Government Failure

Sometimes we see governments intervening in markets in an attempt to make them more efficient. However, it is very often the case that they aren't any better at managing resources than the free market - this is known as government failure. We'll look at example involving land conversion and biodiversity loss.

Land conversion is the main reason for biodiversity loss around the word - both grassland and forest cover is declining rapidly in some parts of the planet. We use a diagram similar to the one used in the last post which looks at the interaction between a firm's marginal net private benefit and the marginal external cost of land conversion. The definitions in this case are as follows:

• Marginal net private benefit (MNPB) = the profit associated with a one unit increase in land conversion.
•  Marginal external cost (MEC) =  External cost of a one unit rise in land conversion.

The market for this looks as follows:

Let us describe the market. We have an initial over-conversion because of the market failure. Lp is converted when the socially optimal level would be L*. This is all explained in the last post I made. The government failure, however, comes in the form of the subsidy. The government may be subsidising farmers' incomes, or something of the sort, but this is encouraging more land to be converted. The subsidy increases the marginal net private benefit of land conversion for the firm and therefore the amount of land converted has moved further away from the socially optimal level. We have to remove the government failure before we can remedy the market failure.

We've assumed a constant upwards sloping marginal external cost curve here, but it may be a good time to mention other plausible curves. We could have a curve that increases at a constant rate and once a threshold point is reached it increases faster. Or, we could even have a downwards sloping MEC curve. How? Imagine a view being ruined by a factory. The first factory has a massive effect on the view but subsequent factories have a lesser effect because the damage has already been done by the previous factories.

Government failure occurs a lot in the real world. One example would be with the Common Agricultural Policy. It aimed to provide farmers with a steady income by offering a guarantee price for their goods. This meant overproduction was rife - farmers knew that the best technique was to farm as much as they possibly could to get the most revenue. Land was farmed more intensively and more land was converted to farming to expand production. This will/has caused degradation of the land and biodiversity loss.

Another example is subsidies in developing countries. Governments there tend to impose subsidies to keep prices below the market price so that food and the like is affordable. This encourages over use of the land once again and makes the economic activity look artificially appealing, attracting more firms in. It is also a waste of financial resources that are needed elsewhere.

As we can see government failure is something that is very real. It can occur fairly easily and it needs to be stopped before any market failure can be addressed. How do we stop it, though? I'll be going into this in later posts, stay tuned. Thanks for reading.

Sam.

Markets and Market Failure

When it comes to a firm deciding what output to produce, they generally take into account only two things: How much they can sell the good for and how much it costs to produce. Using this information, they set out to maximise profit by producing where the marginal costs are equal to the marginal revenue. This means there is a strong incentive for the firm to keep costs as low as possible to maximise profits.  

Many environmental goods do not come with a price tag, they are treated as being free by the firm. This 0 price tag means that firms put no effort into using these resources efficiently. The costs that the firm should incur when using these goods are known as the external costs. They do not get taken into account by the firm when making production decisions and therefore we experience over production. External costs are the difference between the social cost of an economic decision and the private costs (costs to the one making the decision).

Here we can clearly see that at the price P the optimal production would be Q*, if the social costs were taken into account. But production is actually at Q because only the firms private costs are looked at when deciding how much to produce. This is an obvious overproduction and it is due to environmental goods not having a price and therefore being treated as free.

Another way to map this out is using marginal external costs versus the marginal net private benefits of production. The marginal net private benefit is the additional benefit the producing firm gains from each additional unit of production. The marginal external cost is the cost to the third party of each additional unit of production. Each additional unit of production adds an increasing amount to the costs but a decreasing amount to the benefits, hence the shape of the curves you're about to see.

In the scenario here, the firm produces at the point Q. Why? Well, they do not care about the marginal external cost of their actions so we can ignore that curve for now. At point Q, benefit for the firm is maximised. Any more production past point Q and benefit to the firm will start to decline. Any point before Q will mean there is more potential benefit to gain. The socially optimal point of output/pollution would be at Q*. This is where the profit from producing the last unit of pollution equals the cost of producing it. Essentially, here, benefits = costs. The external cost has been paid for and the true value of the environmental good has been taken into account. The problem is getting firms to produce at this point. There needs to be a form of incentive to encourage firms to reduce production and therefore pollution to the socially optimal point. How to do this?

That's market failure in an environmental sense. Thank you for reading, comment if you have questions.. blah blah blah. Have a good day.

Sam.

Externalities and Public Goods

Externalities are the effect on the third party of an action made by an individual or a firm - whether it be for the better or the worse. A lot of the time externalities are negative, pollution for example, and this is the example we will use here. We'll look at a firm in industry creating a good that means they are polluting the atmosphere.

With externalities being ignored, the firm will hire workers and capital according to the rule: (Marginal revenue product of labour = marginal cost of labour = wage = marginal cost of labour)

In Layman's terms, this means they'll employ labour up until the point where the marginal revenue product of labour is equal to the marginal cost of labour, meaning profits are being maximised. If the producer had to clean up the pollution as well then the amount they'd employ would become:

What has been added is a new Price, the price of cleaning pollution. This is taken away from the price of the product they're producing which will overall leave a lower figure. If we rearranged above we could achieve this:

The marginal cost of the good will now be the wage plus the marginal cost of cleaning up the pollution. This means the social cost of the firms actions have been taken into account. Previously, the marginal cost of production was below the marginal social cost - leading to an overproduction. Here it is graphically:

Q2 is the social optimum when the cost of clearing the pollution is taken into account. If MSC is greater than MC then there are external costs of production, if it's the other way round there are external benefits to production.

