IN THIS CHAPTER

• How markets work?

• Markets and welfare
• Externalities
• Public goods
• Common resources

1
 What are exchanges?
• In the economy we are faced with
exchange sometimes using money as the
medium.
o Households purchase final goods
and services for final consumption
and also provide the inputs into
production – land labour and
capital.
o The organizations buy these factors
and use them to produce goods and
services
 What is an economy?

• Economic activity is how much

buying and selling goes on in the
economy over a period of time.
• The economy is all the
production and exchange
activities that take place every
day.
 The Economic Problem
• The three big questions are:
o What goods and services should be
produced?
o How should it be produced using
combinations of land, labour and
capital?
o Who should get the goods and
services produced?

o IMPORTANCE OF SCARCITY
 Types of Economic Systems
• Market Economy
–Free Enterprise Economy/Capitalist Economy (United
States, Singapore, Japan, United Kingdom, Canada)

• Centrally Planned Economy

–Controlled Economy (Cuba, North Korea, Nazi
Germany, Soviet Union, Maoist China)

• Mixed Economy (India, Norway, Singapore, Vietnam)

 Planned Economy
• Production and distribution of goods and services determined by
government
• Key characteristics:
a) Means of production (land and capital) owned by government
b) Most people employed by government
c) Production based on consumers’ need assessment made by government
planner (the what)
d) Production processes based on input-output analysis by govt. planners (the
how)
e) Distribution through state outlets at fixed prices (the for whom)
 Free Market Economy
• Production and consumption determined by individuals and private firms

• Key characteristics:
a) Production of products that yield the highest profits (the what)
b) Production through least costly techniques of production (the how)
c) Consumption depending upon people’s desires and incomes (the for whom)

• Role of government:
– Minimal
– Protects property rights to ensure free competition
 Comparing Market and Planned Economy
Market Economy Planned Economy
Ownership of means of With private firms and With government
production individuals

Decisions about - By businesses - By government planners

production - Based on demand analysis - Based on planners’ assumption about
- Based on cost-benefit analysis consumer needs
- Based on input-output analysis

Flexibility to set prices With businesses With state outlets

Role of government - To protect businesses and - To take economic decisions

consumers - To co-ordinate production and
- To issue money distribution of goods

Prominent examples USA. Japan Cuba, Former Soviet Union, China

 Write down the advantages and disadvantages of with real life example of:

1. Market Economy
2. Planned Economy
 What will happen if the market is free in the following cases?

• National security
• Education
• Healthcare
• Indian Railways
• Environmental activities
 Market Failure and Role of Government
• Market failure: inefficient distribution of goods and services
– individual incentives for rational behavior do not lead to rational outcomes for the
group
• Example of market failure: Public good

• Public goods
– Def: non-excludable and non-rivalrous goods
– Ex: national security, street lighting
– Problem: ‘free-rider problem’
• People enjoy benefits but shirk public responsibility to pay
– Result: may be under-produced, overused or degraded
What are externalities?
An externality is an uncompensated impact of one person’s actions on the
well-being of a bystander.
o Externalities cause markets to be inefficient, and so fail to maximize total
surplus.
o An externality arises...
. . . when a person engages in an activity that affects the well-being of a
bystander and yet neither pays nor receives any compensation for that effect.
Give examples of positive and negative externalities?
The Private/Social Costs and Private/Social Benefits of
Decision Making
Market decisions are be based on weighing up private costs and private benefits.

Social costs and social benefits are lost or gained by those not party to the initial
decision.

Market decisions may not take account of the social costs and benefits of their
actions.

The market equilibrium is not efficient when there are externalities.

Can you provide some examples?

Types of externalities

Negative Externalities
◦ Car exhaust fumes
◦ Cigarette smoking
◦ Barking dogs (loud pets)
◦ Loud stereos in an apartment building

Positive Externalities
◦ Immunizations
◦ Restored historic buildings
◦ Research into new technologies
Welfare Economics: A Recap
Negative externalities lead markets to produce a larger quantity than is socially
desirable.

Positive externalities lead markets to produce a lesser quantity than is socially

desirable.
◦ Look at the market for aluminium (figure 1)
 Negative Externalities
◦ Social Cost=Private cost+ Cost to the
bystanders
◦ The socially optimal output level is less than
the market equilibrium quantity.

