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IB Diploma Economics:
Public goods and Market Failure
Public and Private goods
Public goods are those goods and services that would not be supplied in a free market, and are characterised as being non-rivalrous and non-excludable.
Essential statement: Non-rivalrous is when the consumption of a good or service by an individual does not reduce the availability of the good for others in a market. For example, lighthouses and shipping are considered non-rivalrous because their use by one ship does not make them any less available to use by other ships.
Essential statement: Non-excludable is where once a good or service is supplied then it is impossible to prevent individuals from consuming and benefiting from it. For example, national defence confers the benefit of protection to all in society, and not just a select few who would be willing to pay for it.
Thus, pure public goods are non-rivalrous and non-excludable. Examples include:
Public vs Private goods
Public goods and Market Failure
Whereas public goods are non-rivalrous and non-excludable, private goods are rivalrous and excludable and are much more likely to be provided by the free market than public goods.
Essential statement: Rivalrous is when the consumption of a good or service by an individual reduces the availability of the good for others in a market. For example, the consumption of an ice cream by an individual means that others cannot buy and consume that same good.
Essential statement: Excludable is where once a good or service is supplied then it is possible to prevent individuals from consuming and benefiting from that same good or service. It is usually possible to exclude others in the market from benefiting from a good or a service by charging a price for it. Those who are not willing and able to pay for the good or service will be excluded from using and benefiting from it. Almost all goods and services are excludable by price.
Quasi-public goods are goods and service that are to some extent non-rivalrous and non-excludable in a market. Roads are a good example. Outside of the rush hour, the use of a road by an individual does not reduce the amount of road available to others using the road. However, during peak periods many roads and motorways become congested and the amount of road available to other road users begins to diminish, and the use of road by one individual reduces the amount of road available to others. Further, it is certainly possible to prevent people from using certain roads and/or from using certain roads at certain times. Barriers can be installed and tolls can be employed so that only those consumers willing to pay the price of a toll road can use and benefit from it. However, because the construction of roads is particularly expensive, the cost of roads and toll roads are likely to need some government finance and expenditure.
The free-rider problem
The free-rider problem and public goods
The free-rider problem and market failure: Without being able to exclude individuals from benefiting from a good or a service, then they have less incentive to pay for it. Those consuming and benefiting from a good or a service without paying a cost for it are considered to be free-riders. And, if people free-ride and do not pay for a good or a service then firms will not be willing and/or able to supply the good as there is no incentive for them do so; i.e., there are no profits to be made in such a market.
Public goods lead to market failure. In economics, the free rider problem occurs when those who benefit from resources, goods, or services do not pay for them, which results in an under-provision of those goods or services. The free rider problem is the question of how to limit free riding and its negative effects in these situations. The free rider problem may occur when property rights are not clearly defined and imposed.
The free rider problem is common among public goods. These are goods that have two characteristics: non-excludability – non-paying consumers cannot be prevented from using it – and non-rivalry – when you consume the good, it does not reduce the amount available to others. The potential for free riding exists when people are asked to voluntarily pay for a public good.
Governments must use tax revenues to finance the production of the public good in sufficient quantities to achieve the optimum social level of supply to maximise social welfare and correct the market failure. For example, additional police officers, capital equipment and support services must be provided to a point where crime reduces to a point where the MSC of preventing additional units of crime (e.g., burglaries) is equal to the MSB of this reduction in harm.
Politicians will weigh the benefits and the costs of providing extra units of policing in order to maximise social welfare, bearing in mind that there is always an opportunity cost associated with public good expenditure. For example, one extra police officer may mean one less hospital bed, or less being demanded of individual taxpayers.
Essential statement: There is no incentive for an individual to pay for a good they cannot be excluded from using. When individuals receive the benefit of consuming a good without having to pay a cost for it then they are free-riders. Without consumers paying for the good, there is no profit to be made and in the free market such goods are not supplied.
Free-riders and market failure
Free-RIDER problem step-by-step
An example of free riding
Easy Free-rider explanation
A deeper look at public goods
The problem of common access resources and sustainability
Common access resources
There are environmental problems associated with common access resources. Common access resources are those resources such as the air we breathe, rivers, lakes, the seas, forests, fish and wildlife that are not owned and accessible by anyone and do not have a price associated with their use. They are not public goods because while they may be non-excludable, they are rivalrous. A factory using a river to dispose of pollutants means that it cannot be used for recreation by others.
