As a follow up to my recent post, A Video and Audio Introduction to Market Failure, I plan to introduce the diagrams we use to illustrate and analyze negative and positive externalities and the inefficiency arising in the markets for certain goods. My fellow Econ Video Lecturer, Mr. Clifford, provides a great introduction to these diagrams in his video, EconMovies 7: Anchorman. We’ll watch the video below before beginning our notes on the subject today! Enjoy!
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Which of the stories above is about public goods, or goods which would not be provided at all if left entirely to the free market? Explain.
Which of the stories above is about demerit goods, or ones which would be over-provided by the free market due to their negative effects on the environment or human health? Explain.
Which of the stories above is about merit goods, or ones which are provided by the free market, but at a quantity below which is socially optimal due to the fact that they create spillover benefits for society as a whole.
Which of the stories describes a good or goods which the government currently regulates the production of? Which goods does government currently NOT regulate the production of?
What makes each of the stories above examples of market failure?
The tools of economics can be applied to almost any social institution, even the decision of individuals in society whether or not to have children. All over the rich world today, potential parents have decided against having babies, the result being lower fertility rates across much of Europe and the richer countries in Asia, including Japan, South Korea and Singapore. Lower fertility rates have some advantages, such as less pressure on the country’s natural resources, but the disadvantages generally outweigh the benefits.
The story below, from NPR, explains in detail some of the consequences of declining fertility rates in the rich world, and identifies some of the ways governments have begun to try to increase the fertility rates.
The problem of declining fertility rates can be analyzed using simple supply and demand analysis. In the graph below, we see that the marginal private cost of having children in rich countries is very high. The costs of having children include not only the monetary costs of raising the child, but the opportunity costs of forgone income of the parent who has to quit his or her job to raise the child or the explicit costs of child care, which in some countries can cost thousands of dollars per month. Marginal private cost corresponds with the supply of babies, since private individuals will only choose to have children if the perceived benefit of having a baby exceeds the explicit and implicit costs of child-rearing.
The marginal private benefit of having babies is downward sloping. This reflects the fact that if parents have just one or two children, the benefit of these children is relatively high, due to the emotional and economic contributions a first and second child will bring to parents’ lives. But the more babies a couple has, the less additional benefit each successive child provides the parents. This helps explain why in an era of increased gender equality, families with three or more children are incredibly rare. The diminishing marginal benefit experienced by individual couples applies to society as a whole as well, therefore the market above could represent either the costs and benefits of individual parents or of society at large.
Notice, however, that that the marginal social benefit of having babies is greater than the marginal private benefit. In economics terminology, there are positive externalities of having babies; in other words, additional children provide benefits to society beyond those emotional and economic benefits enjoyed by the parents. The podcast explained some of these external, social benefits of having children: a larger workforce for firms to employ in the future, more people paying taxes, allowing the government to provide more public goods, more workers supporting the non-working retirees of a nation, and more competitive wages in the global market for goods and services. Higher fertility rates, in short, result in more economic growth and higher incomes for a nation.
When individuals decide how many children to have, they make this decision based solely on their private costs and benefits, since the external benefits of having more babies are enjoyed by society, but not necessarily by the parents themselves. Therefore, left entirely alone, the “free market” will produce fewer babies (Qe) than is socially optimal (Qso).
So what are Western governments doing about low fertility rates? The podcast identifies several strategies being employed to narrow the gap between Qe and Qso. In Australia households receive a $1000 subsidy for each baby born. In Germany mothers receive a year of paid leave from work. Here in Switzerland mothers get three months of government paid leave and $200 a month subsidy to help pay for child care after that. Each of these government policies represents a “baby subsidy”. In the graph above, we can see the intended effect of these policies. By making it more affordable to have children, governments are hoping to reduce the marginal private cost to parents, encouraging them to have more children, which on a societal level should increase the number of babies born so that it is closer to the socially optimal level (Qso).
Unfortunately, as the podcast explains, it appears that parents are relatively unresponsive to the monetary incentives governments are providing. This can be explained by the fact that the private demand (MPB) for babies is highly inelastic. Even if the “cost” of having a baby falls due to government subsidies, parents across the Western world are reluctant to increase the number of babies they have.
