One of the main drivers of market economies has been the concept of efficiency. Over the years economists have made the argument that markets allow us to allocate resources efficiently. However, analysing the costs of firm’s behaviour on the environment and broader community provides a much more complex view of efficiency. For example, firms provide electricity by burning fossil fuels leading to greenhouse gas pollution. This pollution poses a threat to health, economic systems and ecosystems around the world. Cigarette and alcohol manufacturers produce products that can cause cancer risks and other health problems leading to increased health expenditure in the society. This raises the question whether resources are being effectively allocated or if there is a market failure.

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Market failure can occur due to a number of reasons. Some of these are: • Imperfect knowledge of and between buyers and sellers: The efficiency of the market

depends on everyone having perfect information in the market. In the real world, this is often not the case. Consumers often do not know about all the prices in the market or advertising may skew their judgement. Producers on the other hand are unlikely to be aware of all the business opportunities open to them.

• Goods are not homogenous where differentiation is prevalent in markets. As discussed

under perfect competition, homogeneity of goods is a very strict assumption that is often not met in the real world. For example, we have multitude of brands in the cola market, different labelling, pricing, advertising etc.

• Resource immobility – resources cannot always be easily moved to put them to their

greatest possible use. For example, labour can be geographically immobile. There is a shortage of labour in Darwin but high unemployment rate in Melbourne. There is a significant cost associated with getting workers from Melbourne and firms often get by on local resources available.

• Market power – Competition assumes the existence of many firms in the market.

However, a number of industries have only one firm or only a handful of competitors giving the firms significant market power to source greater profits, erect barriers to entry and market rigging through activities such as collusion to set prices.

• Inequality exists because of: Inequality may exist because of unequal wealth distribution,

poverty, discrimination and unequal endowments. • Existence of external costs and benefits: This is commonly referred to as externality.

External costs refer to the costs that fall on people other than those who pursue the activity. For example, the costs of caring for people ill due to smoking falls on the whole

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society, not just the individuals who choose to smoke or the companies selling tobacco. Some of the social costs of smoking include health expenditure on people who are sick, second hand exposure to smoking especially kids, growth defects in newborn due to exposure to cigarette smoking by pregnant mothers etc.

Because of the widespread prevalence of market failure, we will examine government policies that can improve allocation of scarce resources

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To be able to analyse the issue of externalities, we need to first distinguish private and social costs. Suppose we are in the market for books. In the publishing process, the publisher takes into account all the costs associated with providing the book such as costs of paper, marketing, paying royalties to the author etc. These are classified as private costs. In publishing a book, there are also a number of costs to the society. Such as the paper used to publish the book creates a by-product call dioxin which pollutes the environment. Distribution of the books may also lead to congestion on the road and greenhouse emissions from the transportation process. All of these social costs are neglected in the firm’s calculation of private costs. There are also social benefits to private actions that are often ignored. For example, immunization is an example of positive externality. Immunization prevents the spread of disease, providing benefits to the individual as well as the whole society. Costs and benefits borne by a third party are referred to as externalities. An external cost of a private action is referred to as negative externality. An external benefit of a private action is referred to as positive externality. Social costs are the private costs and the external costs added together. Social benefits are the private benefits and the external benefits added together.

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In order to ascertain the social costs and benefits of production and consumption, we first need to analyse concept of private value. For a consumer the maximum price that the buyer is willing to pay measures how much a buyer values the good. Consumer surplus is the value consumers get from a good but don’t have to pay. Now lets imagine that you are really hungry and have not eaten for a day. You have the option of getting some pizza. Will u be willing to pay $20 for your first slice in this situation. I think the answer is yes. Remember you have not eaten for a day. For the second slice may be you are not so desperate and you are willing to pay only $18 and so on. Now lets imagine you have eaten your 10th slice of pizza. For the 11th slice you may be willing to pay nothing at all. In other words demand curve captures your willingness and ability to pay for each slice of pizza. But in the real world you don’t pay different prices for each slice of pizza you consume. The difference between the willingness to pay and what you actually pay is consumer surplus.

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Consumer surplus is directly derived from the market demand curve. A s discussed in earlier session, market demand curve represents buyer’s willingness and ability to pay. To derive consumer surplus we measure the difference between buyer’s willingness to pay as well the amount the buyer actually ends up paying. Once we know the market price consumer surplus is easy to derive from the demand curve.

