IB Economics Section 1.4 Market Failure - PowerPoint Presentation

Slide1

IB Economics Section 1.4 Market FailureSection 2.4 Equity in the distribution of incomeSlide2

1. Define community surplus, social efficiency, and Pareto optimality

Explain that the best allocation of resources from society’s point of view is at competitive market equilibrium, where

social (community) surplus

(consumer surplus and producer surplus) is maximized (marginal benefit = marginal cost).

Total surplus = Community

Surplus Slide3

1. Define community surplus, social efficiency, and Pareto optimality

When a market is in equilibrium, with no external influences and with no external effects, it is said to be in a state of

Pareto optimality. Pareto optimality exist when it is impossible to make someone better off without making someone else worse off.

It dose not, however, mean that everyone is equal.

If a market is Pareto optimal, then it is said to be socially efficient. Social efficiency exists when community surplus

is maximized. Community surplus is the welfare of society and it is made up of a

consumer surplus

plus a

producer surplus. Slide4

1. Define community surplus, social efficiency, and Pareto optimality

Allocative efficiency refers to the efficiency with which markets are allocating resources.

A market will be allocatively efficient

if it is producing the right goods for the right people at the right price.

An

allocatively efficient market is therefore one which has no imperfections. (No Deadweight Loss)Slide5

2. Examine the concept of market failure as a failure of the market to achieve allocative efficiency, resulting in an over allocation of resources (overprovision of a good) or an under-allocation of resources (under-provision of a good)

Market failure

is a concept within economic theory describing when the allocation of goods and services by a free market is

not efficient

. That is, there exists another conceivable outcome where a market participant may be made better-off without making someone else worse-off.

(The outcome is not Pareto optimal.) Market failures

can be viewed as scenarios where individuals' pursuit of pure self-interest leads to results that are not efficient – that can be improved upon from the societal point-of-view.Slide6

2. Examine the concept of market failure as a failure of the market to achieve allocative efficiency, resulting in an over allocation of resources (overprovision of a good) or an under-allocation of resources (under-provision of a good)

Markets

can fail for lots of reasons:

Negative externalities

(e.g. the effects of environmental pollution) causing the social cost of production to exceed the private costPositive externalities (e.g. the provision of education and health care) causing the social benefit of consumption to exceed the private benefit

Imperfect information

or

asymmetric information

means that

one party in a transaction has more information than the other or they neglect to take full responsibility for their action with creates

a

moral

hazard.

The private sector in a free-markets cannot profitably supply to consumers

pure public goods

and

common access to resources

and threat to

sustainability

.

Market dominance by

monopolies

lead

to under-production and higher prices than would exist under conditions of competition, causing consumer welfare to be damaged

Factor immobility

causes unemployment and a loss of productive efficiency

Equity (fairness) issues

.

Markets can generate an ‘unacceptable’

distribution of income

and consequent social exclusion which the government may choose to changeSlide7

3. Explain the concepts of marginal private benefits (MPB), marginal social benefits (MSB), marginal private costs (MPC) and marginal social costs (MSC).

Marginal private

cost (MPC): The cost incurred by just the firm in producing each extra unit of a good.

Marginal social

cost (MSC):

The cost incurred by both the firm and society in producing each extra unit of a good.Marginal private benefit (MPB): The increase in private benefit resulting from the consumption of one more unit or the production of one more unit.

Marginal social

benefit (MSB):

The increase in private benefit and society from the consumption of one more unit or the production of one more unit.Slide8

3. Explain the concepts of marginal private benefits (MPB), marginal social benefits (MSB), marginal private costs (MPC) and marginal social costs (MSC).

Private

Costs and Social CostsThe existence of externalities creates a divergence between

private and social costs

of production and the private and social benefits of consumption

.Where there are externalities:Social Cost      =  

Private

Cost + External Cost

Social Benefit  

=

Private

Benefit + External Benefit

Where no externalities exist:

Social benefits = private benefits

Social costs = private costs Slide9

4. Describe the meaning of externalities

as the failure of the market to achieve a social optimum where

MSB = MSC.

Externalities

are third party effects arising from production and consumption of goods and services for which no appropriate compensation is paid.

Externalities

occur outside of the market

i.e. they affect people

not directly involved

in the production and/or consumption of a good or service. They are also known as

spill-over effects

.

Economic activity creates

spill over benefits

and

spill over

costsSlide10

Externalities (MSB

≠ MSC)Slide11

4. Describe the meaning of externalities as the failure of the market to achieve a social optimum where

MSB = MSC.

The cost of an externality is a

negative externality

, or

external cost, while the benefit of an externality is a positive externality, or external benefit.

In the case of both

negative and positive externalities

, prices in a competitive market do not reflect the full costs or benefits of producing or consuming a product or service. Producers and consumers may neither bear all of the costs nor reap all of the benefits of the economic activity, and too much or too little of the goods will be produced or consumed in terms of overall costs and benefits to society.Slide12

4. Describe the meaning of externalities as the failure of the market to achieve a social optimum where

MSB = MSC.

Externalities of both types can in the course of the production or consumption of a good or service.

Negative externality of consumption

(

Demand) = use of a product creates spillover cost to othersNegative externality of production (Supply) = making of a product creates spillover cost to othersPositive externality of consumption

(

Demand

) = use of a product creates spillover benefits to others

Positive externality of production

(

Supply

) = making of a product creates spillover benefits to others Slide13

5. Explain, using diagrams and examples, the concepts of negative externalities of production and consumption, and the welfare loss associated with the production or consumption of a good or service.

Negative externalities

Negative externalities occur when production and/or consumption impose

external costs on third parties

outside of the market for which no appropriate compensation is paid.

When negative production externalities exist, social costs exceed private cost.

This leads to

over-production

if producers do not take into account the externalities.Slide14

5. Explain, using diagrams and examples, the concepts of negative externalities of production and consumption, and the welfare loss associated with the production or consumption of a good or service.

