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When the market fails

Economics project 2014. Details the different types of goods, the tragedy of the commons and information assymetry. Free to use as class material!

Loïc Delorme

on 14 October 2016

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Transcript of When the market fails

When the market fails
design by Dóri Sirály for Prezi
Mankiw's sixth principle: 6. Markets are usually a good way to organise economic activity.
When a market is left to flourish, the invisible hand, a metaphor used to describe the self-regulating behaviour of the market, prices each commodity at the price that is most beneficial to society. However, this can be slow if certain conditions aren't met or at times completely destructive even if the market is perfectly competitive.
Chewing gum failure vs litter success
The oddity examples
Tragedy of commons: small to big
Government intervention is not always required to solve the problem of externalities. Types of private solutions to externalities include moral codes & societal norms, charities and business mergers or social contracts.
Private Solutions
Important: different types of goods
Prisoner's dilemma
The best solution is for both to keep their silence. However, if you can't know what the other is going to do, it is always in your interest to rat the other. Thus, the worst situation occurs.
Typical tragedy of commons
©Encyclopedia Brittanica
CC BY-NC 2.5
Not Rival
Not Excludable
Private Goods
Rival and Excludable
Example: Pieces of Cake
eating it deprives others of cake - rival
you can be excluded from it if you can't pay for the slice
Natural monopolies
Public good
Externalities are the effects of any economic activity, like production or consumption, on a third party.
Externalities: the reason behind it all
xkcd.com easter egg
Information asymmetry
Mankiw's sixth principle: Governments can sometimes improve market outcomes.
Public Solutions
A combination of government initiative and free market principles can solve externalities effectively.This can be done with a tax or a permit market. One limits by price and the other by quantity.
Hybrid Solutions
Wikipedia comedy of commons
Farmer sends flock
Farmer grazes reasonably
General overgrazing
Generally reasonable
Worst case scenario for farmer
Best case scenario for farmer
Bad scenario for farmer
Good scenario for farmer and group
Image from pinterest. If there by copyright violation, please comment this.
(With sound!)
The end!
Thanks for watching, leave comments.
A huge tragedy with many external consequences:
road wear and tear
price of petrol
But it has the individual advantage of speed and comfort.

The State tries to intervene by making public transport cheap and effective. It can also make people pay for the damage they are doing to society. See London's congestion charge.
Plastic bags
by Loïc Delorme, Christopher McMahon, Patrick Byrnes, Luke Harvey
Health care
The Tragedy of Commons can be fixed by making everyone do the "right" thing or by making everyone's decision public. Only the government has this power, making its intervention desirable.
It can set quotas, outlaw the "bad" option, place fines, put transparency into place or regulate access to a resource.
In Ireland, the government limited use with a levy.
In France, the government procrastinated to the point that supermarkets and consumers fixed the problem themselves! The supermarkets started only giving them on request or charged them a cent each. They sold strong reusable bags as an alternative. Each supermarket acted independently, partly as a marketing strategy to seem "green". However, this wouldn't have worked without customer approval.
Credit Majella Brereton
There are some problems with maliciously incorrect editing of articles but the widespread popularity of Wikipedia as the sixth most popular website demonstrates its reliability.
Prisoner of the planet's dilemma: international problems
Types of Externality
Negative Production Externalities- Pollution
Positive Consumption Externalities- Vaccinations
Positive Production Externalities- Education
Negative Consumption Externalities- Traffic Congestion
Social cost > Private cost
Inefficient equilibrium where social cost > social benefit
Social benefit > Private benefit
Inefficient equilibrium where social cost > social benefit
Externalities are caused where the cost or benefit to the individual of producing the externality differs from the cost or benefit to society as a whole.
The demise of the invisible hand!
The government can create a private market for the sale of permits or other forms of rights to produce externalities. This market can then regulate itself.
This solution accepts that some pollution is necessary to produce essential goods and distributes the right to pollute to those firms who need it most, while encouraging all companies to reduce pollution levels . It essentially creates a cap on the market to be distributed in the most efficient manner possible among individuals.
Founded in 2001
Non-excludable and Non-rival
Therefore it is a public good
Why not be a "free rider", and use the website while contributing nothing?
However, Wikipedia is extremely successful. Over 73000 editors have produced 4.6 million articles in English alone with a less errors per article than the Encyclopedia Brittanica.
Somewhat paradoxically, in providing no incentive to contribute, Wikipedia has managed to flourish, suggesting that people don't always act rationally according to the basic assumptions of economics.
excludable but not rival
fixed cost are high but functioning costs are low
competition is less efficient than a monopoly
Example: train tracks
attribution: www.cgpgrey.com
rival but non-excludable
The Ocean
The Tragedy of the Commons
Tragedy of the Commons
Example the Ocean
in everyone's interest to take as much fish as possible
in the collective interest to take a limited amount
fixed with government intervention
Non-rival, non-excludable
Free Rider Problem
Drop in the Bucket Problem
Free Rider Problem
People who didn't pay for it still benefit from it
ruins incentive to pay
solved by levying a tax for good or service
Drop in the Bucket Problem
individual can't see benefit of donating money for something that would benefit society
no individual incentive to pay
solved with levying a tax
The Coase theorem states that if the cost of negotiation is 0, then a private solution will appear. However, in reality, people don't do this because there can be many issues in reaching an agreement. Transaction costs and difficulties in agreement processes and negotiations often lead to the externality problem being left unsolved.
However, external costs and benefits are extremely difficult to quantify in precise monetary terms!
Governments are also forced to intervene in underdeveloped markets where there is an information asymmetry between the buyer and the seller. Information asymmetry is a major problem with private solutions not guided by some degree of government regulation.
If buyers can't discern between good quality products and sub-standard ones, sellers of good products will leave the market, not wanting to lose out by selling their product for a cheaper average price.
Consumers aren't infinitely optimistic and will refrain from purchasing when too many good quality products are taken off the market. Lack of development leaves markets prone to collapse in this way.
Governments can develop these vulnerable markets by enforcing a system of consumer rights that forces sellers to be honest about the quality of their goods.
This can also manifest itself in the form of rules like the principle of "utmost good faith" in insurance and conventions regarding interviews and references in labour markets
Governments don't always select a socially efficient quantity of public goods to produce because of the way that political demands of voters don't always equate to rational outcomes.