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At any quantity, the price given by the demand curve shows the willingness to pay of the marginal buyer. The buyer who would leave the market first if the price were any higher. Thus, consumer surplus is the area below the demand curve and above the price.

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Lets rework this idea of consumer surplus. In the case of discrete goods, such as pizza which works in say number of slices. In a realistic setting where you have not been starved for a day, the 1st slice you may be willing to pay $8 and for second $6 etc. I hope you are able to read the diagram as we practice this. The actual price paid is $2. To calculate consumer surplus all we do is subtract the price we are willing to pay from actually paid for each slice. For the first

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slice it 8-2, for the second slice it is 6-2 and for the third it is 4-2. Then we add all these together to get consumer surplus. In this case it is 12.

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Now lets examine the case of consumer surplus for continuous case. Let’s assume that the slide above shows the demand for the curve for tickets to a musical festival. Let the price be P1. At P1, Q1 tickets will be sold. The marginal buyer at this price is only willing to pay P1 and will leave the market if price was any higher. Remember market demand curve is an aggregation of many different consumers. So at a higher price such as P2 we may have another marginal buyer purchasing the ticket at point Q2. Similarly all the buyers represented between 0 to Q1 are willing to pay a price higher than P1 to get tickets. Thus everyone between these points gained some degree of consumer surplus by purchasing the tickets at price P1. In panel (a) consumer surplus at a price of P1 is therefore the area of triangle ABC. In panel b, when the price falls from P1 to P2, the quantity demanded rises from Q1 to Q2, and the consumer surplus rises to the area of the triangle ADF. The increase in consumer surplus (area BCFD) occurs in part because existing consumers now pay less (area BCED) and in part because new consumers enter the market at the lower price (area CEF). A lower price raises consumer surplus because the existing buyers now have to pay less: increase in consumer surplus (area BCFD). A lower price also induces new entrants in the market. Therefore, when new buyers enter the market then there is an increase in consumer surplus by the area (CEF).

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Consumer surplus helps to quantify the benefits or value of the market outcomes. Since consumer surplus is also the measured from buyer’s perspective, it comes close to measuring economic well-being. This information can further be used by businesses to capitalise on economic opportunities. However, as a side point, the entire analysis is based on the idea that consumers are rational and are making choices that provide them with value or benefit. However, this may not always be the case. For example, drug addicts don’t get a large benefit from being able to buy heroin at a low price.

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We are now going to analyse the producer side of the market. Sellers are only willing to sell their goods if the price they receive exceeds their costs. By costs we mean opportunity costs here. So for a seller providing pizza, the price offered in the market has to at least cover the costs of producing pizza. Moreover, the opportunity cost of producing any good is not constant but it increases as we produce more and more. Thus, the supply curve is upward sloping. Now why do we face increasing opportunity costs in production? Take a simple example. For example, if you are supplying pizza,

you may be willing to supply one pizza at a low price. This may be because you can

make pizza at home in your free time and sell it to your neighbor at very little

expense. If the neighbor wants you to supply large quantities, you might need to take

some time off from work to do this task. In this case you may not be willing to supply

at a low price. Now suppose the whole locality wants your pizza. This may require a

bigger oven, a bigger refrigerator, more time off from work etc. Hence you will need a

higher price. Therefore, my opportunity cost increases as I expand production and hence the supply curve is upward sloping. However, you don’t sell pizza at different

prices. You sell all units of pizza you make at one price. Even though the opportunity cost of producing every unit is different, producers receive a single market price. If the market price is higher than the costs of producing the unit, then the producer will receive some benefit or surplus. Please bear in mind here that producer surplus is not profit.

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Producer surplus is amount a seller is paid for a good minus the seller’s marginal cost of providing it. The lowest price at which a producer is willing to sell a particular unit

is typically the marginal cost. Or it is the opportunity cost of producing one extra unit.

The textbook does not get into marginal cost in this particular chapter. We will expand

on this point in later chapters.

This is similar to consumer surplus. However, here we are looking at the area above

the supply curve but below the market price. Producer surplus captures the difference

between the market price and the minimum price at which the producer would have

been willing to supply the good. For example, if you are supplying pizza, you may be

willing to supply one pizza at a low price but large quantities at higher price.