External costs from production

Production externalities

are generated and received in supplying goods and services - examples include noise and atmospheric pollution from factories

.

External costs from consumptionConsumption externalities are generated and received in consumption - examples include pollution from driving cars and motorbikes and externalities created by smoking and alcohol abuse and also the noise pollution created by loud music being played in built-up areas.

Negative

consumption externalities

lead to a situation where the social benefit of consumption is less than the private benefit.Slide15

5. Explain, using diagrams and examples, the concepts of negative externalities of production and consumption, and the welfare loss associated with the production or consumption of a good or service.Slide16

Deadweight loss

Deadweight loss

(also known as excess burden or allocative inefficiency) is a loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal

. In other words, either people who would have more marginal benefit than marginal cost are not buying the product, or people who have more marginal cost than marginal benefit are buying the product.

Causes of

deadweight loss can include monopoly pricing (in the case of artificial scarcity),

externalities

,

taxes

or

subsidies

, and

binding price ceilings

or

floors

(including minimum wages).

The term

deadweight loss

may also be referred to as the "excess burden" of monopoly or taxation.

Slide17

Deadweight lossSlide18

6. Explain that demerit goods are goods whose consumption creates external costs.

A

demerit good is a good or service whose consumption is considered unhealthy, degrading, or otherwise socially undesirable due to the perceived negative effects on the

consumers themselves

. It is over-consumed if left to market forces.

Examples of demerit goods include tobacco, alcoholic beverages, recreational drugs, gambling, junk food and prostitution. Because of the nature of these goods, governments often levy taxes on these goods (specifically, sin taxes

), in some cases

regulating

or

banning

consumption or

advertisement

of these goods.Slide19

6. Explain that demerit goods are goods whose consumption creates external costs.

There is an important conceptual distinction between a

demerit good and a negative externality

. A

negative externality

occurs when the consumption of a good has measurable negative consequences on others who do not consume the good themselves. Pollution (due, for example, to automobile use) is the canonical example of a negative externality. Another example is cigarettes. It not only affects you, but the people around you (second hand smoking). By contrast, a demerit good

is viewed as undesirable because its consumption has negative effects upon the consumer.Slide20

6. Explain that demerit goods are goods whose consumption creates external costs.Slide21

7. Internalizing the externality

Internalizing the externality:

Altering incentives so that people take account of the external effects of their actions.

When

either private

negotiations or government action lead the price to the party to fully reflect the external costs or benefits of that party’s actions.Slide22

7. Evaluate, using diagrams, the use of policy responses, including market-based policies (taxation and tradable permits), and government regulations, to the problem of negative externalities of production and consumption

Public Policies Toward

Externalities

Two approaches

Command-and-control policies

regulate behavior directly. Examples:limits on quantity of pollution emitted

requirements that firms adopt a particular technology to reduce emissions

EX: Laws & regulations & direct provision

Market-based policies

provide incentives so that private decision-makers will choose to solve the problem on their own.

EX:

Taxes,

Subsidies, Price Controls & Advertising Slide23

7. Evaluate, using diagrams, the use of policy responses, including market-based policies (taxation and tradable permits), and government regulations, to the problem of negative externalities of production and consumption

Command and control instruments (CAC

)Command and control instruments, also referred to as

standards

or regulations, are the most common forms of environmental policies in both the advanced and developing countries. As the name implies, the CAC approach consists of a

'command',

which sets a

standard

- the maximum level of permissible pollution, and a

'control'

, which monitors and enforces the

standard

.Slide24

Advantages of StandardsThe main

advantage of standards is that they are a more widely understood form of environmental policy.

Although standards

are considered to be inefficient, they are a pragmatic approach when there is uncertainty about the effects of pollution on the environment.

Political costs of standards are lower compared to market based instruments such as taxes and subsidies as setting

standards

does not incur direct budgetary implications.Slide25

Disadvantages of StandardsAn

'optimum' standard is one which is not only set at a socially acceptable level, but also is economically efficient or cost effective. In order to set an economically efficient standard, the government needs to know the demand curve for clean air (or water) as well as the supply curve for pollution abatement.

However, clean air (or water) is not a marketable good and therefore

the demand curve is not directly observable .

The government also lacks information about the supply curve,

especially when there are numerous polluting firms.Under a CAC

approach,

firms have no incentives to reduce pollution beyond the standard

, since it tends to discourage the development of technologies that might otherwise result in greater levels of (pollution) control

Penalties for violating standards tend to be too low and enforcement tends to be weak.Slide26

Market-Based Instruments (MBIs)

Market-based instruments

(MBIs

)

are policy instruments that use markets, price, and other economic variables to provide incentives for polluters to reduce or eliminate negative

environmental externalities. MBIs seek to address the market failure of externalities (such as pollution) by incorporating the external cost of production or consumption activities through taxes or

charges

on processes or products, or by creating

property rights

and facilitating the establishment of a proxy market for the use of environmental services. Slide27

Market-Based Instruments (MBIs)

Examples include environmentally-related taxes, charges and subsidies, emissions trading and other tradable permit systems, deposit-refund systems, environmental labeling laws, licenses, and economic property rights.