Essential statement: The lack of a pricing mechanism for common access resources means that these goods may be overused/depleted/degraded as a result of activities of producers and consumers who do not pay for the resources that they use, and that this poses a threat to sustainability
Common access resources and market failure
Rivalrous is when the consumption of a good or service by an individual reduces the availability of the good for others in a market. For example, the consumption or supply of a fish by an individual or producer means that others cannot buy and consume or supply that same good.
Non-excludable is where once a good or service is supplied then it is impossible to prevent individuals from consuming and benefiting from it. For example, the ozone layer confers the benefit of protection to all in society by reducing the amount of damaging UV radiation that reaches our planet’s surface.
Common access resources are like public goods in that they are non-excludable and like private goods in that they are rivalrous. For self-interested individuals common access resources immediately lead to the problem of these resources being overused, depleted and/or degraded.
The tragedy of the commons
The tragedy of the commons is an economic theory of a situation within a shared-resource system where individual users acting independently according to their own self-interest behave contrary to the common good of all users by depleting that resource through their collective action.
The concept and name originate from a hypothetical example of the effects of unregulated grazing on common land (then colloquially called "the commons") in the British Isles. In this context, commons is taken to mean any shared and unregulated resource such as atmosphere, oceans, rivers, fish stocks, or even an office refrigerator.
It has been argued that the very term 'tragedy of the commons' is a misnomer per se, since 'the commons' originally referred to a resource owned by a community, and no individual outside the community had any access to the resource. However, the term is presently used when describing a problem where all individuals have equal and open access to a resource. Hence, 'tragedy of open access regimes' or simply 'the open access problem' are more apt terms.
The tragedy of the commons is often cited in connection with sustainable development, meshing economic growth and environmental protection, as well as in the debate over global warming. It has also been used in analysing behaviour in the fields of economics, evolutionary psychology, anthropology, game theory, politics, taxation and sociology.
Although commons have been known to collapse due to overuse (such as in over-fishing), many examples exist where communities use common resources prudently without collapse. Although it is often claimed that only private ownership or government regulation can prevent the "tragedy of the commons", it is in the interests of the users of a commons to manage it prudently, and social schemes, some of them quite complex, are often devised by them for maintaining common resources efficiently.
Water resources and draught
Student focus question: Explain how Californian farmers trying to maximise their profits in the short-term will reduce profits in the long-term.
Essential statement: Resources without a price means that there are no incentives for individual rationing or restriction of resource use, likely causing its overuse, depletion and/or degradation. These common access resources are unstainable because they will be used to a point where little to nothing is left for the next generation to benefit from.
For a resource to be sustainable it must be able to be maintained at a certain rate or level over time.
Common access resources and sustainability
There is a conflict between the economy and the environment’s joint preservation. The sustainability of the economy means that resources must be preserved so that goods and services can be provided so that future generations will be able to satisfy their wants and needs. Environmental preservation is environmental sustainability and it means that there is a lack of destruction of the environment.
Economic goals and environmental goals can be opposed to each other. Economic goals can include maximising the output of goods and services to profit producers and benefit consumers. Efforts to increase economic output require efforts to maximise resource use. Environmental goals can include the preservation of environmental resources including nature, land, air and water. However, the preservation of such resources could result in the inability of society to satisfy current needs and wants.
Thus, a balance must be achieved between economic and environmental goals, so that both economic and environmental needs can continue to be satisfied into the future.
Sustainable development is a process for meeting human development goals while sustaining the ability of natural systems to continue to provide the natural resources and ecosystem services upon which the economy and society depends. Thus, economic growth should be pursued on terms where natural resources are not degraded or depleted, and allowing future generations to benefit from the same natural resources to satisfy their needs and wants.
A Quick history of RESOURCE use!
The use of fossil fuels threatens sustainability
The burning of fossil fuels such as oil, coal and gas to power transport and provide electricity emits atmospheric greenhouse gases that are detrimental to the environment. Climate change and air pollution are the negative externalities or external costs caused by such pollution. As the planet warms, wetter areas become wetter and dry places become drier. Droughts and floods affect producers (e.g., farmers) and consumers (e.g., homeowners) alike. Rising sea levels will force future generations to incur costs to pay for infrastructure such as flood protection measures, and thus the third parties affected by climate change are going to be found in future generations.
