Market failures such as externalities can cause markets to be inefficient and produce either too much or too little of a good relative to the social optimum. Negative externalities like pollution lead to an overallocation of resources, while positive externalities like education lead to underallocation. Government intervention through command-and-control policies or market-based policies like Pigouvian taxes or tradable permits can help internalize these externalities and achieve efficiency. However, collective action problems mean global issues like climate change require international agreements, though these remain non-binding with issues around equity and enforcement.

1. Market Failures and Collective
Action

2. Market Equilibrium
• Equilibrium in the market results in maximum
benefits, and therefore maximum total
welfare for both the consumers and the
producers of the product.

3. Welfare of Consumer and Producer
• Consumer surplus measures economic welfare
from the buyer’s side.
• Producer surplus measures economic welfare
from the seller’s side.

4. • Consumer Surplus
– Willingness to pay is the maximum amount that a
buyer will pay for a good.
– It measures how much the buyer values the good
or service
– Consumer surplus is the buyer’s willingness to pay
for a good minus the amount the buyer actually
pays for it.

5. Consumer Surplus
Copyright©2003 Southwestern/Thomson Learning
Consumer
surplus
Quantity
(a) Consumer Surplus at Price P
Price
0
Demand
P1
Q1
B
A
C

6. • Producer Surplus
– Producer surplus is the amount a seller is paid for
a good minus the seller’s cost.
– It measures the benefit to sellers participating in a
market.

7. Producer Surplus
Copyright©2003 Southwestern/Thomson Learning
Producer
surplus
Quantity
(a) Producer Surplus at Price P
Price
0
Supply
B
A
C
Q1
P1

8. MARKET EFFICIENCY
• Efficiency is the property of a resource
allocation of maximizing the total surplus
received by all members of society.

9. MARKET EFFICIENCY
Consumer Surplus
= Value to buyers – Amount paid by buyers
and
Producer Surplus
= Amount received by sellers – Cost to sellers

10. MARKET EFFICIENCY
Total surplus
= Consumer surplus + Producer surplus
or
Total surplus
= Value to buyers – Cost to sellers

11. MARKET EFFICIENCY
• In addition to market efficiency, a social
planner might also care about equity – the
fairness of the distribution of well-being
among the various buyers and sellers.

12. Consumer and Producer Surplus in the Market Equilibrium
Copyright©2003 Southwestern/Thomson Learning
Producer
surplus
Consumer
surplus
Price
0 Quantity
Equilibrium
price
Equilibrium
quantity
Supply
Demand
A
C
B
D
E

13. MARKET EFFICIENCY
• Three Insights Concerning Market Outcomes
– Free markets allocate the supply of goods to the
buyers who value them most highly, as measured
by their willingness to pay.
– Free markets allocate the demand for goods to
the sellers who can produce them at least cost.
– Free markets produce the quantity of goods that
maximizes the sum of consumer and producer
surplus.

14. The Efficiency of the Equilibrium Quantity
Copyright©2003 Southwestern/Thomson Learning
Quantity
Price
0
Supply
Demand
Cost
to
sellers
Cost
to
sellers
Value
to
buyers
Value
to
buyers
Value to buyers is greater
than cost to sellers.
Value to buyers is less
than cost to sellers.
Equilibrium
quantity

15. quantity
price
Exploitative
price
offered
by
private
trader
Domestic supply curve
Total Supply curve
(Domestic s + Foreign)
Domestic Supply curve
after cooperative
A
B
C
Fall
in
cost
of
production
due
to
cooperative
P1
Q1
D1
Grains from Cooperative
P1, Q1 is initial equilibrium price and quantity
D1 is initial amount of milk purchased from domestic producers
Producer Surplus (PS) lost due to exploitative pricing of domestic milk
PS obtained by domestic milk producers when price is exploitative
ABC is the Total Surplus (TS) after cooperative is formed
TS increased after cooperative
Both consumer surplus and PS increase after cooperative

16. Evaluating the Market Equilibrium
• Collective Action increases Economic
Efficiency
• Free market alone is less efficient

17. Evaluating the Market Equilibrium
• Market Power
– If a market system is not perfectly competitive,
market power may result.
• Market power is the ability to influence prices.
• Market power can cause markets to be inefficient
because it keeps price and quantity from the
equilibrium of supply and demand.

18. Externalities
• Externalities
– created when a market outcome affects
individuals other than buyers and sellers in that
market.
– Welfare more than just the value to the buyers
and cost to the sellers.
• When buyers and sellers do not take
externalities into account when deciding how
much to consume and produce, the
equilibrium in the market can be inefficient.

19. Market Failures
• Market fails to produce the right amount
of the product
• Resources may be
• Over-allocated
• Under-allocated
LO1 5-19

20. • Recall: Adam Smith’s “invisible hand” of the
marketplace leads self-interested buyers and
sellers in a market to maximize the total
benefit that society can derive from a market.
But market failures can still happen.