Market-based instruments do not prescribe that firms use specific technologies, or that all firms reduce their emissions by the same amount, which allows firms greater flexibility in their approaches to pollution management.Slide28

Market-Based Instruments (MBIs)

Intervention Type

Effect on Domestic Quantity traded

Effect on Domestic Consumer Surplus

Effect on Domestic Producer surplus

Effect on Government Budget

Excise Tax

Falls

Falls

Falls

Positive

Subsidies to producers

Rises

Rises

Rises

Negative

Maximum Price Ceiling for Producers

Falls;

Excess Demand

Rise or Fall

Falls

Zero

Minimum Price Floor for Producers

Falls; Excess Supply

Falls

Rise or Falls

ZeroSlide29

Tradable permits

Tradable

permits are a cost-efficient, market-driven approach to reducing greenhouse gas emissions. A

government must start by deciding how many tons of a particular gas may be emitted each year. It then divides this quantity up into a number of

tradable emissions entitlements

- measured, perhaps, in CO2-equivalent tons - and allocates them to individual firms. This gives each firm a quota of greenhouse gases that it can emit over a specified interval of time. Then the market takes over. Those polluters that can reduce their emissions relatively cheaply may find it profitable to do so and to

sell their emissions permits

to other firms. Those that find it expensive to cut emissions may find it attractive to buy extra permits. Trading would continue until all

profitable

trading opportunities had been exhausted.

Tradable

permits

will result in firms to lower the quantity of goods

produced.Slide30

Tradable Pollution PermitsSlide31

Tradable Pollution PermitsSlide32

8. Explain using diagrams and examples, the concepts of positive externalities of production and consumption, and the welfare loss associated with the production or consumption of a good or service.

There

are many occasions when the production and/or consumption of a good or a service creates

external benefit

s which boost social welfare.

Where positive externalities exist, the good or service may be under-consumed or under-provided since the free market may fail to value them correctly or take them into account when pricing the product.

With

positive externalities

the benefit to society is greater than your personal benefit.

Therefore with a

positive externality

the

Social

Benefit > Private Benefit

Remember

Social Benefit = private benefit + external benefit.Slide33

Positive externalities

Impacts on 'outsiders' that are advantageous to them and for which they do not have to pay. In the case of

positive externalities the external effects are benefits on other people. These are also known as

external benefits

. There may be external benefits from both

production and consumption. If these are added to the private benefits we get the total social benefits.

For example:

When you consume education you get a private benefit. But there are also benefits to the rest of society.

E.g

you are able to educate other people and therefore they benefit as a result of your education.

A farmer who grows apple trees provides a benefit to a beekeeper. The beekeeper gets a good source of nectar to help make more honey.

If you walk to work, it will reduce congestion and pollution, benefiting everyone else in the city.Slide34

Positive ExternalitiesSlide35

9. Explain that merit goods are goods whose consumption creates external benefits.

Merit

Goods

A product, which consumers may undervalue but which the government believes is 'good' for consumers. It would be under-provided in a pure free-market economy. This is because they have external benefits that people would not take into account when they made their decisions about how much to consume.

With

merit goods

the state is concerned with maximizing the consumption of certain goods which it deems to be desirable; goods and services where the

social benefits exceed the private benefits

, e.g.

education and healthcare

are assumed to generate positive externalities. Slide36

9. Explain that merit goods are goods whose consumption creates external benefits.

Higher government spending on these

merit goods

should yield a positive social rate of return which leads to an improvement in total economic welfare.

There is a case for some form of government intervention to encourage increased consumption of

merit goods. This might take the form of an

explicit government subsidy

to reduce the private marginal costs of consumption and cause an expansion of demand or provide it themselves. Slide37

9. Explain that merit goods are goods whose consumption creates external benefits.Slide38

SUBSIDYPayments to producers or consumers designed to encourage

an increase in output.Slide39

Potential Welfare Gain from Positive Externalities Slide40

10. Evaluate, using diagrams, the use of government responses, including subsidies, legislation, advertising to influence behavior, and direct provision of goods and services.

The government could

subsidize

the supply of health care. A

subsidy would shift the MSC curve outward and, in this way, the socially efficient level of consumption could be reached, Indeed" it may be that the government deems the importance of health care to be so great that it will

subsidize

it to the point where it is free to the consumer, or the state will supply it at no direct cost to the consumer.

The main problem with such a solution is cost.

While this provision is possible in many developed countries, developing countries are not able to fund such schemes and so do not fully benefit from the positive externalities that are to be gained from the consumption of health care.Slide41

10. Evaluate, using diagrams, the use of government responses, including subsidies, legislation,

advertising to influence behavior, and direct provision of goods and services.

The government could use positive

advertising

to encourage people to consume more health care. This would shift the MPB curve to the right, towards the MSB curve, and would thus increase welfare

.

The problem here is that there may be a high cost

to providing the advertising and, although the effect may be beneficial in the long run, it takes a long time to have an effect and so the short-run benefits may be minimal

.

The government could

pass laws

(Legislation)

insisting

that citizens have vaccinations against certain diseases, or have regular health checks, but this will only be successful if the government

provides this free of charge.

Also

, people often

resent laws

of this sort being imposed by the government. They see it as an

infringement

of their civil liberties

. Laws can be difficult and costly to enforce. Slide42

10. Evaluate, using diagrams, the use of government responses, including subsidies, legislation, advertising to influence behavior, and direct provision of goods and services.

Direct provision of goods and services

like health care could lead to shortages and rationing of these goods and services if they are provided free or without price.

Items that are free to the users have no price and thus the market can not ration the good or service.

Public goods

are examples of direct provision by governments because markets can’t. Society may deem certain goods and services worthy for everyone to have access because of the social benefit even thou they are provided my the private markets. Examples are

merit goods

like

healthcare

and

education

. Slide43
Slide44

11. Using the concepts of rivalry and excludability, and providing examples, distinguish between public goods (non-rivalries and non-excludable) and private goods (rivalries and excludable).

excludability:

The

ability to keep people who don't pay for a good from consuming the good

.

non-excludability: This means that when the public good is provided to one person, it is not possible to prevent others from enjoying its consumption.

rivalry

in

consumption:

The

property of a good whereby one person’s use diminishes other people’s

use.

non-rivalry

:

This

means that one person’s use of the public good does not deprive any other person of such use or does not diminish the amount available to

others

.Slide45

11. Using the concepts of rivalry and excludability, and providing examples, distinguish between public goods (non-rivalries and non-excludable) and private goods (rivalries and excludable).

