session-3-4-5 public goods and externalities

Economic Policy and Regulatory Environment in India

Market Failure and Need forGovernment Regulation

Rachna GangwarInstitute of Management Technology Ghaziabad

Market Failure and Need forGovernment Regulation

Learning Objectives

• Why do markets fail to produce efficientoutcomes?

• Why is government’s role important?• What is the trade-off between efficiency and

equity?

• Why do markets fail to produce efficientoutcomes?

• Why is government’s role important?• What is the trade-off between efficiency and

equity?

Market Failures

• A situation where free markets fail to– Allocate resources efficiently– Provide goods beneficial to society– Stop production and consumption of

harmful goods

• A situation where free markets fail to– Allocate resources efficiently– Provide goods beneficial to society– Stop production and consumption of

harmful goods

Examples of Market Failure

• Pollution - air, water, soil• Deforestation and loss of biodiversity• Traffic congestion• Health problems associated with consumption

of tobacco, alcohol, and drugs• Depleted fish stock• Global warming

• Pollution - air, water, soil• Deforestation and loss of biodiversity• Traffic congestion• Health problems associated with consumption

of tobacco, alcohol, and drugs• Depleted fish stock• Global warming

Reasons for Market Failure

• Imperfect competition• Public goods• Externalities• Incomplete markets• Imperfect information• Unemployment, inflation, and disequilibrium

• Imperfect competition• Public goods• Externalities• Incomplete markets• Imperfect information• Unemployment, inflation, and disequilibrium

Imperfect Competition

Imperfect competition

• For markets to work efficiently, there shouldbe perfect competition – a sufficiently largenumber of firms that each believes it has noeffect on prices.

• For markets to work efficiently, there shouldbe perfect competition – a sufficiently largenumber of firms that each believes it has noeffect on prices.

Imperfect competition

• Monopoly: E.g. city-wide electrical distribution– Competitive advantage– High transportation costs– Barriers to entry

• Oligopoly: automobile manufacturing• Monopsony: employment in a company town• Oligopsony: employment in professional sports• Patents

– Xerox, Kodak

• Monopoly: E.g. city-wide electrical distribution– Competitive advantage– High transportation costs– Barriers to entry

• Oligopoly: automobile manufacturing• Monopsony: employment in a company town• Oligopsony: employment in professional sports• Patents

– Xerox, Kodak

Imperfect Competition

• Private airports (Delhi, Mumbai etc)• Toll roads• Un-viable markets (rural telecom, air

connectivity to north eastern routes etc)• Power distribution companies• Governments sometimes regulate prices and

profits• Competition commission of India

• Private airports (Delhi, Mumbai etc)• Toll roads• Un-viable markets (rural telecom, air

connectivity to north eastern routes etc)• Power distribution companies• Governments sometimes regulate prices and

profits• Competition commission of India

Aeronautical Non-Aeronautical

Landingcharges

Aero Related

Cargo handling

Commercial(Terminal)

Advertisingfee

Commercial(Other)

Real estatedevelopment

Airport Operator Revenue Streams

Landingcharges

Passengerservice fee

Aircraft refueling

Aircraftmaintenance

Catering services

Advertisingfee

Revenue fromconcessionaires

Rental fromairlines,business, shops

Car parking,publicadmission fee

Real estatedevelopment

Hotel, businessand industrialparks

Retail andentertainment,residential

Parking charges

[Source: Communication from GMR, 2006]

Delhi Airport

• Awarded to GMR in 2006 though competitivebidding

• Airport development fee (ADF) and userdevelopment fee (UDF)

• Awarded to GMR in 2006 though competitivebidding

• Airport development fee (ADF) and userdevelopment fee (UDF)

AERA Constituted

• Airports Economic Regulatory Authority (AERA) wasconstituted in December 2008:– To determine the tariff for the aeronautical

services– To determine the amount of the development fees– To determine the amount of the passengers

service fee– To monitor the set performance standards relating

to quality, continuity and reliability of service

• Airports Economic Regulatory Authority (AERA) wasconstituted in December 2008:– To determine the tariff for the aeronautical

services– To determine the amount of the development fees– To determine the amount of the passengers

service fee– To monitor the set performance standards relating

to quality, continuity and reliability of service

Public Good

Public Goods

• Private good: A good or service whoseconsumption by one person excludesconsumption by others

• Public good: A good or service whoseconsumption by one person does not excludeconsumption by others

• Private good: A good or service whoseconsumption by one person excludesconsumption by others

• Public good: A good or service whoseconsumption by one person does not excludeconsumption by others

Public Goods

– Non-rival competition(one person’s consumption does not preventother person’s consumption)

– Non-excludability (difficult to exclude anyone fromthe benefits)

– E.g. National defence, lighthouse, public health(international vaccine prgramme), street light etc

– Free rider problem

– Non-rival competition(one person’s consumption does not preventother person’s consumption)

– Non-excludability (difficult to exclude anyone fromthe benefits)

– E.g. National defence, lighthouse, public health(international vaccine prgramme), street light etc