An industry such as electricity generation may burn coal in its power plants. In a free market, industry will pay the private costs of production; i.e., the price of coal. Its use of coal results in external spillover costs such as future flood defences which will be paid for by third parties external to the electricity market, and not by the electricity producers burning coal. As always, MPC = MPB is the optimum social level of coal-fired electricity output (Q* in Figure 1 below). Yet, in the free market, producers in the industry supply electricity generated by coal at the quantity Qe (where MSC > MSB). A misallocation of resources occurs. Too many resources are allocated to coal-fired electricity generation and consumption – output is too high because the price is too low. A conscientious government may choose to intervene in such a market and correct for the market failure
Cars burn petrol, and the emissions such as CO2 that contribute to an atmospheric increase in greenhouse gasses that cause climate change and rising sea levels. Draughts and floods impose costs on third parties, and thus the consumption of petrol must be considered to cause a negative externality. The MPB of petrol consumption is greater than the MSB, meaning that the private benefit of petrol consumption is greater than that derived from society which incurs the external costs. In a free market, consumption occurs to the point where MPB = MPC (Qe in Figure 2 below). However, the socially optimum level of petrol consumption is where MSB = MPC (Q*). Any units of petrol consumption that occurs between Q* and Qe results in a loss of welfare to society because resources would be misallocated in a free market because consumption is higher than that which is optimal. To correct for the negative externalities of production caused by petrol consumption in a free market, a conscientious government must step in and intervene.
Thus, the use of fossil fuels will lead to negative externalities in a range of different markets, and has two implications for sustainability:
the over-exploitation of land for agriculture in LDCs
Less-developed countries are particularly affected by the negative externalities created by the over-exploitation of land for agriculture
Average incomes in LDCs are relatively low and people are relatively poor. They are heavily reliant on the production of primary goods such as mining, fishing and agriculture to generate jobs and income. Globally, this sector of the economy has seen efficiency and productivity gains, lowering the cost of production.
For example, cheaper and better fertilisers, plant breeding programmes and the introduction of capital equipment such as pumps and irrigation infrastructure has been adopted to boost crop yields and overall output. As such, the world price of primary goods and commodities has fallen over time as supply has increased.
Farmers in LDCs have seen their incomes decrease as a result. Low income farmers do not have the finance to purchase fertilisers, adopt new technologies or introduce new capital equipment to increase their agricultural production. As a result, LDC farmers are less productive than their developed country peers and every dollar input produces less output.
Over time, as world prices continue to decrease, it becomes harder and harder for farmers in LDCs to maintain or increase their incomes. Without access to fertilisers and capital equipment their one method of increasing production is to over use the land they farm. Extra crops may be grown, extra cattle may be grazed, the ground is never left unused to recover, nutrients are not replaced and water sources are exploited. As a result, farm land in LDCs becomes less and less productive over time.
The over-exploitation of the land imposes external costs or negative externalities of production such as the depletion of water sources and the degradation of soils. As such, farming becomes unsustainable and future generations are likely to face increasing difficulties in generating an adequate income from their farms.
Government responses to threats to sustainability
Essential statement: The overuse and exploitation of a common access resource occurs because no one can claim ownership of it. Without ownership, the use of it does not incur a cost, and a price cannot be charged for its use. Thus a common access resource is very likely to be unsustainable in the long-term.
A river or lake that is not owned by any individual, company or government risks being polluted by firms. A factory may choose to dispose of its pollutants or a farmer the effluent from her livestock in a river. If ownership of that stream is claimed by the government or granted to a water company or each stretch of the river is deemed to be owned by the landowner whose land the river flows through, then pollution can incur a cost. If a firm can be sued for damages, fined or charged for polluting the river then its will increase its marginal private costs (MPC), which will in turn, affect its output decisions. Pollution becomes more expensive and this reduces the optimum private level of output and reduces external costs (spillover costs). Thus, the extension of property rights can internalise the negative externality because they become part of the mechanisms of the market.