Private goods:

A good that's easy to keep nonpayers from consuming (called excludability), and use of the good by one person prevents use by others (termed

rival

consumption). They are privately owned and can be sold to others for a price. Public goods: A goods or services which are non-excludable

by the producers and

non-rivalry

in consumption. Because of these characteristics, private sector firms have little or no incentive to produce them, since they would be impossible to sell. Therefore, government must provide them. Slide46

11. Using the concepts of rivalry and excludability, and providing examples, distinguish between public goods (non-rivalries and non-excludable) and private goods

(rivalries and excludable).

Public

Goods

do not have well-defined property rights meaning they are, in essence, owned by everyone. But such "public

" ownership is okay because every member of the public can benefit from simultaneously consuming the goods. This public

or joint ownership of

public goods

means they cannot be exchanged through markets. The only efficient way to provide public goods is through governments. The prime example of a

public good

is

national defense

. Every member of society benefits when the country is protected from foreign attack and nonpayers can not be excluded from this protection. Slide47

11. Using the concepts of rivalry and excludability, and providing examples, distinguish between public goods (non-rivalries and non-excludable) and private goods

(rivalries and excludable).Slide48

The Different Kinds of Goods

Private goods: excludable, rival in consumption

example: foodPublic goods

: not excludable, not rival

example: national defense

Common resources: rival but not excludableexample: fish in the ocean

Natural monopolies

: excludable but not rival

example: cable TVSlide49

A

C

T

I

V

E L

E

A

R

N

I

N

G

1

:

Categorizing roads

A road is

which

of the four kinds of goods?

Hint

: The answer depends on whether the road is congested or not, and whether it’s a toll road or not. Consider the different cases.

49Slide50

A

C

T

I

V

E L

E

A

R

N

I

N

G

1

:

Answers

Rival in consumption? Only if congested.

Excludable? Only if a toll road.

Four possibilities

uncongested non-toll road: public good

uncongested toll road: natural monopoly

congested non-toll road: common resource

congested toll road: private good

50Slide51

12. Explain, with reference to the free rider problem, how the lack of public goods indicates market failure.

Public goods

are difficult for private markets to provide because of the free-rider problem

.

Free rider:

a person who receives the benefit of a good but avoids paying for it If good is not excludable, people have incentive to be free riders, because firms cannot prevent non-payers from consuming the good. Result: The good is not produced, even if buyers collectively value the good higher than the cost of providing it. Slide52

12. Explain, with reference to the free rider problem, how the lack of public goods indicates market failure.

If the benefit of a

public good exceeds the cost of providing it, government should provide the good and pay for it with a tax on people who benefit.

Problem

: Measuring the benefit is usually difficult.

Cost-benefit analysis: a study that compares the costs and benefits of providing a

public good

Cost-benefit analyses

are imprecise, so the efficient provision of

public goods

is more difficult than that of private goods. Slide53

13. Discuss the implications of the direct provision of public goods by government.

Public goods

are invariably provided by government because there's no way a private business can profitably produce them. Private businesses can't sell public goods in markets, because they can't charge a price

and keep nonpaying people away. Moreover, businesses shouldn't charge a

price, because there's no opportunity cost for extra consumers. For efficiency, government needs to pay for public goods through taxes.Slide54

14. Explain, using examples, common access resources.

Common access

resource: A resource, or good, whose characteristics make it costly to exclude potential consumers from its usage, and which is vulnerable to congestion and overuse.

Examples

include natural resources over which there is no established private ownership. They are owned by no one, thus available to anyone to use. Their existence gives rise to the tragedy of the commons.

Tragedy of the

Commons:

a parable that illustrates why common resources get used more than is desirable from the standpoint of society as a wholeSlide55

14. Explain, using examples, common access resources.

Common Resources

Like public goods, common resources are

not excludable.

cannot prevent free riders from using

little incentive for firms to providerole for government: seeing that they are providedAdditional problem with common resources:

rival

in consumption

each person’s use reduces others’ ability

to use

role for government: ensuring they are not overusedSlide56

Policy Options to Prevent Overconsumption of Common Resources

regulate

use of the resourceimpose a corrective tax

to internalize the externality

example: hunting & fishing licenses,

entrance fees for congested national parksauction off permits

allowing use of the resource

example: spectrum auctions by the

U.S. Federal Communications Commission

if the resource is land,

convert to a private good

by dividing and selling parcels to individuals

Assign

property rights Slide57

15. Apply the concept of sustainability to the problem of common access resources.

It is argued that the lack of a price mechanism for

common access resources results in their overuse, depletion and degradation. The consequence of the actions of producers and consumers, who do not pay for the resources they use, creates a threat to

sustainability

and, therefore, the availability of common access resources for future generations.Slide58

SustainabilitySustainability

is the capacity to endure. For humans, sustainability is the long-term maintenance of responsibility, which has environmental, economic, and social dimensions, and encompasses the concept of stewardship, the responsible management of resource use.

"Sustainable development

is development that meets the needs of the present without compromising the ability of future generations to meet their own needs." Slide59

16. Examine the consequences of 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.

The threat to

sustainability

comes from the unplanned and often unfettered exploitation of the world's natural resources. The increase in globalization, the drive for economic growth, population growth and developments in technology has made the need for management of global common access resources more acute, whether this is by governments or by local communities.

Clearly, there are already many examples of threats to sustainability from the depletion and destruction of common access resources, such as

deforestation, soil erosion and the overfishing of oceans.

These are compounded by the pursuit of economic growth by newly developing countries, and in less economically developed countries where high levels of poverty and poor regulation creates negative externalities through over-exploitation of land for agriculture.

