Unit 2.8 - Market Failure: Externalities and Common Pool Resources

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A characteristic indicating that the usage of a resource reduces the amount available for others to use or consume.

rivalrous

Resources not owned by anyone, available for use without direct payment, leading to potential over-consumption.

Common access resources

The inability to prevent individuals from benefiting from a resource once it is made available.

non-excludability

The phenomenon where shared resources are overused, leading to their degradation or depletion.

tragedy of the commons

CPRs

Common pool resources are natural resources that are available to all but are not owned by any individual. They are non-excludable but rivalrous, leading to potential overuse and depletion, creating challenges for sustainability.

Pigouvian tax

An indirect tax aimed at internalizing negative externalities by taxing producers or consumers to account for the true costs of their actions. This tax is used to address issues like overfishing and pollution, encouraging more sustainable practices.

congestion

Overuse of a common access resource such as a road network, so each extra user imposes costs on everyone else — hours lost and heavier air pollution. It is a standard negative externality of consumption.

free riders

Individuals who benefit from a resource without contributing to its cost, often due to the non-excludability of common pool resources. This behavior leads to over-consumption and makes it difficult to sustain these resources.

overfishing

The commercial practice of removing too many fish from their natural habitat, preventing species from replenishing themselves. This leads to depleted fish stocks and poses a threat to sustainability, causing negative externalities like pollution from fishing activities.

unsustainable production

The exploitation of common pool resources leading to negative externalities, such as overfishing and pollution, which results in a long-term decline in natural capital beyond sustainable levels. This unsustainable production arises from the non-excludability of these resources, causing over-consumption.

corporate social responsibility

A voluntary framework where businesses acknowledge and take responsibility for their societal and environmental impact. This practice can lead to changes in consumer behavior, as seen in initiatives that contribute to public health, such as reducing smoking rates.

enforcement costs

The costs associated with ensuring compliance with government policies, which can include expenses related to monitoring, fines, and administrative actions. These costs can limit the effectiveness of government interventions, particularly in areas like public health and environmental regulations.

stakeholders

Individuals or groups that have an interest in the outcomes of government policies. Different stakeholders can be affected in various ways, leading to potential exploitation, especially when large firms benefit more from regulations than smaller ones.

time lags

Delays between the implementation of government policies and their observable effects. These lags can hinder the effectiveness of interventions aimed at addressing issues like public health and education, as the benefits may take time to materialize.

A levy imposed to reduce harmful emissions from fossil fuels.

carbon tax

Government-regulated schemes that allow for the trading of emissions to achieve a more socially efficient production level.

tradable permits

Laws enacted by the government aimed at addressing market imperfections and externalities.

legislation

Voluntary actions taken by a community to address negative externalities and manage shared resources effectively.

collective self-governance

Congestion charge

An indirect tax imposed to manage traffic congestion by internalizing the external costs associated with road use. This charge aims to reduce traffic and pollution by making users pay for the true costs of their driving.

Education (awareness creation)

A government response to externalities that focuses on informing the public about the costs of their consumption choices. This approach aims to reduce the consumption of demerit goods through awareness rather than direct regulation or taxation.

Emissions trading scheme (ETS)

A specific type of tradable permit system that regulates the total amount of emissions allowed in an industry. Firms can trade permits, creating a market for pollution rights and encouraging reductions in emissions through economic incentives.

Kyoto Protocol

An international agreement under the UNFCCC that commits participating countries to reduce greenhouse gas emissions, recognizing different responsibilities based on economic capabilities and historical contributions to emissions.

MPC, MSC, MPB, MSB

A set of economic concepts representing marginal private cost (MPC), marginal social cost (MSC), marginal private benefit (MPB), and marginal social benefit (MSB), used to analyze externalities in production and consumption.

Tradable permits (cap and trade schemes)

Government-regulated emissions trading schemes that set a cap on total emissions allowed in an industry. Firms receive permits to pollute, which can be traded, incentivizing reductions in pollution by allowing efficient firms to sell excess permits.

UNFCCC

The United Nations Framework Convention on Climate Change, established in 1992, which serves as a foundation for international agreements like the Kyoto Protocol, aimed at combating climate change by reducing greenhouse gas emissions.

cap and trade

A market-based approach to controlling pollution by providing economic incentives for reducing emissions. It involves setting a cap on total emissions and allowing firms to trade permits to pollute within that limit.

cap and trade schemes

Government-regulated systems that allow firms to buy and sell emissions permits to limit pollution. By setting a cap on total emissions, these schemes incentivize firms to reduce their pollution levels efficiently.

cap and trade schemes (CATS)

A market-based approach to limit pollution where firms are given permits to emit a certain amount of pollutants. These permits can be traded among firms, allowing more efficient firms to sell excess permits, thus creating economic incentives to reduce emissions.

carbon emissions permits

A type of permit that allows the holder to emit a specified amount of carbon dioxide, typically used in cap and trade schemes to regulate total emissions.

education

A government response to externalities that works by awareness creation rather than compulsion — teaching safe sex in schools, promoting health screening, advertising the benefits of recycling. It raises perceived private benefit, shifting demand towards the socially optimal quantity.

environmental agreements

International treaties aimed at addressing negative externalities related to environmental issues. These legally binding agreements facilitate cooperation among countries to protect the environment and manage resources sustainably.

international agreements

Formal contracts between countries aimed at addressing negative externalities, often legally binding, and essential for environmental protection. They can be bilateral or multilateral and cover various environmental issues.

pollution permits

Government-issued allowances that permit firms to emit a specific amount of pollutants. These permits can be traded, creating a market for pollution rights and encouraging firms to reduce emissions to save costs.