Similarly, if a common grazing land (see Tragedy of the Commons) was owned by an individual or collective, then the resources it provides are likely to be allocated more efficiently and managed sustainably. There are now incentives to manage the land for the long-term and not just short-term profits.
Legislation and regulations
Governments can enact legislation and regulate firms to reduce or prevent the spillover costs associated with negative production externalities. If firms are polluting then governments may ban the dumping of toxic waste and materials into the environment, such as a factory using a river to dump its waste. More often than not, legislation and regulations do not result in a total ban on firms producing pollutants, rather government legislation aims to achieve:
Being forced to install new technology increases the costs of production faced by firms and this decreases supply. Similarly, firms that are required to limit their pollutants will have to adopt new and higher cost production processes, which again, decreases supply. And, being forced to limit the output of goods which pollute increases the marginal costs of production as economies of scale can no longer be achieved. Higher marginal costs will also decrease supply to the market.
The higher costs of production which decrease supply of the products associated with the external costs would ideally be equal to the value of the negative externality. By regulating the firms producing the good and increasing their costs of production the government aims to achieve a shift of the MPC curve upwards to a point where it overlies the MSC curve and the allocatively efficient supply of the polluting good is achieved. The overallocation of resources (factors of production) to the production of a good imposing external costs on third parties is corrected. Any polluting firm not in compliance with regulations and legislation governing pollutants would be required to face fines and/or legal sanctions such as criminal charges being laid against a company’s directors.
A pollution limit can also be modelled as follows:
In figure 4 above, we can see that production is limited at a set quantity of output that limits production in accordance with the level of pollution quantity of output set by the government.
There are market-based policies providing governments with tools to correct for negative externalities of production – taxes and tradable permits (cap and trade schemes).
Pollution taxes seek an efficient outcome by making a polluter pay the marginal external cost of pollution. Pollution charges have been used only modestly in the United States, but are common in Europe.
Governments could either impose a tax on each unit of output produced by the firm, or they could tax per unit of pollutant that is being emitted (e.g., a carbon tax).
Figure 8 illustrates the effects of a pollution tax. By charging or taxing the producer at a rate equal to marginal external cost, the marginal social cost curve becomes the market supply curve. The market price rises, the quantity produced decreases to the efficient quantity, and the government collects tax revenue of an amount shown by the yellow rectangle. The tax results in supply decreasing, shifting up and to the left, from S = MPC to MSC = (MPC + tax).
The most efficient per unit tax is one that is exactly equal to the external costs associated with pollution. The government aims to achieve a shift of the MPC curve upwards to a point where it overlies the MSC curve and the allocatively efficient supply of the polluting good is achieved.
The new equilibrium that is achieved after the tax is imposed is that of the intersection of MSC and the demand curve (MPB). The tax results in a higher price being paid by consumers (P*) and a lower price being received by producers (PP), and at the higher price the allocatively efficient quantity of the good is being produced and consumed.
Per unit axes on the output of a polluting good being produced or a per unit tax on the actual pollutant emitted in the production of a good, appears superficially, to have the same result. However, they both work quite differently.
The per unit tax on the output of goods correcting for the external costs associated with production, works by affecting the allocation of resources within the economy away from the polluting good to a more allocatively efficient use. This results in Q*, the allocatively efficient amount, being produced by firms in the market that are imposing external costs on third parties.
The per unit tax on the quantity of pollutant being emitted works by incentivising firms to adopt better, more allocatively efficient, production processes that reduce the amount they pollute, and therefore, reduce the cost of production to firms. This tax is a two-step process (see Figure 6 below):
Essential statement: A tax on pollution makes the ‘polluter pay’, and thus internalises the externality. The costs that were forced onto and paid by third parties are now paid by the producers and consumers who are producing and consuming in the market.
Impact of climate change
A price on carbon
Marketable pollution permits (also called cap-and-trade) seek an efficient outcome by assigning or selling pollution rights to individual producers who are then free to trade permits with each other.
Cap and trade schemes are another market-based approach to controlling emissions that impose costs on third parties. They are used by some governments to control greenhouse gas emissions, the primary driver of global warming, as well as other pollutants.