21. EXTERNALITIES AND MARKET
INEFFICIENCY
• An externality refers to the uncompensated
impact of one person’s actions on the well-
being of a bystander.
• Externalities cause markets to be inefficient,
and thus fail to maximize total surplus.

22. EXTERNALITIES AND MARKET
INEFFICIENCY
• An externality arises...
. . . when a person engages in an activity that
influences the well-being of a bystander and yet
neither pays nor receives any compensation for
that effect.

23. EXTERNALITIES AND MARKET
INEFFICIENCY
• When the impact on the bystander is adverse,
the externality is called a negative externality.
• When the impact on the bystander is
beneficial, the externality is called a positive
externality.

24. EXTERNALITIES AND MARKET
INEFFICIENCY
• Negative Externalities
– Automobile exhaust
– Cigarette smoking
– Barking dogs (loud pets)
– Loud stereos in an apartment building

25. EXTERNALITIES AND MARKET
INEFFICIENCY
• Positive Externalities
– Immunizations
– Restored historic buildings
– Research into new technologies

26. EXTERNALITIES AND MARKET
INEFFICIENCY
• Negative externalities lead markets to
produce a larger quantity than is socially
desirable.
• Positive externalities lead markets to produce
a smaller quantity than is socially desirable.

27. Pollution and the Social Optimum
Equilibrium
Quantity of
Aluminum
0
Price of
Aluminum
Demand
(private value)
Supply
(private cost)
Social
cost
QOPTIMUM
Optimum
Cost of
pollution
QMARKET

28. Education and the Social Optimum
Copyright © 2004 South-Western
Quantity of
Education
0
Price of
Education
Demand
(private value)
Social
value
Supply
(private cost)
QMARKET QOPTIMUM

29. Other Reasons of Market Failure
• Incomplete Information
– Consumers do not have accurate information
about market prices or product quality
– Lack of information may give producers an
incentive to supply too much or too little
– Consumers may not buy product even though it is
beneficial to buy
– Lack of information may prevent some markets to
develop

30. Government Intervention
• Tax
– Negative externality
• Subsidy
– Positive externality

31. PRIVATE SOLUTIONS TO
EXTERNALITIES
• Moral codes and social sanctions
• Charitable organizations
• Integrating different types of businesses
• Contracting between parties

32. Private Solutions: Coase Theorem
• The Coase Theorem is a proposition that if private
parties can bargain without cost over the allocation of
resources, they can solve the problem of externalities
on their own.
• Whatever the initial distribution of rights, the
interested parties can reach a bargain in which
everyone is better off and the outcome is efficient
– distribution of property rights have implications
• Transactions Costs
– Transaction costs are the costs that parties incur in the
process of agreeing to and following through on a bargain.

33. Why Private Solutions Do Not Always Work
• Sometimes the private solution approach fails
because transaction costs can be so high that
private agreement is not possible.
• Number of individuals involved on both sides
high
• Need to resolve Collective Action Problem

34. PUBLIC POLICY TOWARD
EXTERNALITIES
• When externalities are significant and private
solutions are not found, government may
attempt to solve the problem through . . .
– command-and-control policies.
– market-based policies.

35. PUBLIC POLICY TOWARD
EXTERNALITIES
• Command-and-Control Policies
– Usually take the form of regulations:
• Forbid certain behaviors.
• Require certain behaviors.
– Examples:
• Requirements that all students be immunized.
• Stipulations on pollution emission levels set by the
Environmental Protection Agency (EPA).

36. PUBLIC POLICY TOWARD
EXTERNALITIES
• Market-Based Policies
– Government uses taxes and subsidies to align
private incentives with social efficiency.
– Pigovian taxes are taxes enacted to correct the
effects of a negative externality.

37. PUBLIC POLICY TOWARD
EXTERNALITIES
• Examples of Regulation versus Pigovian Tax
– If the EPA decides it wants to reduce the amount
of pollution coming from a specific plant. The EPA
could…
– tell the firm to reduce its pollution by a specific
amount (i.e. regulation).
– levy a tax of a given amount for each unit of
pollution the firm emits (i.e. Pigovian tax).

38. PUBLIC POLICY TOWARD
EXTERNALITIES
• Market-Based Policies
• Tradable pollution permits allow the voluntary
transfer of the right to pollute from one firm
to another.
– A market for these permits will eventually
develop.
– A firm that can reduce pollution at a low cost may
prefer to sell its permit to a firm that can reduce
pollution only at a high cost.

39. Climate change – the biggest market failure the
world has ever seen?

40. The equivalence of corrective taxes & pollution permits
Price of
pollution
In panel (a), the EPA sets a price on pollution by levying a corrective tax, and the demand curve
determines the quantity of pollution. In panel (b), the EPA limits the quantity of pollution by limiting the
number of pollution permits, and the demand curve determines the price of pollution. The price and
quantity of pollution are the same in the two cases.
0 Quantity of
pollution
(a) Corrective tax (b) Pollution permits
Demand for
pollution rights
Q
P
Corrective tax
1. A corrective tax sets
the price of pollution . . .
2. . . . which, together
with the demand curve,
determines the quantity
of pollution.
Price of
pollution
0 Quantity of
pollution
Demand for
pollution rights
P
Q
Supply of
pollution permits
1. Pollution
permits set
the quantity
of pollution . . .
2. . . . which, together
with the demand curve,
determines the price
of pollution.