The depletion of natural resources, such as fossil fuels and fishing resources, creates individual hardship and political instability and potentially threatens world peace. Resource depletion is accelerating and the economic growth of countries that ignore this trend will be eroded by higher commodity prices. Slide60

17. Discuss, using negative externalities diagrams, that economic activity requiring the use of fossil fuels

to satisfy demand poses a threat to sustainability

.

Fossil fuels

are non-renewable resources as they take millions of years to form and accelerating overuse is leading to their rapid depletion. The principles of supply and demand mean that as

fossil fuel supplies diminish, prices rise. However, since the producers and consumers of fossil fuels do not have to account to later generations for their overexploitation of resources, fossil fuels are over-produced, and over-consumed despite their increase in price.

The over-production and overuse of

fossil fuels

raises environmental as well as economic concerns, since coal, petroleum, and natural gas contain high percentages of carbon; the burning of which generates

greenhouse gasses

(GHGs), such as Carbon Dioxide (CO2 ) contributing to the process of

global warming

. Although there is much argument about the extent to which the human activity contributes to

climate change

, the effects of climate change are undisputed, leading to increases in average temperature, altered habitats, extreme weather conditions, sea-level changes and flooding. Slide61

18. Discuss the view that the existence of poverty

in economically less developed countries creates negative externalities through

over-exploitation of land for agriculture, and that this poses a threat to sustainability.

Population increases are both a consequence, and cause, of increasing poverty and low standards of living around the world, especially in Asia and Africa. As populations increase the demand on

common access resources

intensifies resulting in extensive negative externalities

which threatens

sustainability

.

For the 70% of the world's poor who live in rural areas, agriculture is the main source of income and employment. The depletion and degradation of natural resources poses serious challenges to producing enough food and other agricultural products to sustain local livelihoods, but also to meet the needs of urban populations which rely on this supply.Slide62

18. Discuss the view that the existence of poverty

in economically less developed countries creates negative externalities through

over-exploitation of land for agriculture, and that this poses a threat to sustainability.

Where low-income rural populations rely on subsistence agriculture, the likelihood is that

common access resources

will become depleted, unless there is some form of community collaboration.

Sustainability

of resources may be lost if poor communities are forced to sell land and resources, such as forests, to external private corporations who do not have the interests of the local community as a priority, but need to satisfy their shareholders.

Logging

companies,

for example

, will wish to

maximize

their

utilization

of timber resources taking only their private costs into consideration, ignoring the external costs to the local population. As a consequence, there will be overexploitation of timber and deforestation creating

negative externalities

such soil erosion, landslides, flooding and loss of bio-diversity.Slide63

19. Evaluate, using diagrams, possible government responses to threats to sustainability, including legislation

, carbon taxes, cap and trade schemes, and funding for clean technologies.

Governments

can respond to

negative externalities

of production and to resource depletion and CO2 pollution using a number of mechanisms designed to reduce emissions of global greenhouse gasses and promote sustainability. These include:environmental taxation, such as carbon taxes, to recover the external costs of pollution

legislation

setting environmental standards and banning firms which fail to meet these standards

adoption of

cap and trade schemes

for carbon trading

funding

for cleaner technologies

Taxation and financial penalties increase

the market price of carbon. This provides strong incentives to reduce carbon emissions by sending signals:

to

consumers

about what goods and services produce high carbon emissions and which should be used more sparingly.

to

producers

about which inputs emit more carbon, and which emit less, so encouraging them to move to lower-carbon technologies.

to

inventors and innovators

to develop and introduce lower-carbon products and processes. Slide64

19. Evaluate, using diagrams, possible government responses to threats to sustainability, including legislation, carbon taxes

, cap and trade schemes, and funding for clean technologies.

A

cap and trade scheme

is a

market-based approach to reduce carbon emissions via financial incentives that allows corporations or national governments to trade emissions allowances under an overall cap, or limit, on those emissions. Fines are imposed for producers exceeding those limits, while producers operating below their carbon limits can sell or "trade" their offsets to companies that are operating above the limits.

Taxation

has the advantage that it can be implemented by individual governments without international agreement, but, environmental taxes have

dead-weight losses

in addition to their beneficial effects in addressing externalities.

It

is also argued that establishing a price for GHGs through

cap and trade schemes

has the advantage of providing some certainty about reductions in quantities of emissions and creates a market to achieve the climate change mitigation target at the lowest cost.Slide65

19. Evaluate, using diagrams, possible government responses to threats to sustainability, including legislation, carbon taxes, cap and trade schemes, and funding for

clean technologies.

Clean technologies are designed to

minimize

pollution and the emissions of

greenhouse gasses, by creating electricity and fuels with a smaller environmental and carbon footprint. These technologies include recycling, renewable energies (wind and solar power, biomass and biofuels and hydropower), green transportation, waste water recycling and energy efficient lighting, homes, buildings, electric motors and commercial and domestic appliances.Slide66

19. Evaluate, using diagrams, possible government responses to threats to sustainability, including legislation, carbon taxes, cap and trade schemes, and funding

for clean technologies.

If government

subsidies

are particularly focused on the generation of electricity using renewable energy sources, such as wind and solar power, then firms generating electricity using cleaner technologies will face lower costs of production. This will encourage energy producers to produce more wind and solar power, shifting the supply curve to the right and lowering prices for consumers. Slide67

19. Evaluate, using diagrams, possible government responses to threats to sustainability, including legislation, carbon taxes, cap and trade schemes, and funding for clean technologies.

Cleaner technologies

are not always welcomed by local and national communities.

'Wind farms

', for example, may consist of hundreds of wind turbines and are frequently

criticized by some local communities for their negative environmental impacts. They are often seen as a 'blot on the landscape' as well as posing a danger for birds and bats, whose migratory and flight paths may take them into collision with wind turbines and towers. Other alternative energy sources have created similar controversies. The production of

biofuels

has resulted in

food price inflation

worldwide, with land previously used for growing food for human consumption being transferred to the production of crops used to produce biofuelsSlide68

20. Explain, using examples, that government response to threats to sustainability are limited by the global nature of the problems and the lack of ownership of common access resources, and that effective responses require international cooperation.