Efforts to deter the public from littering have been have been far more successful than similar efforts to prevent the dropping of chewing gum. A negative externality exists with the consumption of chewing gum. There is a social cost of the gum being dropped and a cost of cleaning it up, and littering has a negative externality due to similar reasons.
As we've already seen, education is a positive production externality because all of society benefits from a more informed, skilled and employable workforce. There is an external benefit to education that is enjoyed by individuals who are uninvolved in the transaction.
As with other positive externalities, we would expect the market equilibrium to produce an output of education services that is less than the socially efficient quantity. In developed countries and in an increasing number of developing ones, education is therefore financed by the government, creating a service that provides education for everyone.
However, in many countries, a separate private education sector does exist, coexisting and competing with the public sector. While in some countries such as Ireland this sector merely combines tuition fee revenue with government funding, in the United Kingdom, among other countries, there is a flourishing group of independent schools that receive no government funding whatsoever. These institutions provide much needed education services and save the money for the government.
As we've seen before with other externalities, they can be dealt with most efficiently and effectively through a combination of public intervention and private organisations and interactions.
A reduction in the supply of potatoes will lead to an increase in their marginal social benefit, prices will rise and the market will allocate equilibrium price and quantity of the good. The idea is that the invisible hand will always bring the market back into equilibrium.
If the production cost of smartphones fell, supply would increase, the cost of a smartphone will fall, and marginal social benefit is brought to equilibrium with marginal social cost.
Moral codes and social norms are largely what affect our behaviour, & this can sometimes help to solve the problem of externalities. An example of this is people not littering as they believe it is the wrong thing to do.
Charities are another example. Greenpeace is a non-profit organisation funded by private donations.
The private market can often act as a solution in itself by relying on the self interest of the relevant parties. Business mergers and social contracts can solve the problem of externalities.
An effective example is that of the neighbouring apple grower and beekeeper who operate next to each other.
Healthcare is another example that proves difficult to classify. Healthcare is an essential service with growing ubiquity in the modern world, but how exactly can it be classified in economic terms?
It should also be noted that classifying healthcare as a type of good proves problematic. While we can certainly say that it is excludable, is it rival?
In the context of a vast public health scheme built to serve a large community, only a small proportion of whom need treatment at any given time, the cost of taking on responsibility for the health of any one extra individual is marginal. In these circumstances health services are excludable but not rival, making them a natural monopoly.
However, in order to create this natural monopoly, large amounts of capital investment in infrastructure is essential.
This can be provided by state funds by bringing healthcare under the control of the government..
Government control of these services overcomes the externality problem by ensuring that the optimum level of services is provided.
Problems with Public Solutions
Command Economy
Organisational overload
Decrease in productivity
Collectively owned property and the tragedy of the commons
Lack of competition
Restriction of Freedom
If the government directs all economic activity, individual freedom will be limited.
Implications for innovation and creativity.
Freedom is an idea that many societies value.
How rival healthcare services are is very dependent on scale. While it is true that one person's use of hospital services and doctors' time does diminish to a certain extent the usage of others, this rival nature of healthcare tends to diminish where it is provided on larger scales.