Internalizing an externality involves altering

incentives so that people take account of the
external effects of their actions. (example: by
imposing a tax on the producer)
Welfare Economics: A Recap
Figure 1. The Market for Aluminium
Price of
Aluminum Supply
(private cost)

Equilibrium

Demand
(private value)

0 QMARKET Quantity of
Aluminum

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION 9781473725331 © CENGAGE
EMEA 2017
Negative Externalities
Figure 2 Pollution and the Social Optimum
Price of
Social
Aluminum
cost
Cost of
pollution
Supply
(private cost)

Optimum

Equilibrium

Demand
(private value)

0 QOPTIMUM QMARKET Quantity of

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION 9781473725331 © CENGAGE Aluminum
EMEA 2017
Positive Externalities
A positive externality exists when an externality
benefits the bystanders.
◦ The social value of the good exceeds the private value.
◦ Example: Education yields positive externalities.
◦ A better-educated population leads to improved
productivity and economic growth. The economic growth is
the positive externality as it benefits everyone.

The marginal social benefit (MSB) is the private

value plus the external benefit to society at each
price.
 Figure 3. Education and the Social Optimum
Price of
Education
Supply
(private cost)

MSB
or
Social
value
Demand
(private value)

0 QMARKET QOPTIMUM Quantity of

Education
Question
The above figure shows the market for steel ingots.
(a) What is the socially optimal quantity of steel?
(b) What is the optimal quantity of pollution?
(c) At the social optimum, what is the private producer surplus?
(d) What is the change in externality cost if the market switches
from competitive equilibrium to social optimum?
(e) What is the total surplus under social optimum?
(f) What is the change in consumer surplus if the market
switches from competitive equilibrium to social optimum?
(g) What is the reason
(h) In a competitive market, why does a negative externality
create a deadweight loss?
Answers
(a) 50
(b) cannot be determined from the information provided.
(c) $3100.
(d) a + b + c
(e) $2500
(f) $1875
(g) price equals private marginal cost.
Types of Private Solutions
Government action is not always needed to
solve the problem of externalities.

Social norms and Moral Behaviour

◦ Do unto others as you would have them do unto you.

Charities that deal with externalities.

◦ E.g. Greenpeace.

Self-interest
◦ Where two firms gain from each other’s presence

Social Contracts
What are the Public Policies Toward Externalities?
Command and Control: Regulation
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 government.

◦ Needs good information

Market based policies: Corrective Taxes and Subsidies
Pigovian taxes are taxes enacted to correct
the effects of a negative externality.
• Factories an incentive to reduce pollution up to
a point where the marginal abatement cost is
equal to the tax rate imposed.
• Firms that can reduce pollution with the
least cost are likely to do so (to avoid the
tax) while firms that encounter high costs when
reducing pollution will pay the tax.
Market based policies: Corrective Taxes and Subsidies

Regulation Versus PigovianTax.

If the government decides it wants to
reduce the amount of pollution coming
from a specific plant, the government
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).
Tradable Pollution Permits
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.
Tradable Pollution Permits
Figure 4a. The Equivalence of Pigovian Taxes and Pollution Permits: Pigovian tax

Price of
Pollution

P Pigovian
tax
1. A Pigovian
tax sets the
price of Demand for
pollution . . . pollution rights
0 Q Quantity of
Pollution
2. . . . which, together
with the demand curve,
determines the quantity
of pollution.
Tradable Pollution Permits
Figure 4b. The Equivalence of Pigovian Taxes and Pollution Permits: Pollution Permits
Price of Supply of
Pollution pollution permits

Demand for
pollution rights
0 Q Quantity of
Pollution
2. . . . which, together 1. Pollution
with the demand curve, permits set
determines the price the quantity
of pollution. of pollution . . .
Property Rights
o Property rights is the exclusive right
of an individual, group or
organization to determine how a
resource is used.
◦ If I have ownership rights over the air 1 km
above my house, then no one can legally
pollute it.
◦ I can negotiate with a firm that wishes to
pollute that air and agree a price for the
right to do so.
Government Failure: The Invisible Hand versus Public
Interest
Why do you think
government fails?
Public choice theory looks at are cases
where individual self interest of
voters, politicians, lobbyists or civil
servants leads to decisions and the
allocation of resources which may not
be the most efficient allocation.
 Voter, Politician and Bureaucrat Incentives
Rational ignorance
◦ Voters do not consider their individual vote as
making any difference.

