market failure and public policy february 6, 2005
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Market Failure and Public Policy
February 6, 2005
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An efficient market allocation:
Maximizes net benefits MB = MC MNB0=PV MNB1=PV MNB2=…=PV MNBn
Cannot make anyone better off without making someone else worse off
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Market Failure:
External costs (S=MPC only)
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Tons of coal mined
$
D
S=MPC only
S=MPC + MSC
qm
pm
q*
P*
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Market Failure:
External costs (S=MPC only) External benefits (D=MPB only)
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Acres of farmland
$MC
qm
pm
q*
P*
MPB
MSB + MPB
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External costs (S=MPC only) External benefits (D=MPB only) High exclusion costs
High exclusion costs limit incentive for private production of good or service
Market Failure:
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Market Failure:
External costs (S=MPC only) External benefits (D=MPB only) High exclusion costs Non-rival goods (MC for additional user is 0)
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Market Failure:
External costs (S=MPC only) External benefits (D=MPB only) High exclusion costs Non-rival goods (MC for additional user is 0) Open access
Individual users benefit but do not bear all costs of their use
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Case 1 - Privately owned land
Commodity produced with labor: Q = 12n – 2n2
Input is labor (n): n = number of laborers
MB = 12 – 4n
MC = wage rate = 8
P = $1 so TB = $1*Q so TB = 12n – 2n2
MB = MC
12 – 4n = 8
n = 1, TB = 10
Rent = TB – TC
= 10 – 8 = 2
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0
2
4
6
8
10
12
0 1 2 3
MB
Number of laborers
$
— MC
Rent = ½(4)(1) = 2
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Case 2 – Open access land
Commodity produced with labor: Q = 12n – 2n2
n = number of laborers
Labor is added until all potential gains are exhausted(on average, all costs are
covered)
P = $1 so Q = TB
AB = TB/n = (12n – 2n2)/n = 12 – 2n
First laborer earns rent. Second laborer observes this “surplus” and sees an opportunity to benefit.
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0
2
4
6
8
10
12
0 1 2 3 4 5 6
MBAB
Number of laborers
$
— MC
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AB = 12 – 2n
MC = wage rate = 8
AB = MC
8 = 12 – 2n
n = 2, TB = 16
Rent = 16 – 16 = 0
Case 2 (cont.)
Rent is exhausted, or dissipated.
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0
2
4
6
8
10
12
0 1 2 3 4 5 6
MBAB
Number of laborers
$
— MFC
Rent dissipated
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Market Failure:
External costs (S=MPC only) External benefits (D=MPB only) High exclusion costs Non-rival goods Open access Planning horizon
Private vs. social discount rate
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Reasons for public policy:
Correct market failure Internalize externalities Provide public goods Change/create property rights
Change outcome if we don’t like the efficient market outcome Change/create property rights
Correct government failure
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Incentive-based policies:
Property rights changes Market failure: Open access shellfish flats on
Cape Cod resulted in decreased quantity and quality of shellfish
Property rights change: Shellfish flats divided into individual parcels, sold or leased, and owners or lessees manage for the long run
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Incentive-based policies:
Property rights changes Public (government) incentives
Taxes (increase cost of undesired activity) Subsidies (increase benefits of desired activity) These imply underlying property rights
preferences
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Tons of coal mined
$
D
S=MPC onlyS=MPC + severance tax
qm
pm
q*
P*
tax
rate
= p
* -
pmExample: Severance tax $t per ton of coal mined
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Example: Subsidy payment for land retained in farming
Acres of farmland
$MC
qm
pm
q*
P*
MPB
MSB + MPB
Total subsidy paid
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Direct public action:
Command and control Direct regulations or controls
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Example: Zoning regulations limit development options
Acres of farmland
$MC
qm
pm
q*
P*
MPB
MSB
MC with regulation
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Direct public action:
Command and control Direct regulations or controls
Public goods production Where no private incentive for production exists High exclusion costs Non-rival goods