As we can see in the graph above, a subsidy for babies reduces the marginal private cost of child-rearing to parents. But the MPB curve, representing the private demand for babies, is highly inelastic, meaning the large subsidy has minimal effect on the quantity of babies produced. Without the subsidy, Qe babies would be born, while with the subsidy only Qs are born, which is closer to the socially optimal number of births at Qso, but still short of the number of births society truly needs.
The “market for babies” in rich countries is failing. Because of the positive externalities of having children, parents are currently under-producing this “merit good”. One of two things must happen to resolve this market failure. Either the marginal private costs of having babies must fall by much more than the government subsidies for babies have allowed, or the marginal private benefit must increase. Either larger subsidies are needed, or some moral revival aimed at encouraging potential parents to consider both the private and social benefits of having children when making their decisions.
Don’t you love economics? We make everything seem so logical! And like they say, it all comes down to supply and demand!
What makes low fertility rates among parents in the rich world an example of a “market failure”?
What are the primary reasons fertility rates are lower in the rich world than they are in the developing world?
What are the economic consequences of lower birth rates? What are the environmental consequences of lower birth rates? Should government be trying to increase the number of babies born?
Why have government incentives for parents to have more babies failed to achieve the fertility rates that government wish they would achieve?
Do you believe that government can create strong enough incentives for parents to have more babies? If not, what will become of the populations of Western Europe and the rich countries of Asia given today’s low fertility rates? Should we be worried?
Some say that Global Warming may be the greatest market failure of all. This podcast was originally broadcast in January of 2007 while George Bush was still in office. The commentator claims that global warming is “nothing but one giant market failure”, arguing that the United States therefore must get serious about tackling the problem.
The allocation of resources towards carbon emitting industries has almost undoubtedly contributed to the warming of the planet over the last half century. Only recently have governments begun taking active measures to reduce the impact of industry on the environment through greater regulation of polluting industries, employing corrective taxes in some instances and market-based approaches to pollution reduction in others.
US President Barack Obama, unlike his predecessor, appears to be serious about correcting the “market failure” represented by global warming:
Obama’s budget, announced Thursday, looks to fund a host of new energy programs, from carbon sequestration to electric transmission upgrades. It would also provide the EPA with a $10.5 billion budget for 2010, a 34% increase over the likely 2009 budget. Nineteen million dollars of that would be used to upgrade greenhouse gas reporting measures.
The Interior Department would get $12 billion for 2010. The agency would use part of the money to asses the availability of alternative energy resources throughout the country.
Funding comes from elaborate carbon “cap and trade” program, which puts a price on emitting pollution and is the core of Obama’s plans. Starting in 2012, the government would sell permits giving businesses the right to emit pollution, generating $646 billion in revenue through 2019.
During those years, the number of available permits would gradually decline, forcing businesses to buy the increasingly scarce, and costly, rights to pollute on an open market. Obama hopes that the rising cost of permits will encourage businesses to invest in clean technologies as a cheaper alternative to meeting pollution mandates, helping to cut greenhouse gas production to 14% below 2005 levels by 2020.
Below is a diagram that illustrates precisely how the Obama cap and trade plan is meant to work. Notice that between 2012 and 2020 the cost to firms of emitting pollution will increase dramatically, while at the same time the total amount of carbon emissions in the US economy will fall due to regular reductions in the number of permits issued to industry.
The Obama cap and trade scheme is not the first experiment with such a market based approach to externality reduction:
Europe established such a market in 2005. But some E.U. governments allocated too many credits at the outset, causing the value of some permits to fall by half and making it relatively easy for large polluters to simply buy credits rather than cut emissions. Overall emissions grew in 2005 and 2006. In 2008, E.U. emissions dropped 3%; 40% of that drop was attributed to the carbon trading scheme.
Europe’s cap and trade program took a few years before it began having any noticeable impact on the emission of carbon by European industry. While unpopular among the firms who are forced to pay to pollute, the fall in emissions in Europe shows that a market for carbon may be effective in forcing firms “internalize” the costs of carbon emissions, which until now have been born by society and the environment in the form of the negative effects of global warming.
Why do you think tradeable pollution permits are more politically viable than a direct tax on firms’ carbon emissions?
Why did Europe’s carbon emission permit market fail to reduce emissions over its first couple of years of implementation?
