC + tax).
• The optimal (or best) tax policy is to impose a tax that is exactly equal to the external cost, so the MPC curve shifts upward until it overlaps with MSC.
• The new, after-tax equilibrium is given by the intersection of MSC and the demand curve, D = MPB = MSB, resulting in the lower, optimal quantity of the good produced, Qopt, and higher, optimal price, Popt.
• Correction of negative production externalities involves shifting the MPC curve upward toward the MSC curve through government regulations or market- based policies.
• For allocative efficiency to be achieved, the quantity of the good produced and consumed must fall to Q opt as price increases to Popt.

Negative Externalities of Consumption

Government Regulations

• If negative consumption externalities were corrected, Qs quantity of the good would be produced, reflecting allocative efficiency.
• Regulations can be used to prevent or limit consumer activities that impose costs on third parties, such as legal restrictions on activities such as smoking in public places.
• This has the effect of shifting the D1 = MPB curve towards the MSB curve until D2 overlaps with MSB.
• This would eliminate the externality, with production and consumption occurring at Qopt and price falling to Popt.

Government regulations: Advertising

• Advertising and campaigns by the government can be used to try to persuade consumers to buy fewer goods with negative externalities, such as anti-smoking campaigns or campaigns to reduce the consumption of goods based on fossil fuel use.
• For example, campaigns to use public transportation to economise on petrol (gasoline) use, and to improve home insulation to reduce oil consumption for heating.
• The objective is to try to decrease demand for such goods, and the effects are the same as with government regulations
• The MPB curve shifts to D2 after the campaign, where it coincides with MSB where Qopt is produced and consumed, and the price falls from Pm to Ps.

Market based policies

• Market-based policies to correct negative consumption externalities involve the imposition of indirect (excise) taxes.
• Indirect taxes can be imposed on the good whose consumption creates external costs (for example, cigarettes and petrol/gasoline).
• Note that whereas the indirect taxes discussed in the previous topic introduced allocative inefficiency, indirect taxes in the present context are intended to lead to allocative efficiency
• The effects of an indirect tax are shown below
  • When such a tax is imposed on the good whose consumption creates the external cost, the result is a decrease in supply and an upward shift of the supply curve from MPC to MPC + tax.
• If the tax equals the external cost, the MPC + tax curve intersects MPB at the Q opt level of output, and quantity produced and consumed drops to Q opt.
• (The demand curve does not shift but remains at D = MPB.) Qopt is the socially optimum quantity, and price increases from Pm to Pc.
• The tax therefore permits allocative efficiency to be achieved.

Summary

Correction of negative consumption externalities involves either decreasing demand and shifting the MPB curve toward the MSB curve through regulations or advertising; or decreasing supply and shifting the MPC curve upward by imposing an indirect tax.

• Both demand decreases and supply decreases can lead to production and consumption at Qopt and the achievement of allocative efficiency.
• The price paid by consumers falls to Popt when demand decreases, and rises when supply decreases.

Positive externalities of Production

Direct government provision

• A solution often pursued by governments involves direct government provision of the good or service creating the positive production externality.
• For example, governments often engage in research and development (R&D) for new technology, for medicine and pharmaceuticals, and many other areas. The government can also directly provide training for workers.
• Governments pay for such activities with government funds, raised through taxes
• When the government intervenes by providing goods and services itself, this has the effect of shifting the supply curve (= MPC curve) downward (or to the right), toward the MSC curve so that the optimum quantity of the good, Qopt, will be produced, with price falling from Pm to Popt.

Subsidies

• We studied subsidies and their effects, where we saw how their introduction into a perfect market (with no market failures) creates allocative inefficiency.
• Now, we will see how subsidies can correct allocative inefficiency by correcting a market failure
• If the government provides a subsidy to a firm per unit of the good produced that is equal to the external benefit, then the marginal private cost (MPC = supply) curve shifts downward (or rightward) until it coincides with the MSC curve
• The result is to increase quantity produced to Q opt and to lower the price from Pm to Popt.
• The problem of underallocation of resources an underprovision of the good is corrected, and allocative efficiency is achieved.
• You may note that direct government provision and subsidies have the same market outcomes.

Summary

Correction of positive production externalities involves shifting the MPC curve downward toward the MSC curve through direct government provision or by subsidies.

• For allocative efficiency to be achieved, the quantity produced and consume must increase to Qopt as price falls to Popt.

Positive externalities of Consumption

Legislation

• Legislation can be used to promote greater consumption of goods with positive externalities.
• For example, many countries have legislation that makes education compulsory up to a certain age (note that education is a merit good).
• In this case, demand for education increases, and the demand curve D1 = MPB shifts to the right (or upward)
• Ideally, it will shift until it reaches the MSB curve, where D2 = MSB, and Q opt is produced and consumed.

Advertisement

• Governments can use advertising to try to persuade consumers to buy more goods with positive externalities.
• For example, they can try to encourage the use of sports facilities for improved health.
• The objective is to increase demand for such services, and the effect is the same as with legislation
• D1 shifts to D2 = MSB and Qopt is produced and consumed, while price increases to Popt.

Direct Government Provision

• Governments are frequently involved in the direct provision of goods and services with positive consumption externalities.
• The most important examples include government (public) provision of education and health care in virtually all countries in the world.
• Education and health care are merit goods with external benefits so large and important that it is widely believed that they must not be left to private sector provision alone.
• In most countries where there is government provision of health care and education, there is also private sector provision of these services (though to varying degrees).
• Direct government provision has the effect of increasing supply and therefore shifting the supply curve S rightward (or downward) to S + government provision.
• To achieve the social optimum Q opt, the new supply curve must intersect MPB at the level of output Q opt, as seen in the figure.
• At the new equilibrium, price falls to Pc, Q opt is produced and allocative efficiency is achieved. (However, note that Pc is not P opt; it lies below P opt.)

Subsidies

• A subsidy to the producer of the good with the positive externality has the same effects as direct government provision.
• It results in increasing supply and shifting the supply curve rightward (or downward)
• If the subsidy is equal to the external benefit, the new supply curve is MPC − subsidy, and it intersects MPB at the Popt level of output.
• Again, price falls from Pm to Pc, Q opt is produced and allocative efficiency is achieved.

Summary

Correction of positive consumption externalities involves either increasing demand and shifting the MPB curve towards the MSB curve through legislation or advertising; or increasing supply and shifting the MPC curve downward by direct government provision or by granting a subsidy.

• Both demand increases and supply increases can lead to production and consumption at Qopt and the achievement of allocative efficiency. The price paid by consumers increases when demand increases, and falls when supply increases.