41. Carbon Trading
• Carbon Trading is market-based mechanism to
incentivise reduction of greenhouse gas
emissions in a cost-effective and economically-
efficient manner
• Under Carbon trading, a country having more
emissions of carbon is able to purchase the right
to emit more and the country having less
emission trades the right to emit carbon to other
countries. More carbon emitting countries, by
this way try to keep the limit of carbon emission
specified to them

42. Carbon Markets
• EU Emissions Trading System (EU-ETS)
– Operates in the 28 EU countries and the three EEA-
EFTA states (Iceland, Liechtenstein and Norway)
– covers more than 11,000 power stations and
industrial plants
• Clean Development Mechanism (CDM)
– emission-reduction projects in developing
countries can earn certified emission reduction
credits.
– These saleable credits can be used by industrialized
countries to meet a part of their emission
reduction targets under the Kyoto Protocol

43. Carbon Credits
• A carbon credit is a generic term for any tradable certificate or permit
representing the right to emit one tonne of carbon dioxide or the mass of
another greenhouse gas with a carbon dioxide equivalent
• Carbon Credits are the production cost, for which, ultimately the consumer
pay
• Cap and trade (or emission trading) – compliance market
– a limit (or "cap") on certain types of emissions or pollutions is set, and
companies are permitted to sell (or "trade") the unused portion of their
limits to other companies that are struggling to comply.
• Offset trading (trading in project based carbon credit) – voluntary market
– restore forests, update power plants and factories or increase the energy
efficiency of buildings and transportation
– UN's Clean Development Mechanism (CDM) is the largest offsetting
scheme with almost 3,000 registered projects in the global South as of
April 2011
– Offsetting does not reduce emissions, but allows companies and
governments in the North that have the historical responsibility to clean
up the atmosphere to buy credits from projects in the South.

44. CDM in India
• ONGC has 6 CDM projects registered with UNFCCC
(United Nations Framework Convention on
Climate Change) and is the only PSU to achieve
this feat.
• Carbon Trading in Ankleshwar
– A sulphuric acid treatment plant, using technology
imported from Canada, and a pharmaceutical company
wanting new technology to help cut nitrogen dioxide
emissions are among those seeking revenue from
carbon credits
• NGOs and MFIs
– SEWA and Grameen Shakti for solar lighting
– CTRAN, A BASIX group company for solar water heaters

45. Carbon Market Failures
• No legally binding agreement to reduce emission
• More credits allocated than needed
– Low price of carbon
– No incentive for carbon saving
• "total lack of environmental integrity“ of CDM
• High transaction cost on the process for applying
for mitigation and adapting financing
• Need International Collective action
– Provision of global public good
– The transparency and comparability of national action
across a range of dimensions of effort are key to
mutual understanding and recognition of what others
are doing, as well as ensuring public accountability

46. Efforts
• Kyoto Protocol – 1997
– Binding international action and agreed specific
commitments from 2008 to 2012
– Entered into force 2005 and ratified by 162
countries
– "common but differentiated responsibilities.“
– Market based mechanisms (Carbon market)
– US and Australia declined to join the Protocol
• Post-Koyoto: China, India, and the United States
have all signaled that they will not ratify any
treaty that will commit them legally to reduce
CO2 emissions

47. United Nations Framework Convention
on Climate Change
• UNFCCC is an international environmental
treaty negotiated at the Earth Summit in Rio
de Janeiro in 1992
• Outlines how specific international treaties
(called "protocols" or "Agreements") may be
negotiated to set binding limits on greenhouse
gases.

48. • Conference of Parties
– The COP is the supreme decision-making body of the
Convention (UNFCCC )
– COP is to review the national communications and
emission inventories submitted by Parties. Based on
this information, the COP assesses the effects of the
measures taken by Parties and the progress made in
achieving the ultimate objective of the Convention.
– COP serve as the meeting of the Parties to the Kyoto
Protocol (CMP)
• Collection Action

49. COP 21 or CMP 11 - 2015
Paris Agreement
• Holding the increase in the global average
temperature to well below 2°C above pre-
industrial levels and pursuing efforts to limit the
temperature increase to 1.5°C above pre-
industrial levels
• Making finance flows consistent with a pathway
towards low greenhouse gas emissions and
climate-resilient development
• reflect equity and the principle of common but
differentiated responsibilities and respective
capabilities, in the light of different national
circumstances.

50. Ratification
• reflect equity and the principle of common but
differentiated responsibilities and respective
capabilities, in the light of different national
circumstances.
– USA ??? China ????
• Each country that ratifies the agreement will be
required to set a target for emission reduction or
limitation, called a "nationally determined
contribution," or "NDC," but the amount will be
voluntary
• Name and shame
• No binding constraint
• 2017 USA withdrew from Paris Agreement (four-year
exit process)