However, you don’t sell pizza at different prices. You sell all units of pizza you make

at one price. Thus, producer surplus is the sum of difference between the price you get

from the sale of a particular unit of pizza and the lowest amount that you will be

willing to accept for that unit of pizza.

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To reiterate the points made earlier. At any quantity price given by the supply curve shows the willingness of the marginal seller to supply at that price. Marginal seller would leave the market first if the price were any lower. Producer surplus is derived out of the supply curve. This is because producer surplus is the amount seller is paid minus the lowest price at which the producer would have been willing to sell that particular unit, which is essentially reflected on the supply curve. Producer surplus in a market is the area below the price and above the supply curve.

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The graph in the above slide shows a typical supply curve. Lets assume that this the supply of online rental access to movies. At P1, Q1 movies will be rented. The marginal seller at this price is only willing to rent the movie at price P1 and will not supply the Q1th unit if the price were any lower. Remember market supply curve is an aggregation of many different seller. So at a lower price we may have the same seller or another supplying less than Q1. However, in the market everyone receives price P1. In panel (a) producer surplus at a price of P1 is therefore the area of triangle ABC. Now if the price rises to P2 then the producer surplus increases to the area ADF, shown in panel b. Firstly, existing sellers who were already selling Q1 of the good at the lower price P1 are better off because they now get more for what they sell (area BCED). The higher price also induce greater production. Thus the new producers receive CEF as their producer surplus.

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Just as we use consumer surplus to measure the well-being of the buyer, we use producer surplus to measure the well being of the seller. We now combine the two measures of well-being to get a more holistic picture. Suppose the market depicted above was in equilibrium, the total surplus such that the equilibrium price was P1 and equilibrium quantity was Q1. The total surplus in the market would have been A+B+C+D+E+F. Now suppose that the price rises due to a tax or any other government policy such that we get to the point PB on the graph above. This essentially reduces consumer surplus by the area C and producer surplus by the area E. C+E is also known as the deadweight loss. The deadweight loss is the fall in total surplus that results when a tax (or some other policy) distorts a market outcome.

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Lets take an example of negative externality. The supply curve represents private costs and demand curve represents private value. Let’s further assume that we have an aluminium factory that emits pollution. The emitted pollution poses a health risk for those who breathe the air and therefore it is a negative externality. Costs of ill health in this case fall on people who are not involved in buying or producing aluminium. To account for the externality we add the external costs to the private costs to find the total social cost of producing aluminium. The social costs are higher than the private costs and therefore the social costs curve lies above or to the left of the private costs curve. The difference between the private costs and social cost reflect external costs of the pollution emitted. In the presence of a negative externality, such as pollution, the social cost of the good exceeds the private cost. The optimal quantity, QOPTIMUM, is therefore smaller than the equilibrium quantity, QMARKET. In the case of a negative, we are clearly producing above the socially optimum level. At the QMARKET equilibrium levels the private value of the good is less than the social cost of producing it. Hence, creating inefficiencies. One way to restore efficiency in the market is by taxing. The tax would force the producers to take into account the external costs of production. If the tax is imposed on sellers then it would move the supply curve upwards by the amount of the tax. Setting the tax=external costs will accurately capture the social costs of production and restore the equilibrium to the QOPTIMUM point. The use of this tax is called internalizing an

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externality, means altering incentives so that people take account of the external effects of their actions.

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Externalities can also yield positive benefits. Education is an example of positive externality. Educated people command higher salaries. A highly educated workforce also benefits the whole economy. More educated workforce attracts firms into the market as they are able to hire more flexible and productive workers. Educated people are also better informed voters, more aware of their civic responsibilities and therefore better citizens. Thus, education can lead to higher economic growth due to the availability of highly skilled workforce and due to a more stable social and political environment. The private valuation of benefits does not take into account the actual value of education to the society. The individual only takes into account his/her private value. Adding the external benefits of education provides with the true social value of education.