Now for a quick look at public goods, a fairly simple sub-topic. A public good is one that has the characteristics 'non rival' and 'non excludable'. What does this mean? It means that my consumption of the good does not stop other people consuming it (non rival) and I cannot be prevented from consuming the good once it is provided (non excludable). Street lighting is a good example. It's a good that generally has to be provided by a government because no individual or firm would pay for it - they'd just wait for someone else to buy and free ride. A good that has only one of the characteristics stated above but not both is known as a 'quasi-public good'.

That's all boys and girls! Comment if you need more help, share the blog if it has assisted you. Cheers!
Sam.

Government Intervention - Taxation (Microeconomics)

Another way the government can intervene to correct market failure is through taxation. Basically, the government will try to tax goods with lots of negative externalities to attempt to discourage consumers from buying them, thus lowering consumption and somewhat correcting the market failure.

The government has two forms of taxation at its disposal, these being direct and indirect.

1. Direct Taxes - These are taxes off the incomes of individuals and firms. So examples of these would be income tax and corporation tax. Direct taxes cannot be avoided.
2. Indirect Taxes - These are taxes charged locally on goods and services. Examples would be VAT (Value added tax) and council tax (Tax on your house).

The aim of the tax is to try to reduce the consumption of the good by raising the price. So, the tax shifts the supply curve leftwards, moving the equilibrium point to a higher price and lower quantity. The tax that is imposed should equal the value of the negative externality. The price rises and the price then takes into account the full cost of the negative externality, this is known as the polluter pays principle. Basically, the polluter is now paying for all the pollution caused. 

There are problems with taxation however. Firstly, the amount to tax is difficult to workout. As it is hard to estimate the exact cost of a negative externality it means it is difficult to tax the absolute correct amount, most of the time its either too much or too little. Price elasticity of demand comes into play too. A rise in price caused by the taxation may not cause a big enough fall in demand because the goods PED may be inelastic. This is another problem. 

That's all for this topic, next is 'Government Intervention - Subsidies'. Stay tuned. :-)

Government Intervention - Regulation (Microeconomics)

Government intervention is when the government intervenes in the market to attempt to correct the market failure. This post will be on a specific type of government intervention - regulation.

Regulation comes in three different forms, these being laws/legislation, price controls and control of monopoly powers.

Laws and legislation is pretty self explanatory, passing laws or introducing legislation as an attempt to fix the market failure. An example of this would be passing the law meaning you have to be 18 to purchase alcohol. Alcohol is a good with negative externalities, thus is causing market failure. So passing the law means that the consumption of alcohol is limited somewhat and the market failure should be lessened.

Price controls is also a fairly self explanatory form of government regulation. It involves setting a minimum or maximum price for the good to affect the consumption. An example is the minimum wage, that is classed as a minimum price. This reduces the consumption of low paid workers, and corrects that market failure to a certain extent.

Finally, control of monopoly powers. This is the government intervening in a market where a monopoly exist to try and stop consumers being ripped off so to speak. In a monopoly market, one firm/business/individual has a large majority of that market, meaning they are pretty much in control and can set prices to whatever level they like whilst offering a poor service and still receive customers. Controlling these monopoly powers means the government will get involved to limit how much power the monopoly business has to protect the consumer, thus correcting the market failure.

That's about it, but ill list a few more examples of goods/services that have regulations imposed on them.

• Tobacco - Required to be 18 to buy it, shops need a license to sell it.
• Education - Law makes it compulsory. Not relevant anymore, but there used to be price controls with the maximum tuition fees.
• Driving - Law to wear a seatbelt.

Thanks for reading, up next is government intervention - Taxation!

Externalities (Microeconomics)

An externality, in the economic world, occurs when people not directly involved in a decision are affected by it. Some examples of this are fishermen may not be able to fish in a river if someone has contaminated it with rubbish or a new hospital being built will benefit all people in the local area. The term given to those not directly involved in the decision is third party. The third parties in the two examples I've given are the fishermen and the people in the local area.

Linked in with the externalities theory are the costs and benefits that come about from someones decision. The three types are private, external and social. Private costs/benefits are the costs and benefits to the person actually making the decision. Say i decided to pave over my front garden, the private cost would be me losing garden space but the private benefit would be extra parking space. External costs/benefits are the costs and benefits of a decision that someone makes that fall onto the third party. Continuing my example, the external cost of me paving my garden would be the street wouldn't like as nice to the neighbours and passers-by. The external benefits would be a clearer road for the neighbours to drive down because i could then park my car on the new paved area rather than in the street. Finally, the social costs/benefits are the total costs and benefits to society as a whole of the decision. The social cost equals the private costs plus the external costs.

External costs = Social costs - Private costs.
External benefits = Social benefits - Private benefits.

When the social cost is higher than the private cost it means there are external costs in play, these are known as negative externalities. Binge drinking, chewing gum and fly tipping all have negative externalities. The situation of a negative externality can be illustrated on a diagram...

The diagram represents our negative externality. The current equilibrium point is PQ, at this price we are at supply curve 'Supply' but this is only taking into account the private costs of the good. If the external costs are taken into account then the supply curve should shift leftwards to 'Supply 1'. This would raise the price to pay for the extra external costs, as well as lower the supply. The problem with negative externalities is that there is over-production of Q-Q1 and price is lower than it should be. Too many scarce resources are being used, so there is market failure.

Positive externalities work in the same way, this is when the social benefit of a decision is higher than the private benefit.Examples are vaccinations and education. They are the opposite of negative externalities, goods with positive externalities tend to be under-produced. If the external benefits were taken into account then the supply curve would shift to the right, lowering price and increasing production. The under-production here is another form of market failure.

Enjoy. :)