Archive for the 'Externalities' Category

Nov 01 2012

Has the Baby Market Failed?

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!

Discussion Questions:

  1. What makes low fertility rates among parents in the rich world an example of a “market failure”?
  2. What are the primary reasons fertility rates are lower in the rich world than they are in the developing world?
  3.  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?
  4. Why have government incentives for parents to have more babies failed to achieve the fertility rates that government wish they would achieve?
  5. 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?

11 responses so far

Nov 01 2012

“Cap & Trade” – An introduction market-based approaches to pollution reduction

Inside Obama’s Green Budget –

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.

Discussion Questions:

  1. Why do you think tradeable pollution permits are more politically viable than a direct tax on firms’ carbon emissions?
  2. Why did Europe’s carbon emission permit market fail to reduce emissions over its first couple of years of implementation?
  3. 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?

58 responses so far

Jan 11 2012

The Tragedy of the Commons as a Market Failure

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

Discussion Questions:

  1. 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?
  2. 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?
  3. 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?
  4. 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?
  5. Whose responsibility should it be to decide how common resources should be dealt with?
  6. 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.

5 responses so far

Dec 06 2011

Grinchonomics, 2nd edition: “Santa’s hollow threat…” or “how the Economist can help save Christmas”

Last year, I argued that Christmas was the most inefficient time of the year due to the large loss of welfare that goes with the tradition of gift giving. This year I will argue that Santa Claus, as the tradition is embraced in the English speaking world, fails to provide children with strong enough incentives to behave nicely, thus resulting in too much naughty behavior, reducing society’s welfare in the months leading up to Christmas. We’ll explore a market-based solution to this market failure,  already being practiced across the European continent, which harnesses the power of incentives to improve children’s behavior, and the overall efficiency of the Christmas holiday.

The lyrics to the popular Christmas song, Santa Claus is Coming to Town, are a warning to little children that they better not act naughty, OR ELSE! Read them and see what I mean:

You better watch out, You better not cry
Better not pout, I’m telling you why
Santa Claus is coming to town
He’s making a list, And checking it twice;
Gonna find out who’s naughty and nice
Santa Claus is coming to town
He sees you when you’re sleeping, He knows when you’re awake
He knows if you’ve been bad or good, So be good for goodness sake!
O! You better watch out! You better not cry
Better not pout, I’m telling you why
Santa Claus is coming to town

“So be good for goodness sake,” a child will say, ” OR WHAT? What are you going to do Santa, if I am naughty? Are you not going to bring me a present that I really want?”

You see, this is the problem with the Santa I grew up with. He is all carrot, and no stick. Humans respond to incentives, and the Santa I grew up with is great at incentivizing nice behavior, but he’s really bad at disincentivizing naughty behavior. Consider the following:

  • Santa sees me when I’m sleeping and knows when I’m awake, so he knows when I’ve been bad or good. If I’m good, the implication is that I will be rewarded with wonderful gifts from Santa come Christmas time.
  • If I’m bad, however, I will experience no loss whatsoever. While I will not benefit as much as the good children, nothing will be taken away from me. I will be made no worse off by being naughty, rather the degree to which I will be made better off is reduced.

This is a classic incentive problem. Santa provides rewards for good behavior, but fails to dole out punishment for bad behavior. A culture which embraces this benevolent Santa will invariably produce too many naughty children. Such a market failure can be illustrated clearly using benefit and cost analysis:

As economists, we’re always exploring ways to improve efficiency in the markets for different goods, services, and human behaviors. Clearly, in the market above, in which children determine how naughty they will be based on their perceived private benefits and costs of their own behavior, there is a market failure.

Due to Santa’s hollow threat (“…you better watch out!”), children lack a strong disincentive to not act naughtily, and therefore choose to engage in naughty behavior to the extent that overall welfare in society is reduced. The marginal private benefits of naughty behavior are far greater than the marginal social benefits of naughty behavior (let’s face it, acting naughty is FUN!).

So how could Santa better harness incentives and disincentives (both the carrot and the stick) to reduce naughty behavior and increase overall welfare in society, thereby increasing the overall efficiency? Santa must do more than just encourage good behavior; he must also strongly discourage naughty behavior.

Well, as it turns out, the Santa I grew up with is not the only version of Santa Claus in the world, and in fact the Santa known to millions of children all over Europe is one with a fearsome, wrathful side that is not timid about doling out punishment to naughty children. Allow me to introduce the European Santa, and his evil alter-ego, known here in Switzerland by the ominous name Schmutzli (which translates loosely to “dirty face”).

img source:

The Swiss news site introduces the character Schmutzli:

This is not the Santa Claus known to English-speaking countries but the Swiss version – who is normally accompanied by a strange-looking individual with a blacked out face.