Given the effectiveness of public solutions in eliminating externalities and the benefits of state oversight and planning to focus on social costs and benefits rather than private ones, why shouldn't all economic decisions be placed under state control?
Governmental bureacracy can receive too much information if it controls the entire economy
Vast economic planning machines can't always process this information adequately or efficiently.
Similar to education and is a positive externality
There is a broader social benefit of having a healthy and productive populace where disease doesn't spread easily.
External benefits prevent the market producing a socially efficient quantity.
Pigovian tax
One way the government can directly intervene is through the introduction of a Pigovian incentive. This is a tax or subsidy that is placed on the production of an externality, fixed at the marginal external cost or benefit (i.e the absolute value of the difference between the marginal social cost/benefit and the marginal private cost/benefit) of the externality.
The producer of the externality has no choice but to consider the societal implications of their actions, leading to a Pareto-efficient quantity of the externality produced.
However, it's crucial to note the importance of taxing the externality itself, (e.g. pollution) and not the useful product of which it is a consequence. This way, an incentive to reduce emissions with more eco-friendly processes is created.
tax the externality
internalise the externality
Permit sales
However, the EU has done this but was criticized for giving the permits and not auctioning them and gave out too many.
fire brigade
networks: electricity grid, telephone lines, pipes...
Television programs
video games
a cat!
These types of goods are best regulated by a free market and the invisible hand. "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest" Adam Smith.
Clean Air and Water
Congested roads
Fish in the ocean
Non excludable areas: streets, plains,...
lighting in public
National defence
Knowledge and research
a lighthouse
an open air cinema
an off-season port
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Second-hand cars
Debtors in lending relationships
Estate agents
All images are (unless otherwise noted) available are for non commercial re-use. Please note that Wikimedia commons and Encyclopedia Brittanica pictures require attribution and that Encyclopedia Brittanica is only reusable for students.
We don't have any rights over images courtesy of Majella Bereton, tcd lecturer.
(see Poor Economics in the bibliography for more on nudges)
wikimedia commons
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Anon., n.d. [Online]
Available at: http://www.econlib.org/library/Enc/PrisonersDilemma.html
[Accessed 21 November 2014].
Anon., n.d. [Online]
Available at: http://www.iterated-prisoners-dilemma.net/
[Accessed 21 November 2014].
Anon., n.d. [Online]
Available at: https://en.wikipedia.org/wiki/Prisoner's_dilemma
[Accessed 21 November 2014].
Banerjee, A. V. & Duflo, E., 2011. Poor Economics: A Radical Rethinking of the Way to Fight Global Poverty. s.l.:s.n.
Coase, R., 1973. The Problem of Social Cost. In: R. Staaf & F. Tannian, eds. Externalities: Theoretical Dimensions of Political Economy. New York: Dunellen Publishing Company, Inc., pp. 119-163.
Davis, O. A. & Whinston, A. B., 1967. On the Distinction Between Public and Private Goods. American Economic Review, 57(2), p. 360.
Kapp, K. W., 1973. On the Nature and Significance of Social Costs. In: R. Staaf & F. Tannian, eds. Externalities: Theoretical Dimensions of Political Economy. New York: Dunellen Publishing Company, Inc., pp. 3-19.
Laffont, J.-J., 1980. Essays on the economics of uncertainty. s.l.:Harvard University Press.
Main, R. S., 2010. Simple Pigovian Taxes vs Emission Fees to Control Negative Externalities: A Pedagogical Note. American Economist, 55(2), p. 104.
Mankiw, N. G. & Taylor, M. P., 2011. Economics. 2nd ed. s.l.:Cengage Learning.

Government also taxes goods with a negative externality on our health such as cigarettes and alcohol.
(we'll consider that we are in a competitive market)
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