The “cap” sets a limit on emissions, which is lowered over time to reduce the amount of pollutants released into the atmosphere. For example, a small country such as New Zealand may set a cap for its most polluting industries at 40 million tonnes of CO2, and this cap will have staged decreases over time – say 30 million tonnes in 2025, 25 million tonnes in 2030, and so on.
The “trade” creates a market for carbon allowances, helping companies innovate in order to meet, or come in under, their allocated limit. The less they emit, the less they pay, so it is in their economic incentive to pollute less.
A cap sets a maximum allowable level of pollution and penalises companies that exceed their emission allowance.
The cap is a limit on the amount of pollution that can be released, measured in billions of tons of carbon dioxide (or equivalent) per year. It is set based on science.
It covers all major sources of pollution. The cap should limit emissions economy-wide, covering electric power generation, natural gas, transportation, and large manufacturers.
Emitters can release only limited pollution. Permits or “allowances” are distributed or auctioned to polluting entities: one allowance per ton of carbon dioxide, or CO2 equivalent heat-trapping gases. The total amount of allowances will be equal to the cap. A company or utility may only emit as much carbon as it has allowances for.
Industry can plan ahead. Each year, the cap is ratcheted down on a gradual and predictable schedule. Companies can plan well in advance to be allowed fewer and fewer permits – less global warming pollution – each year.
Trading leads to investment and innovation. Some companies will find it easy to reduce their pollution to match their number of permits; others may find it more difficult. Trading lets companies buy and sell allowances, leading to more cost-effective pollution cuts, and incentives to invest in cleaner technology.
Unlike with some pollutants, all CO2 goes into the upper atmosphere and has a global – not local – effect. So it doesn’t matter whether the factory making the emission cuts is in Boston, Baton Rouge, or Berlin, it reduces global emissions.
Companies can turn pollution cuts into revenue. If a company is able to cut its pollution easily and cheaply, it can end up with extra allowances. It can then sell its extra allowances to other companies. This provides a powerful incentive for creativity, energy conservation and investment – companies can turn pollution cuts into dollars.
The option to buy allowances gives companies flexibility. On the other hand, some companies might have trouble reducing their emissions, or want to make longer-term investments instead of quick changes. Trading allowances gives these companies another option for how to meet each year’s cap.
The same amount of pollution cuts are achieved. While companies may exchange allowances with each other, the total number of allowances remains the same and the hard limit on pollution is still met every year.
Figure 7 above shows the market for tradeable pollution permits. The supply of permits is determined by the government and then distributed to firms. Firms cannot emit more pollution than the permits they have allow them to. The demand for such permits determines their market price. As the economy grows, the demand for such permits may increase, and so too will the price. Firms will have an incentive to reduce their emissions to reduce their costs of production and/or sell permits to other less efficient firms to earn additional revenues.
Figure 8 below shows that over time, as the government reduces the supply of the permits to reduce the level of pollution being emitted by firms operating in the economy, and further reducing the external costs imposed on third parties. Governments will usually purchase its own permits circulating in the economy, thus reducing the supply available to firms. As supply is reduced, the price of these permits will increase, providing firms with added incentives to reduce their emissions, and hence, their costs of production. To become more profitable, firms can adopt new technologies and/or substitute to less polluting inputs.
Subsidies for clean technologies
Many counties subsidise electric vehicles as they are less polluting than petrol or diesel powered vehicles.
A subsidy is a sum of money granted by the state or a public body to help an industry or business keep the price of a good or service lower than the market can usually supply the good or service. Supply increases as lower costs of production make supplying the good or service relatively more profitable. A subsidy decreases the cost of production to firms and reduce the price paid by consumers. Any subsidy will increase supply and shift the supply curve to the right.
A targeted subsidy can be used by government to correct an allocative inefficiency by correcting a market failure. To fully correct for the market failure caused by a positive externality of consumption, the government will pay the firm a per unit subsidy that is equal to the value of the external benefit. The marginal private cost curve shifts right until it equals (or overlaps) with the MSC curve (see Figure 9 below right).
Paying a subsidy to firms producing the good generating the positive externality of consumption increases the supply of the good (shifts the supply curve right). If the subsidy is equal to the external benefit then the new supply curve (MPC – subsidy) will intersect with MPB at the Q* level of output and consumption. The socially optimum quantity of the good or service is produced and consumed at Q* and the price will decrease from Pe to P*.
