Market Failure Essay Q3

5/26/2018 Market Failure Essay Q3

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According to The World Bank, 16 of the 20 most polluted cities

in the world are in China. A plan to lift Beijings shroud of

pollution ahead of the Olympic Games includes stopping half

of Beijings 3.3 million vehicles and shutting down chemical

plants, power stations and foundries to cut emissions by 30%.

(a) Using appropriate examples, explain and illustrate theterms externality and public goods. [10]

(b) Assess whether the measures stated above is the best way

to curb pollution in China. [15]


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(a) Using appropriate examples, explain and illustrate

the terms externality and public goods. [10]

INTRODUCTION

Define market failure Failure of unregulated free market to achieve efficient

allocation of resources and/or othersocial goals Two examples of sources of market failure:

externalities and public goods


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DEVELOPMENT

Externalities Definition: third-party effects arising from production

or consumption of a good or service, for which thethird-party neither pays nor receives anycompensation

There can be negativeor positiveexternalities




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DEVELOPMENT

Negative externalities An example of negative externalities is ___.

In the pursuit of self-interest, producers of ___ will onlyconsider their own private costs,

ignoring external cost imposed on society, such as ___.

As shown in the diagram, this creates a divergencebetween MSC and MPC of the distance of the MEC

You may want to assume

constant or increasing MEC


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DEVELOPMENT

Negative externalities Assuming that that MSB = MPB,

the free market results in an overproductionof ___, above the socially optimal level of output(___) whereMSB = MSC.

The resulting deadweight lossof area ___ indicates an

inefficient allocation of resourcesin the free market.


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A

E

E1

Quantity

Price

0

MPB = MSB

MPC

QR

Socially ideal

output = 0R

Actual output = 0Q

Overproduction

Welfare Loss

to Society

(DWL)

MSC = MPC + MEC

MEC

What you need to know

Deadweight loss

is the decrease in

total society

surplus that

results from an

inefficient level of

production

Introduction to Negative Externalities


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7

A

E

E1

Quantity

Price

0

MPB = MSB

MPC

QR

Welfare Loss

to Society

(DWL)

MSC = MPC + MEC

MEC

How to draw the diagram


1. Draw MPC and

MPB diagram

2. Indicate Qty(free market)

3. Draw MSC

4. Indicate MEC

5. Indicate Qty

(socially optm)

6. Highlight DWL


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8

Practice time: Activity -Smoking


1. Identify good / service as one with negative externalities

The consumption of cigarettes; smoking creates negativeexternalities which are costs spilled over to 3rdparties not

involved in the consumption of the good.


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2. Identify MEC such that MSC > MPC

In such an activity, there incurs external cost on 3rdparties and

this external cost is not taken into account by private consumers

of cigarettes. This causes the marginal social cost of smoking to

be greater than the marginal private cost due to the marginal

external cost burdened on 3rdparties.

This marginal external cost comes in the form of 2ndhandsmoke which non-smokers inhale, possibly leading to health

problems such as lung cancer.


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3. Explain that when left to a free market, production

(consumption) will be at MPB=MPC

When left to the free market, a smoker will choose to consume

cigarettes to the point where his marginal private benefit is

equal to his marginal private cost.

In this case, his satisfaction and happiness will determine his

marginal private benefit and the cost of the cigarettes as well asthe health damage to himself makes up his marginal private

cost.


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4. Explain that societys welfare will instead be at MSB=MSC

However, societys welfare is not maximised in this case as thesocially optimum level of consumption should be where

marginal social benefit to society is equal to the marginal social

cost. Because the external cost to 3rdparties are not considered

in a smokers consumption of cigarettes, marginal social cost is

thus greater than marginal private cost.


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5. Identify over production of good

Thus, an over-consumption of cigarettes occur, whereby qtywhen left to the free market is higher than where it is allocatively

efficient for society.


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6. Explain dead weight loss is observed and thus society is not at

allocative efficient point.

This overconsumption of cigarettes that causes society to be

allocatively inefficient thus result in a dead weight loss to

society, thus explaining market failure in smoking.


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DEVELOPMENT

Positive externalities Example (e.g., vaccination)

Self-interest External benefit

Diagram

Divergence between MSB and MPB


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DEVELOPMENT

Positive externalities Assuming MSC = MPC

Underconsumption Socially optimal level of output where MSB = MSC

Deadweight loss

Inefficient allocation of resources


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DEVELOPMENT

Public Goods 2 key features: non-rivalry and non-excludability

Non-rivalry: consumption of a good or service by one person

does not reduce amount available to others Non-excludability: not possible or very costly to exclude a

non-payer from consuming the good or service

An example is ___.


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DEVELOPMENT

Public Goods It is non-rivalrous because ___. Once produced, the marginal

cost of providing___to the additional user is zero,

meaning that the price has to be zero for allocative efficiency. It is non-excludable because ___. This leads to the free riderproblem, where no one has the incentive to pay for ___.

Typically, a public good will not be provided by the freemarket, even though people want to consume it.

This represents an inefficient allocation of resources.


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CONCLUSION(an example)

As a result of sources of market failure such asexternalities and public goods, the unregulated

free market will be unable to achieve an efficientallocation of resources. Hence, governmentintervention may be required to correct themarket failure, and this will be discussed in (b).


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(b) Assess whether the measures stated above is the

best way to curb pollution in China. [15]

INTRODUCTION

Clarify that pollution is a form of externality

Clarify measures Stopping vehicles in Beijing

Shutting down chemical plants, etc

Clarify objective specified in question Curbing pollution in China

Criteria for best Effectiveness

Desirability

FeasibilityNote:best, most effective, only

must consider alternatives!


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DEVELOPMENT

Briefly explain the stated measures Stopping vehicles in Beijing

A form of quotalimit max no. of cars on roads in Beijing

Diagram with perfectly inelastic supply curve

Shutting down chemical plants, etc Banon production of such goods altogether within Beijing

Diagram indicating production of the good is zero


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DEVELOPMENT

Advantages of the stated measures Effectiveness

Meets objectiveof reducing pollution from cars and theindustrial entities in Beijing

Desirability Less congestion and pollutionfor non-car owners

Also good for tourism and future growth

Feasibility Relatively quick to implement


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DEVELOPMENT

Limitations of the stated measured Effectiveness

Depends on estimationof optimal quantity (information)

Does not curb pollution in China, only in Beijing

Desirability May result in varying degrees of allocative inefficiency

(depending on type of measures and effectiveness)

Possible losses in production(from industrial entities) andproductivity(for car drivers who did not obtain the permit)


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DEVELOPMENT

Limitations of the stated measured Feasibility

May not be sustainable over time

May not be feasible across whole of China

Ease of enforcement(corruption?)


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DEVELOPMENT

Explain and examine pros and cons of at leasttwoother alternatives, e.g.,

Education (dd-side) Long term measure May not reap immediate results

Results not guaranteed


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DEVELOPMENT

Explain and examine pros and cons of at leasttwoother alternatives, e.g.,

Tax (ss-side) Market-basedapproach which internalises the externality Tax revenue can be further channelled to R&D

Difficulty in estimating the right amount of tax

Tradeable permits

Other regulatory measures


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CONCLUSION

Make a stand and jus t i fy

Overall, which is the best measure? Why?

Relate back to aim of curbing pollution in China Cost-benefit analysis

Cost of implementation / enforcement comparedwith the LR and SR benefits of the measures

Combination of measures

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Market Failure Essay Q3