Government

responses to threats to sustainability

are limited by the global nature of the problems and the lack of ownership of

common access resources. Therefore, effective responses require international cooperation.The United Nations Framework Convention on Climate Change (UNFCCC or FCCC)The UNFCCC is an international environmental treaty resulting from the 1992 United Nations Conference on Environment and Development (the 'Earth Summit'), held in Rio de Janeiro. The objective of the treaty was to

stabilize

greenhouse gas concentrations in the atmosphere, although it was considered legally non-binding as it set no mandatory limits on greenhouse gas emissions for individual countries. However, the treaty provided for future 'protocols' or updates that would set these enforceable limits.

The

1997 Kyoto Protocol

The Kyoto Protocol established legally binding obligations for developed countries to reduce their greenhouse gas emissions.

Industrialized

countries agreed to reduce their combined emissions to 5.2% below 1990 levels during the five-year period 2008-2012. The protocol came into force in 2005.Slide69

21. Explain, using examples, that market failure may occur when one party in an economic transaction (either the buyer or the seller) possesses more information than the other party.

For markets to work, there needs to be

symmetric information

i.e. consumers and producers have the same level of knowledge about the products, and they know everything there is to know about them.

Asymmetric information

occurs when somebody knows more than somebody else in the market. This can make it difficult for the two people to do business together. This is an example of information failure in a market. Slide70

21. Explain, using examples, that market failure may occur when one party in an economic transaction (either the buyer or the seller) possesses more

information than the other party.

The

moral hazard

problem is the tendency of one party to a contract to alter their behavior after the contract is signed in ways which could be costly to the other party.

An example of moral hazard is when people are more likely to behave recklessly after becoming insured, either because the insurer cannot observe this behavior or cannot effectively retaliate against it, for example by failing to renew the insurance.

The

adverse selection

problem arises when information known by the first party to a contract is not known by the second and, as a result, the second party incurs major costs.

An

example

of

adverse selection

is when people who are high risk are more likely to buy insurance, because the insurance company cannot effectively discriminate against them, usually due to lack of information about the particular individual's risk but also sometimes by force of law or other constraints. Slide71

21. Explain, using examples, that market failure may occur when one party in an economic transaction (either the buyer or the seller) possesses more information than the other party.

A common example of where the buyer pays more for a good than is socially efficient is where the seller knows much more about the characteristics of that good than the buyer.

For example where:

the seller of a product knows it is faulty

commercial ideas with technical aspects are hard to describe contractually, but privately known by innovators

labelling of food products use alternative terms for ingredients consumers would normally avoid, e.g. various names for sugars such as glucose, sucrose and fructosefirms may have no incentive to provide consumers with information in markets with a public good aspect Slide72

22. Evaluate possible government responses, including legislation, regulation and provision of information.

The

government

has a number of policy tools at its disposal to correct

asymmetric information and to control externalities. These include taxes, education

programs

and production regulation intended to increase the flow of information to consumers.

Remedies for information

failure:

Clearly,

government

has a considerable role in trying to ensure that some of these information failures are reduced or eliminated.

The

two basic strategies are to increase both the supply of, and demand for, information.Slide73

22. Evaluate possible government responses, including legislation, regulation and provision of information.

Increasing

the supply of information:Options to increase the supply of knowledge include:Government may force producers to provide accurate information about products through

accurate labeling

.

Public broadcasts to improve knowledge may also be made. A government can subsidies public service TV and radio broadcasting. Laws

may be passed to force public limited companies to be more transparent, and publish their financial accounts, as well as have them audited to ensure accuracy.

Government may also

regulate advertising standards

to make advertising more informative, and less persuasive. Slide74

22. Evaluate possible government responses, including legislation, regulation and provision of information.

Increasing the supply of

informationEmployers may be forced to request that job applicants disclose information about themselves, such as whether they have a criminal record.Government may force car owners to have their vehicles regularly checked by test, which provides some basic information to potential buyers.

In addition to direct intervention, government may establish organizations to act as

regulators

and watchdogsIncreasing

the demand for information

Market theory suggests that demand for knowledge will increase if it is provided freely, or at low cost, hence consumers should not have to pay for

information.

Government

may also promote the formation of

pressure groups

, which campaign for more knowledge to be made available by producers.

In addition, promoting literacy, numeracy, and IT skills may help increase the demand for information. Having the skills to acquire knowledge can create an increase in demand for knowledge, and a greater appreciation of the value of information in making rational choices. Slide75

23. Explain how monopoly power can create a welfare loss and is therefore a type of market failure.

Monopolists,

and other imperfect markets, restrict output in order to push up prices and maximize profits. Because of this, they are not producing at the socially efficient level of output. Any imperfect market will fail to equate marginal social cost (

MSC

) and marginal social benefit (

MSB). Slide76

23. Explain how monopoly power can create a welfare loss and is therefore a type of market failure.

Market power

is the ability to affect the terms and conditions of exchange so that the price of a product is set by a single company (price is not imposed by the market as in perfect competition). Although a

monopoly's market power

is great it is still limited by the demand side of the market. A monopoly has a negatively sloped demand curve, not a perfectly inelastic curve. Consequently, any price increase will result in the loss of some customers.Slide77

24. Discuss possible government responses, including legislation, regulation, nationalization and trade liberalization.

Governments may try to reduce this market failure by intervening in a number of ways. They may use legal measures to make markets more competitive. They may pass laws that

do not permit mergers or takeovers

that give an individual firm more than a certain percentage of the market. In addition, they may pass laws that do not permit mergers or takeovers that enable a specified number of the largest firms in an oligopoly to control more than a certain percentage of the market.