The Swiss Father Christmas was based on Saint Nicholas, whose feast day was celebrated on Saturday – his Swiss German name, Samichlaus, alludes to that. But the origins of his sinister companion are less easy to make out.

Known as Schmutzli in the German part of the country… Samichlaus’s alter ego usually carries a broom of twigs for administering punishment to children whose behaviour throughout the year has not been up to scratch.

You see, here in Switzerland, and in much of Western Europe, Santa brings gifts for the children who have been nice, but his partner Schmutzli delivers harsh punishments to those children who have been naughty. Schmutzli, who goes by different names in other parts of Europe, is known to throw naughty children in his sack, carry them into the woods, and administer a fierce beating with his birch stick, and for the naughtiest children, to eat them or throw their beaten bodies into a river.

Schmutzli, quite literally, provides the stick to accompany Santa’s carrot. In Europe, children not only receive wonderful rewards from Santa for good behavior, but fierce punishments from Schmutzli for naughty behavior.

From an economic perspective, Schmutzli’s existence increases the efficiency of the Santa character dramatically, and therefore improves overall welfare in society by giving children both an incentive to act nice and a strong disincentive to act naughty, thereby internalizing the negative social costs of naughty behavior. The outcome can be as illustrated as below:

As the graph illustrates, Schmutzli’s presence by Santa’s side come Christmas time forces children, in their decisions regarding naughty behavior, to account for the likelihood that Santa truly “knows when you’ve been bad or good”. For if he does know when you’ve been bad, Santa will unleash Schmutzli, his child-hauling sack and his birch stick on those whose behavior has been more naughty than nice.

Schmutli’s existence in Switzerland’s Santa story internalizes the external costs of naughty behavior among children, and thereby reduces the marginal benefits enjoyed by naughty children, reducing the actual number of naughty children and the size of the deadweight loss they impose on society. Fewer children will act naughty, the externality is reduced, and overall welfare in society improves.

There you have it. The deadweight loss of Santa. If you ever doubted that Economists could find the inefficiency in Christmas, I’ve shown you once again that it is indeed the most inefficient time of the year. By providing a balance of rewards and punishments, Schmutzli’s presence corrects the incentive problem of an always benevolent Santa. Society as a whole should therefore suffer from less naughty behavior among its children.

Once again, a little Economic analysis can help make Christmas more efficient for all!

2 responses so far

Nov 29 2011

“I am the condom friend ever useful to you”

Market failures exist all around us. Until you have studied the concept, however, you would probably never know it! Not all market failures are in the form of pollution, however, and in fact many of the goods that are beneficial to society can be pointed to as examples of market failure.

If a good creates external benefits for society beyond those enjoyed by the consumer of the good itself, it is said to create positive externalities of consumption. Condoms are an example of such a good; when an individual uses a condom when having sex, he enjoys several private benefits, such as reducing the chance of becoming infected with a sexually transmitted disease and reducing the likelihood of an unwanted pregnancy. However, the benefits for society of condom use are much greater, and include lower HIV and other STD infection rates, thus a healthier, more productive population, lower birth rates thus less pressure on resources from excessive population growth. These are external benefits of condom use, which means they will not be considered when an individual decides whether or not he will use a condom when engaging in sex.

Using the terminology of market failure, the marginal social benefits of condom use exceed the marginal private benefits. Thus, when left to the free market, the quantity of condoms consumed will be less than the socially optimal quantity. Not enough people will use protection when having sex: birth rates will be higher than desired, HIV infection rates will be higher and society as a whole will bear the costs of unsafe sexual activity.

In India, a developing country where the average woman still has nearly three children in her life, population growth threatens to put increasing pressure on the nation’s resources. Therefore, the country could benefit greatly from increased use of condoms.  The video below demonstrates an attempt by non-governmental organizations to increase awareness among Indian males about the purpose and appropriate use of condoms.

Watch the video and respond to the questions that follow:

Discussion Questions:

  1. What approach does the video take to correcting the market failure in the use of condoms?
  2. Why is condom use lower than what is socially optimal in India?
  3. Is this video an example of a commercial, or is it a public service announcement? What’s the difference?
  4. Do you think it will work? How would we know if the video succeeded or failed?

2 responses so far

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