An electric vehicle is likely to be strong substitute for a petrol vehicle; i.e., if a consumer purchases an electric car then it is unlikely that they will purchase a petrol vehicle – these two good have a strong positive cross elasticity of demand. Thus, a government subsidy for clean electric cars will increase the quantity demanded, and the substitution effect will reduce the demand for petrol vehicles. The fewer petrol vehicles that are being purchased and driven, the less CO2 and other pollutants will be emitted into the atmosphere.
An evaluation of government Policies
Advantages of market-based approaches
Most economists prefer the efficiency of market-based approaches to solve the problem of negative production externalities. Taxes and tradeable permit schemes both can internalise the externality – making those consumers and producers in the market (i.e., those parties directly involved in the transaction) bear the real costs of their consumption and production decisions. They pay more, their costs are higher or they adopt new technologies and production methods.
We have seen that taxes on emissions are more efficient and lead to better outcomes than taxes on production output. When firms are taxed on their output of the polluting goods they are producing, they reduce the quantity of output but still produce with the same polluting production technologies and methods. As it affects their competitors equally, there is no incentive to switch to less polluting resources or adopt newer and more expensive technologies.
Taxes on the output of emissions which pollute and affect third parties are more efficient. As those firms that can reduce their pollutants stand to become relatively more profitable as their costs of production decrease – these firms will supply more to the market than their higher cost competitors. Thus, there is an incentive to use production methods that pollute less and switch to less polluting resources. Some firms face higher costs in reducing their emissions than other firms do. These firms will be slowest to reduce their emissions and will pay more tax than those firms who find it easier to reduce pollution by changing production processes. Thus, firms who pollute will pay the tax, and this type of tax will lead to less pollution at less overall cost.
It is a similar case for tradable permits. Tradeable permits create incentives for businesses to reduce the amount of pollution they create, if the benefits of doing so (reducing the costs paid for permits, selling excess permits) exceed the costs (investing in new technology, using different raw materials). If a firm can reduce its pollution at a relatively low cost, then to maximise profits, it will do so and their excess permits will be sold into the tradeable permits market earning the firm additional revenue. However, firms where reducing polluting emissions is relatively costly, will be forced to purchase extra permits in the market for tradable permits. Thus, the incentives to reduce pollution and disincentives to pollute created by the tradeable permits system, shift productive resources in the economy away from increasingly less profitable polluting industries and into relatively more profitable industries. The desired result of less overall pollution at less overall cost is therefore achieved.
Disadvantages of market-based policies
There are considerable technical difficulties in designing a tax or tradeable permit system that effectively tackles firms and industries that pollute. There are several issues that need to be carefully assessed, including:
Student focus question: Outline each of the necessary steps that led to our planet's ozone layer being saved.
Advantages of government regulations
Disadvantages of government regulations
An international perspective
There are market failures that cannot be fixed by any single government and require coordinated action. For example, the depletion of the ozone which was occurring at a rapid pace in the 1990s and 2000s was caused by the emission of ozone destroying chemicals used in refrigerants and aerosol sprays. A small country such as Sweden or New Zealand would have virtually no impact if their governments chose to intervene and correct for the market failure. Even big economies such as Japan, China and the US could not have had much effect by introducing policies to correct for this type of negative externality. As long as other countries continued to pollute, their citizens would continue to bear the external costs. An international agreement was needed where progress could be made if enough countries signed up, ratified and began reducing their use of pollutants.
It is a similar picture with global warming and greenhouse gas emissions. No one country can have much of an effect on reducing the external costs of climate change that occur globally. International agreements, such as the Paris Agreement, are needed.
The Paris Agreement is an agreement within the United Nations Framework Convention on Climate Change (UNFCCC) dealing with greenhouse gases emissions mitigation, adaptation and finance starting in the year 2020. The language of the agreement was negotiated by representatives of 195 countries in Paris and adopted by consensus in 2015. As of November 2016, 193 UNFCCC members have signed the treaty, 105 of which have ratified it. After the European Union ratified the agreement in October 2016, there were enough countries that had ratified the agreement that produce enough of the world's greenhouse gases for the agreement to enter into force.
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