They may set up

regulatory bodies to investigate markets where it is felt that monopoly power is being used against the public interest. For example most countries have some sort of "Monopolies Commission" or "

monopoly watchdog

". These bodies are then empowered to take action of some kind, or to recommend that the government should take action, if it can be shown that the public interest is being harmed.Slide78

2.3 Macroeconomic Objectives: Equity in the distribution of incomeSlide79

25. Explain the difference between equity

in the distribution of income and

equality in the distribution of income.

Equity

is a normative concept and concerns the fairness with which scarce resources are allocated among competing

ends. Inevitably there are huge disagreements between people as to what an

equitable distribution

of resources should be.

Some people argue for much great

equality

in the post-tax distribution of income and wealth

achieved by

making the tax and benefit system much more

progressive

. They believe that a lack of

equity

leads

to market

failure because each one

dollar

of income equates to an economic vote. And since resources

tend to

flow to those markets where economics votes are highest, a high level of inequality can lead to what

is perceived

as being an unfair allocation of goods and services.Slide80

25. Explain the difference between equity in the distribution of income and

equality in the distribution of income.

The opposite of equity is

inequality

, and this can arise in two main ways:

Inequality of outcomeInequality of outcome from economic transactions occurs when some individuals gain much more than others from an economic transaction. For example, individuals who sell their labor to a single buyer, a monopsony's, may receive a much lower wage than those who sell their labor

to a firm in a very competitive market.

Differences in income are an important type of inequality of outcome.

Inequality of opportunity

Inequality of opportunity occurs

when individuals are denied access to institutions or employment

, which limits their ability to benefit from living in a market economy. For example, children from poor homes may be denied access to high quality education, which limits their ability to achieve high levels of income in the future..Slide81

26. Explain that due to unequal ownership of factors of production, the market system may not result in an equitable distribution of income.

Given

the unequal distribution of income

that exists in most capitalist economies, is unlikely to be one in which all have an equal say _ clearly

economic voting power is directly related to income so that the rich would have many more votes, and thus a much greater pull on resources, than the poor. Consequently, the resulting pattern of resource allocation may overlook the pressing, often life and death needs of the poor, and reflect instead the more trivial wants of the rich.

In

the economics of the market place, human wants are those that are supported by

effective demand

i.e. demand backed by the ability and willingness to pay the market price

. Human needs

, however, if unaccompanied by the wherewithal to pay, are simply ignored. This is the overriding reason for the existence of mal-nutrition and starvation in the world today: it is not that there is an overall shortage of food - there is more than enough in total terms to feed everyone; the problem, quite simply, is that those who need the food lack the money to pay for it.

Hence the

'free' market, given the degree of inequality

which typically exists, is likely to be one in which many people are severely disadvantaged in terms of their market power. Slide82

27. Analyze data on relative income shares of given percentages of the population, including deciles and quintiles.

A

quintile is a 20%

portion of a country’s population; we can divide a population into

five quintiles

, ranging from the lowest quintile (the poorest 20% of the population) to the highest quintile (the richest 20%). If income were completely equally distributed, everyone would receive exactly the same income, in which case every quintile would receive 20% of income. However, in the real world this is a virtual impossibility. Income shares can also be shown by deciles, which are

10%

portions of the population (there are ten deciles) as well as

quartiles

, or

25%

portions of the populations (there are four quartiles). Slide83

28. Draw a Lorenz curve and explain its significance.

The

two main methods for measuring inequality are the Lorenz curve and the Gini index.

The Lorenz

curve:

A Lorenz curve shows the % of income earned by a given % of the population. A

‘perfect’ income distribution

would be

one where

each % received the same % of income.  

Perfect

equality

would be, for example, where 60% of the population gain 60% of national income. In the above

Lorenz curve

, 60% of the population gain only 20% of the income, hence the curve diverges from the line of perfect equality of

income.

The

further the

Lorenz curve

is from the 45 degree line, the less equal is the distribution of income.

‘Slide84

28. Draw a Lorenz curve and explain its significance.Slide85

29. Explain how the Gini coefficient is derived and interpreted.

The

Gini co-efficient or index

is a mathematical device used to compare income distributions over time and between economies. The

Gini co-efficient can be used in conjunction with the Lorenz curve. It is calculated by comparing the area under the Lorenz curve and the area from the 450 line to the right hand and 'x' axis. In terms of the

Gini index

, the closer the number is to 100 the greater the degree of inequality.Slide86

30. Distinguish between absolute poverty and relative poverty.

Absolute Poverty

The state of people who live on less than $1.25 per day (purchasing power parity), as defined by the World Bank. Generally, such individual are unable to afford the basic necessities of life: food, shelter, education, health, etc.Relative Poverty

The state of earning an income that puts one in the lowest income level within his or her own country. Unlike

absolute poverty, it exists everywhere, since within even the richest nations a proportion of the population earns relatively less than the top income earners.Slide87

30. Distinguish between absolute poverty and relative poverty.poverty line an absolute level of income set by the federal government for each family size below which a family is deemed to be in poverty

poverty rate

the percentage of the population whose family income falls below an absolute level called the poverty lineSlide88

31. Explain possible causes of poverty, including low incomes, unemployment and lack of human capital.

Poverty has many causes

, some of them very basic. Some experts suggest, for instance, that the world has too many people, too few jobs, and not enough food. But such basic causes are quite intractable and not easily eradicated. In most cases, the causes and effects of poverty interact, so that what makes people poor also creates conditions that keep them poor.

Primary factors that may lead to poverty include

overpopulation, the unequal distribution of resources in the world economy, inability to meet high standards of living and costs of living, inadequate education and employment opportunities, environmental degradation, certain economic and demographic trends, and welfare incentives.Slide89

32. Explain possible consequences of poverty, including low living standards, and lack of access to health care and education.