Resources that are available to all but can be depleted through consumption.

common pool resources

Sustainable Development Goals (SDG)

A set of 17 interconnected global goals established by the United Nations to promote ecological and social sustainability. These goals aim to address various challenges, including poverty, inequality, and environmental degradation, emphasizing a balanced approach to development.

international co-operation

The collaboration between countries to address global issues such as market failures and resource management. This cooperation is essential for tackling challenges like sustainability and the management of common pool resources that transcend national borders.

international cooperation

Collaboration between nations to tackle global challenges, especially those related to market failures and common pool resources. It is crucial for addressing issues like sustainability and resource management, necessitating effective enforcement and monitoring.

monitoring and enforcement

The processes and costs involved in ensuring compliance with regulations aimed at correcting market failures. Effective monitoring and enforcement are crucial for the success of policies related to environmental protection and resource management.

rivalry (rivalrous)

A characteristic of goods where one person's consumption reduces the availability for others. This concept is significant in understanding common pool resources, as overuse can lead to depletion and market failure, exemplifying the tragedy of the commons.

Products that cause negative spillover effects to third parties not involved in the economic transaction.

Demerit goods

The additional expense of production for firms or the extra charge paid by customers for the output or consumption of an extra unit of a good or service.

marginal private cost (MPC)

The additional value enjoyed by households and firms from the consumption or production of an extra unit of a particular good or service.

marginal private benefit (MPB)

The benefits enjoyed by a third party from an economic transaction.

positive externalities

The external costs or benefits resulting from an economic transaction that lead to market failure in achieving social optimum levels.

Externalities

State the formula: P (P)

P = MC When price equals marginal cost, economic welfare (consumer and producer surplus) is maximized in a competitive market.

Externalities (spillover effects)

The external costs or benefits of an economic transaction that affect third parties not directly involved in the transaction. These spillover effects can lead to market failure if they are not accounted for in the decision-making process.

Negative externalities (external costs)

The expenses incurred by third parties due to the negative effects of production or consumption that are not compensated. These costs can lead to adverse outcomes for society, such as environmental damage or health issues.

Over-consumption

A condition where the consumption of a good or service exceeds the socially optimal level, typically due to negative externalities. This can lead to welfare loss, as the social costs outweigh the private benefits, resulting in harm to society.

Positive externalities (external benefits)

The advantages or gains experienced by third parties from the production or consumption of a good or service. These benefits can enhance social welfare and are not reflected in the market price, often justifying government intervention.

Under-consumption

A situation where the consumption of a good or service is below the socially optimal level, often due to positive externalities that are not fully realized. This can result in welfare loss, indicating that more consumption would benefit society.

excludable

A characteristic of goods or services that allows suppliers to prevent non-payers from accessing or benefiting from them. This property is essential in determining how resources are allocated and consumed in a market.

The actual expenses incurred by an individual firm or person during production and consumption.

Private costs

The advantages or gains of production and consumption enjoyed by an individual firm or person.

Private benefits

monopoly power

The ability of a single firm to set prices above market equilibrium, leading to inefficiencies in resource allocation and potential market failure. This power can result in higher prices for consumers and reduced output compared to competitive markets.

Advantages or gains of production or consumption to a third party not directly involved in an economic transaction.

external benefits

External costs

The disadvantages or losses incurred by third parties from production or consumption, which are not reflected in the market prices. These costs can include negative effects such as pollution or traffic congestion that impact individuals not directly involved in the economic transaction.

Social benefits

The true or full benefits of consumption or production, which consist of private benefits enjoyed by individuals or firms and external benefits that accrue to third parties. Social benefits represent the total positive impact of an economic activity on society.

Social costs

The true or full costs of consumption or production, which include both private costs incurred by individuals or firms and external costs imposed on society. This means that social costs reflect the overall impact of an economic activity on the community.

government provision

A government initiative to supply goods and services directly to rectify market failures. This includes services like public transportation, education, and healthcare to ensure equitable access and the achievement of socially optimal output levels, despite challenges like economic inefficiency.

producer subsidy

Financial support given to producers to reduce their production costs, encouraging increased supply and consumption of goods, which can lead to positive externalities such as reduced congestion.

socially optimal output

The level of output where the marginal social cost equals the marginal social benefit, ensuring that resources are allocated efficiently. This concept is crucial for addressing market failures, particularly in the provision of public and merit goods, as it leads to improved economic well-being for society.

supply shift

A change in the supply curve resulting from factors like subsidies, which can increase the quantity supplied at each price level, affecting market equilibrium.

The level of output where the total additional benefit to society equals the total additional cost of production.

socially optimum output

The total additional benefit to society from consuming one more unit of a good or service.

marginal social benefit

The total additional cost to society from producing one more unit.

marginal social cost

State the formula: MSB (MSB)

MSB = MSC Condition for the socially optimum output where marginal social benefit equals marginal social cost.

A situation where the quantity produced results in marginal social benefit equaling marginal social cost.HL

allocatively efficient

The decrease in economic effectiveness occurring when market outcomes deviate from the optimal level for society.HL

welfare loss

The level of production determined by private decision-makers based on their marginal private benefit and cost.HL

Market output

State the formula: Example: 0.5 × 30 × 12HL

Example: 0.5 × 30 × 12 = 180 If market quantity is 100 and socially optimum quantity is 70 (base = 30) and the vertical gap between MSC and MSB at the market quantity is $12 (height), then welfare loss = $180.

State the formula: Socially optimum outputHL

The socially optimum output occurs where MSB = MSC. Socially optimum output

State the formula: Welfare lossHL

Welfare loss = 0.5 × base × height Calculate the area of the triangle where base = difference between market quantity and socially optimum quantity, and height = vertical difference between MSB and MSC at the relevant quantity.