– Free rider problem

Public Goods

• Pure public goods– Marginal cost is zero– E.g. National defence

• Impure public goods– Marginal cost very small but not zero– Though expansive, possible to exclude– E.g. un-crowded highways

• Pure public goods– Marginal cost is zero– E.g. National defence

• Impure public goods– Marginal cost very small but not zero– Though expansive, possible to exclude– E.g. un-crowded highways

Public Goods

Congestedhighway Health services,

Education

Mar

gina

l cos

t of u

sePure private good

Nationaldefence

Fireprotection

Mar

gina

l cos

t of u

se

Ease of exclusion

Pure public good

• A local park• College education• Sewage collection• Water• Electricity• Telephone service• Medicine• Police protection• Cable service• Applied research

• A local park• College education• Sewage collection• Water• Electricity• Telephone service• Medicine• Police protection• Cable service• Applied research

• What happens to the efficient allocationbetween public and private goods as aneconomy becomes wealthier?

• Think of an example of a free rider problem inyour city. Think of a way for your localgovernment to overcome this problem.

• Think of an example of a free rider problem inyour city. Think of a way for your localgovernment to overcome this problem.

Merit Goods

• Goods that government compels individualsto consume

• E.g. seat belts, helmets, elementary education

• Goods that government compels individualsto consume

• E.g. seat belts, helmets, elementary education

Demerit Goods

• A demerit good is a good or service whoseconsumption is considered unhealthy,degrading, or otherwise socially undesirabledue to the perceived negative effects on theconsumers themselves. It is over-consumed ifleft to market forces.

• A demerit good is a good or service whoseconsumption is considered unhealthy,degrading, or otherwise socially undesirabledue to the perceived negative effects on theconsumers themselves. It is over-consumed ifleft to market forces.

Club Goods

• Club goods (also artificially scarce goods) are atype of good that are excludable but non-rivalrous, at least until reaching a pointwhere congestion occurs.

• e.g. golf courses, cinemas, cable television,access to copyrighted works, and the servicesprovided by social or religious clubs to theirmembers.

• Club goods (also artificially scarce goods) are atype of good that are excludable but non-rivalrous, at least until reaching a pointwhere congestion occurs.

• e.g. golf courses, cinemas, cable television,access to copyrighted works, and the servicesprovided by social or religious clubs to theirmembers.

Excludable Non-excludable

RivalrousPrivate goodsfood, clothing, cars,personal electronics

Common goodsfish stocks

Private goodsfood, clothing, cars,personal electronics

Common goodsfish stocks

Non-rivalrous

Club goodscinemas, private parks,satellite television

Public goodsnational defense,air

Externalities

Externalities

• Costs (or benefits) of a market activity borneby a third party; the difference between thesocial and private costs (benefits) of a marketactivity

• When externalities are present, market pricesare not a valid measure of a good’s value tosociety

• Costs (or benefits) of a market activity borneby a third party; the difference between thesocial and private costs (benefits) of a marketactivity

• When externalities are present, market pricesare not a valid measure of a good’s value tosociety

Positive Externalities

Externalities

Negative Externalities

Third parties benefit fromproduction of goods andservices

Third parties bear spillovercosts of the production ofgoods and services

Third parties benefit fromproduction of goods andservices

Third parties benefit fromconsumption of goods andservices

Third parties bear spillovercosts of the production ofgoods and services

Third parties bear spillovercosts of the consumption ofgoods and services

Externalities

• Negative externalities.– e.g. air, water, noise pollution, smoking, garbage

• Positive externalities.– e.g flower garden

• Overproduction of goods generatingnegative externalities

• Undersupply of goods generating positiveexternalities

• Environmental policy

• Negative externalities.– e.g. air, water, noise pollution, smoking, garbage

• Positive externalities.– e.g flower garden

• Overproduction of goods generatingnegative externalities

• Undersupply of goods generating positiveexternalities

• Environmental policy

Pollution related New Items

• Delhi's air pollution level is up by five times in eightyrs, says study (India today, July 08, 2012)

• Indian coal power plants kill 120,000 people a year,says Greenpeace(http://www.guardian.co.uk/world/2013/mar/10/india-coal-plants-emissions-greenpeace)

• India River Pollution: 80 Percent of Indian SewageFlows Untreated Into Country's Rivers(http://www.huffingtonpost.com/2013/03/05/india-river-pollution-sewage_n_2810213.html)

• Delhi's air pollution level is up by five times in eightyrs, says study (India today, July 08, 2012)

• Indian coal power plants kill 120,000 people a year,says Greenpeace(http://www.guardian.co.uk/world/2013/mar/10/india-coal-plants-emissions-greenpeace)

• India River Pollution: 80 Percent of Indian SewageFlows Untreated Into Country's Rivers(http://www.huffingtonpost.com/2013/03/05/india-river-pollution-sewage_n_2810213.html)

Social Demand

• Market demand• Social demand• Externalities

• Market demand• Social demand• Externalities

Social Demand Market Demand Externalities Subtract external costs, a negative impactAdd external benefits, a positive impact

• The optimal production mix is where the socialdemand curve intersects the supply curve

Negative Production Externalities

• When an firm’s consumption reduces thewell-being of others who are notcompensated by the firm

Negative Production Externality

Negative Production Externality• When a firm’s production reduces the well-being of

others who are not compensated by the firm– Private marginal cost (PMC) The direct cost to producers of

producing an additional unit of a good.– Social marginal cost (SMC) The private marginal cost to

producers plus any costs associated with the production of thegood that are imposed on others.