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The social value curve lies to the right of the private benefit curve or the demand curve as illustrated on the slide. In the presence of a positive externality, the social value of the good exceeds the private value. The optimal quantity, QOPTIMUM, is therefore larger than the equilibrium quantity, QMARKET. The social value curve represents the private benefit curve + external benefits. The efficient quantity is where the social value curve intersects the supply curve. To induce the market participants to internalise the externality the government can provide incentives such as subsidies. A subsidy in this case can be form of payment that induces the consumers to demand more education or adds more value to obtaining education. Thus moving the market to QOPTIMUM

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Other methods to control externalities is regulation, which is a command and control method. For example, government can regulate the companies from dumping pollutants into the water supply. Because nearly all economic activity requires some emissions, it is not so easy to regulate against pollution. For example, banning all activity is not an option. It can be argued that government can design policies such that emissions etc. can be reduced or provide licences only if certain standards have been met. This would require the government to have intimate knowledge of various industries, which is not very practical. Instead of regulating behaviour, government can adopt market based solutions, such as:

• Provides incentives for decision makers to solve problem themselves.

• Implement taxes enacted to correct the effects of negative

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externalities, know as Pigovian taxes

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The slide shows an example of Pigovian taxes, which are taxes essentially to correct negative externality. The pigovian taxes are called after the name of Arthur Pigou who was an advocate of their use. In panel (a) the government sets a price on pollution by levying a Pigovian tax, and the demand curve determines the quantity of pollution. The tax is set by taking the external cost of pollution into account. Most economist would advocate to reduce pollution through tax rather than regulation. The reason is that the tax allows firms to compare the costs and benefits of pollution and settle on the most efficient point. For example, say we had a regulation that required each firm to reduce pollution by a set amount. This may not necessarily be efficient. The local paper mill may be able to reduce pollution but a steel mill may not be able to meet the regulatory standard for instance. In the case of regulation, steel mill may have to close down which is not necessarily the most efficient outcome. However, if there was a tax then paper mill would reduce pollution to avoid the tax whereas steel mill would respond by reducing pollution less and paying the tax. Also Pigovian taxes provide incentives for firms to innovate to eliminate the tax completely. However, once the regulation target of pollution has been met there is no incentive for firms to reduce emissions further. In panel a the supply of pollution is perfectly elastic. Firms can pollute as much as they like by paying the tax. Thus the position of the demand curves determines how much pollution will ultimately take place. An alternative to tax is cap and trade or tradable pollution permit system. In this case the firms are allocated a certain pollution units or permits. However, these permits are tradeable amongst firms. The forces of demand and supply essentially ensure that the permits are allocated in the most efficient manner. The polluting firms in the case of cap and trade must pay for their emissions through permits. So both cap and trade system and pigovian tax internalise the cost of pollution. The cap and trade system is shown in panel b. In panel (b) the government limits the quantity of pollution by limiting the number of pollution permits, and the demand curve determines the price of pollution. The supply curve is perfectly inelastic because the quantity of pollution is fixed by the government. The position of the demand curve essentially determines the price.

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We will now analyse step by step effect of tax. Suppose a tax of 50 cent is levied on nail varnish manufacturers. As discussed earlier the tax will shift the supply curve to the left by exact 50 cents. Why? Simply because

sellers will now need an additional 50 cents to supply the good. The tax on sellers makes the nail varnish remover business less profitable at any given price, so it shifts the supply curve to the left and the tax reduces the size of the nail varnish remover market. Even though the tax is on the seller both buyers and sellers share the burden of the tax. For example, buyers now pay a higher price and the seller receives a lower price than the equilibrium. In the example above, buyers pay a price of €3.30 and sellers receive

€2.80.

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A subsidy is the opposite of tax. The easiest way to think of subsidies is a payment given to buyers or sellers, depending on the behaviour the government is trying to influence. Suppose the government in France wants to encourage private providers to operate more trains and it decides to €20 subsidy made to train operators. This will increase the supply of train operators as their costs reduce. Note the subsidy is given to the producer in this case, so the supply is affected not the demand. The supply curve shifts to the right by €20. The price now falls to €60. The subsidy benefits both consumers and producers.

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Another way to protect from externalities is through property rights. Property rights grant the exclusive right of an individual, group or organization to determine how a resource is used. Ownership of a house is an example of property rights. So if someone damages our house, we seek compensations. Similarly this idea can be extended to common resources such as rivers, land, air etc. If the property rights were well defined on each of these resources then individuals can get into negotiations about how best to protect these resources. However, there are problems in defining who has property rights to land, river, air etc. So in the face of variety of interventions, markets interventions as outlined earlier provide one of the most practical solution to the climate debate.

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