Direct costs:

Health care for the uninsured and the underinsured

Shelters for the

homeless

Public housing and support for private housingFood for the hungryDirect costs to victims of higher crime ratesHigh debt levels

Indirect costs:

Increased costs for police, the judicial system, correction facilities and security systems

Reduced income taxes and other taxes

“Loss of the multiplier effect of having people employed at living wages”

Contributions to society lost because of an uneducated publicSlide90

33. Distinguish between direct

and indirect taxes

, providing examples of each, and explain that direct taxes may be used as a mechanism to redistribute income.

An

indirect tax

is a tax collected by an intermediary i.e. seller, from the person who bears the ultimate economic burden of the tax i.e. consumer. It is imposed on expenditure. In simple terms, it is a tax which is imposed on goods and services sold. It is usually added to the cost of the good or service and charged from the ultimate consumer. The seller will then file a return to the government on all the taxes he has collected from the consumer

.

Examples

GST

(Goods and service tax)

VAT

(Value added tax)

Consumers are charged a

percentage of tax

while purchasing a good/service and then the seller pays the tax collected to the Government.Slide91

33.

Distinguish between

direct and indirect taxes

, providing examples of each, and explain that direct taxes may be used as a mechanism to redistribute income.

Direct Taxes

It is a tax paid directly to the government by the persons on whom it is imposed.

Examples

Tax imposed on peoples’ income-

Income tax

Tax on wealth –

wealth Tax

Tax on firm’s profits.-

corporate taxSlide92

34. Distinguish between progressive, regressive and proportional taxation, providing examples of each.

Progressive Tax

A tax in which people with more income pay a larger percentage in

taxes.

Example: Income tax (Direct Tax)

Regressive Tax A tax in which people with more income pay a smaller percentage in taxes. Example: Sales Tax (Indirect Tax)

Proportional Tax

A tax in which people pay the same percentage of income in taxes regardless of their incomes.

Example: Flat Tax (Direct Tax)Slide93

200,000

100,000

$50,000

% of income

tax

% of income

tax

% of income

tax

income

30

60,000

25

25,000

20%

$10,000

progressive

25

50,000

25

25,000

25%

$12,500

proportional

20

40,000

25

25,000

30%

$15,000

regressive

Examples of the Three Tax Systems

0Slide94

35. Calculate the

marginal rate of tax and the

average rate of tax from a set of data. 

An

average tax rate

is the ratio of the total amount of taxes paid to the total tax base (taxable income or spending), expressed as a percentage.Let T

be the total tax liability.

Let

B

be the total tax

base.

Average tax rate =

T / B Slide95

35. Calculate the marginal rate of tax

and the average rate of tax

from a set of data.

A

marginal tax rate

is sometimes defined as the tax rate that applies to the last (or next) unit of the tax base (taxable income or spending). In plain English, the marginal tax rate is the tax percentage on the highest dollar earned. For example, in the United States, the top

marginal tax rate

is 39.6%, but that rate applies only to earnings over $400,000 per year; earnings under $400,000 have a lower tax rate of 33% or less

.

That formal definition only holds true to the equation following when the denominator equals one unit of the tax base. In practice most decisions require the denominator to be a larger amount. The

marginal tax rate

equals the change in taxes divided by the change in tax base, expressed as a percentage.

Let

T

be the total tax liability.

Let

B

be

the total tax base

.

Marginal

tax

rate =

T / BSlide96

36. Explain that governments undertake expenditures to provide directly, or to subsidize, a variety of socially desirable goods and services (including health care services, education, and infrastructure that includes sanitation and clean water supplies), thereby making them available to those on low incomes.

Higher government spending on

merit

goods

should yield a

positive social rate of return which leads to an improvement in total economic welfare.There is a case for some form of government intervention to encourage increased consumption of merit goods

. This might take the form of an

explicit government subsidy

to reduce the private marginal costs of consumption and cause an expansion of demand.

The government often provides merit goods "

free at the point of use

" and then finances them through general taxation.

Examples of merit goods that are largely state provided include primary health care

and public schooling. Slide97

37. Explain the term transfer payments, and provide examples, including old age pensions, unemployment benefits and child allowances.

A

transfer payment is a payment from the government to an individual for which no good or service is exchanged. In order to be eligible to receive them, an individual has to fall below a certain income threshold or to be experiencing economic hardship.

Transfer payments

existing in most developed countries include:

Unemployment benefitsSocial security benefitsNutritional subsidiesHigher education grants and tuition subsidiesWelfare benefitsSlide98

38. Evaluate government policies to promote

equity (taxation, government expenditure and transfer payments) in terms of their potential positive or negative effects on

efficiency in the allocation of resources.

A

tax system

that punishes innovation, productivity and hard work is clearly undesirable and should therefore be avoided. However, a tax system including progressive marginal income taxes combined with

regressive indirect taxes

ensures that both the rich and the poor share a portion of the nation’s tax burden. Yet it also ensures that those with the greatest ability to pay bear the largest burden while those whose ability to pay the lowest benefit from the

public

and

transfer payments

that the government provides. This reduces the inequality of income distribution and corrects for the

market failures

that results in a

free market system

.Slide99

38. Evaluate government policies to promote equity

(taxation, government expenditure and transfer payments) in terms of their potential positive or negative effects on

efficiency in the allocation of resources.

Progressive Tax

A tax in which people with more income pay a larger percentage in taxes.

Regressive Tax A tax in which people with more income pay a smaller percentage in taxes.Proportional Tax A tax in which people pay the same percentage of income in taxes regardless of their incomes.

in-kind transfers

transfers to the poor given in the form of goods and services rather than

cashSlide100

38. Evaluate government policies to promote equity

(taxation, government expenditure and transfer payments) in terms of their potential positive or negative effects on

efficiency in the allocation of resources.