– Private marginal benefit (PMB) The direct benefit to consumersof consuming an additional unit of a good by the consumer.

– Social marginal benefit (SMB) The private marginal benefit toconsumers plus any costs associated with the consumption ofthe good that are imposed on others.

• When a firm’s production reduces the well-being ofothers who are not compensated by the firm– Private marginal cost (PMC) The direct cost to producers of

producing an additional unit of a good.– Social marginal cost (SMC) The private marginal cost to

producers plus any costs associated with the production of thegood that are imposed on others.

– Private marginal benefit (PMB) The direct benefit to consumersof consuming an additional unit of a good by the consumer.

– Social marginal benefit (SMB) The private marginal benefit toconsumers plus any costs associated with the consumption ofthe good that are imposed on others.

Negative Consumption Externalities

• When an individual’s consumption reducesthe well-being of others who are notcompensated by the individual.

Negative Consumption Externalities

Externality of SUVs The typical driver in 2008 was in a car that weighed about 4,117 pounds. The

major culprits in this evolution of car size are sport utility vehicles (SUVs)with an average weight size of 4,742 pounds.

The consumption of large cars such as SUVs produces three types of negativeexternalities: Environmental Externalities:

The contribution of driving to global warming is directly proportional to theamount of fossil fuel a vehicle requires to travel a mile. SUV drivers usemore gas to go to work or run their errands, increasing fossil fuel emissions.

Wear and Tear on Roads: Each year, federal, state, and local governments spend $33.1 billion repairing

our roadways. Damage to roadways comes from many sources, but a majorculprit is the passenger vehicle, and the damage it does to the roads isproportional to vehicle weight.

Safety Externalities:One major appeal of SUVs is that they provide a feeling of security because

they are so much larger than other cars on the road. Offsetting this feeling ofsecurity is the added insecurity imposed on other cars on the road.

The typical driver in 2008 was in a car that weighed about 4,117 pounds. Themajor culprits in this evolution of car size are sport utility vehicles (SUVs)with an average weight size of 4,742 pounds.

The consumption of large cars such as SUVs produces three types of negativeexternalities: Environmental Externalities:

The contribution of driving to global warming is directly proportional to theamount of fossil fuel a vehicle requires to travel a mile. SUV drivers usemore gas to go to work or run their errands, increasing fossil fuel emissions.

Wear and Tear on Roads: Each year, federal, state, and local governments spend $33.1 billion repairing

our roadways. Damage to roadways comes from many sources, but a majorculprit is the passenger vehicle, and the damage it does to the roads isproportional to vehicle weight.

Safety Externalities:One major appeal of SUVs is that they provide a feeling of security because

they are so much larger than other cars on the road. Offsetting this feeling ofsecurity is the added insecurity imposed on other cars on the road.

Positive Production Externalities

Global Warming

CO2 Emmission

• Can an activity generate both positive andnegative externalities at the same time?

Others

Incomplete markets

• Complete market will provide all goods andservices for which the cost of provision is leesthan what individuals are willing to pay

• E.g. insurance and loans. life insurance, cropinsurance, education loan etc

• Underinvestment in innovation• Enforcement costs

• Complete market will provide all goods andservices for which the cost of provision is leesthan what individuals are willing to pay

• E.g. insurance and loans. life insurance, cropinsurance, education loan etc

• Underinvestment in innovation• Enforcement costs

• Imperfect information– Imperfect information prevents consumers from

making utility-maximizing decisions.– E.g. Insurance policies, loans

• Unemployment, inflation and disequilibrium

• Imperfect information– Imperfect information prevents consumers from

making utility-maximizing decisions.– E.g. Insurance policies, loans

• Unemployment, inflation and disequilibrium

Government Inventions

• Taxes• Subsidies• Regulation

• Taxes• Subsidies• Regulation

Taxes07_08A

New supply curve

Old supply curve

Demand curve

QUANTITY

PRICE

Quantity declines by this amount.

New quantity Old quantity

New price

Old price

Price rises by this amount.

Price receivedby sellers aftersending tax togovernment

Deadweight lossAmount ofsales tax

Deadweight Loss from a Sales Tax

07_08A

New supply curve

Old supply curve

Demand curve

QUANTITY

PRICE

Quantity declines by this amount.

New quantity Old quantity

New price

Old price

Price rises by this amount.

Price receivedby sellers aftersending tax togovernment

Deadweight lossAmount ofsales tax

Deadweight Loss from a Sales Tax