Is making firms pay to pollute a good idea in the middle of a recession? Do you think that we should even be worrying about the environment when millions of people are losing their jobs and entire industries are struggling to survive?
Over the last few weeks in our IB Economics class, we have been studying cases in which markets fail to achieve an efficient, socially optimal level of production and consumption when the private buyers and sellers are left to interact in a free market. Markets fail in many ways; sometimes they produce too much of a good, and sometimes too little is produced. There are some things society would benefit from having more of, while other things society would be better off with less than what is produced by the free market.
When the free market fails to achieve a socially optimal level of output, at which the costs and benefits not just of the individual consumers and producers are accounted for, but all social, environmental and health costs and benefits are weighed as well, the government may be able to improve on the free market outcome by intervening in some way. For example, certain goods deemed beneficial for society are simply under-provided by private firms: Education, infrastructure, public transportation, security, health care… these are all markets in which government often intervenes to increase the provision of the good to society. In other cases, government intervenes to decrease the amount of a good consumed: Cigarettes, alcohol, reckless driving, polluting factories, violence on TV, child pornography, dangerous drugs… in each of these cases governments tend to use taxes, regulation or legislation to reduce the amount of the harmful good available on the market.
Besides the merit (beneficial) goods and the demerit (harmful) goods described above, markets may fail in other ways as well. One notable form of market failure arises due to a phenomenon first articulated by American ecologist Garrett Hardin, who warned of the Tragedy of the Commons. In his 1968 essay, Hardin explained that when there exist common resources, for which there is no private owner, the incentive among rational users of that resources is to exploit it to the fullest potential in order to maximize their own self gain before the resource is depleted. The tragedy of the commons, therefore, is that common resources will inevitably be depleted due to humans’ self-interested behavior, leaving us with shortages in key resources essential to human survival.
Each of the videos below illustrates a different example of the tragedy of the commons. Watch the videos and think about how each applies Hardin’s concept.
Example 1: Thousands of fishermen empty lake in minutes:
Example 2 – Dr. Suess’s The Lorax
Example 3 – Tuna fishing
In each of the videos above, there is a common resource (fish and trees) over which no ownership has previously been established. The resource users (the Malian fishermen, the Once-ler and his family and the tuna boat), all have a strong incentive to maximize their own short term gain by extracting and exploiting the resource as quickly as possible.
In the Mali fishing hole, the outcome is observable: within minutes the resource is depleted and there are no more fish for for future fisherman to enjoy.
In The Lorax the result of the Once-ler’s exploitation of the forest is foretold in the beginning of the story when the young boy comes upon the desolate outskirts of his town.
The tragedy of the commons acts as a warning to the tuna fishing industry, in which there are still tuna surviving in the world’s oceans, but at the rates industrial fishing boats such as the Albatun Tres exploit the resource, it will not be around much longer.
In each instance above, a market failure occurs. Due to the lack of private ownership over valuable resources, self-interested individuals stand to gain by exploiting them to the fullest extent possible while they still exist. The unfortunate outcome is that over time the resources are exploited unsustainably until they are ultimately depleted. As in the case of merit and demerit goods, the market failure of common resources provides an opportunity for government to intervene to achieve a more socially optimal allocation of resources. In the interview below, Garrett Hardin suggests that there are only two possible solutions to the tragedy of the commons. Watch the video and then respond to the discussion questions that follow.
Garret Hardin – the Tragedy of the Commons
Hardin refers to Karl Marx’s adage “from each according to his abilities, to each according to this needs.” What does Hardin have against this socialist idea?
How does Hardin’s example of a “common pasture” illustrate the tragedy of the commons? How is a common pasture similar to the three examples in the videos above?
According to Hardin, what are the only two solutions to the common pasture problem? Which of these solutions do you think would be most socially desirable?
Explain Hardin’s claim that “the unmanaged commons cannot possibly work once the population gets above a certain size”. Of the world’s common resources today, what are some examples of common resources that remain unmanaged?
Whose responsibility should it be to decide how common resources should be dealt with?
Do you agree with Hardin’s claim that “the world cannot possibly live at the American standard of living at its present population size”? Which of his predictions do you think is most likely to occur: Will the American (and Western European) standard of living have to go down or will the number of people in the world have to be reduced? Or is there a third possibility? Discuss.