Politicians will reflect the interests of

the local communities they are
seeking to serve.
◦ They want to be re-elected.

Bureaucrat
◦ Civil servants providing advice have power.
Other Distorting Behaviour
The special-interest effect may lead to minorities
gaining significant benefits, but the cost is borne by
the population as a whole.

Logrolling is a term used to describe vote trading in

government.

Rent seeking is where individuals or groups take

actions to redirect resources to generate income (rents)
for themselves or the group.

Public sector inefficiency.

Cronyism (returning favours).

Inefficiency in the Tax System

Even If government intervention is distorting, then why
governments intervenes?
Most goods in our economy are
allocated in markets.
Free goods provide a special
challenge for economic analysis.
When goods are available free
of charge, the market forces
that normally allocate
resources in our economy are
absent.
 Excludability and rivalry
Is the good excludable?
◦ Is the good rival?
Excludability
◦ Excludability refers to the property of a good whereby a person can be prevented from
using it.
Rivalry
◦ Rivalry refers to the property of a good whereby one person’s use diminishes other
people’s use.
 Types of Goods
Rival?
Yes No
Private Goods Club goods

Yes • Chocolates • The fire service

• Clothing • Cable TV
• Congested toll roads • Uncongested toll roads
Excludable?
Common Resources Public Goods

No • Fish in the ocean • Street lighting

• The environment • Flood control dams
• Congested non-toll roads • Uncongested non-toll roads
The Free Rider Problem: Can you give some examples?
A free-rider is a person who
receives the benefit of a good
but avoids paying for it.
o Since people cannot be excluded from
enjoying the benefits of a public good,
individuals may withhold paying for the
good hoping that others will pay for it.
o The free rider problem prevents private
markets from supplying public goods.
What are the important Public Goods
o National Defence
o Basic Research
o Fighting Poverty
Who decide whether to provide a public good or
not?
The Difficult Job of Cost-Benefit
Analysis
Cost-benefit analysis refers to a
study that compares the costs
and benefits to society of
providing a public good.
In order to, the total benefits of all
those who use the good must be
compared to the costs of
providing and maintaining the
public good.
Case:
Suppose the government wishes to regulate mercury emissions of factories in a specific
industry by either setting an emissions standard or imposing an emissions fee (per ton
of mercury). The government is uncertain as to the marginal abatement costs, which
may be high (MC1) or low (MC2).
MC1 = 15M + 500
MC2 = 15M – 500
where M is the units of mercury abated. The government believes there is a 50% chance
of each of the marginal abatement costs. The marginal benefit of abatement is known
to be:
MB = 1500 – 10M
Questions
a. What is the optimal level of emissions for each of the cost curves above?
b. What is the expected marginal abatement cost (equation)?
c. What is the optimal emissions standard according to the expected abatement costs?
d. What is the optimal abatement fee according to the expected abatement costs?
e. Which regulation will result in a lower Dead Weight Loss in the presence of the uncertainty?
Explicitly compute the expected Dead Weight Loss arising from each proposal.
Answers
 The Optimal Provision of a Public Good
Governments should continue
to provide a public good….
◦ …..up to a point where the
marginal benefit gained from
an extra unit provided is equal
to the marginal cost of
providing that extra unit.

MSB=MC
The Optimal Provision for a Public Good
(a) Price
1. Assume Inelastic
there are onlySupply
two consumers who
place different values on the provision of a
public good as shown.
2. The combined values of their individual
demand curves make up the MSB curve ABC.
3. Optimum provision where MC crosses MSB
at an output 30.
Tragedy of the Commons.
Can you provide some examples?
The Tragedy of the Commons is a parable
that illustrates why common resources get
used more than is desirable from the
standpoint of society as a whole.
◦ Common resources tend to be used
excessively when individuals are not
charged for their usage.
◦ This is similar to a negative externality.
Question
(a) If the market is competitive,
what is the deadweight loss to
society?
(b) If the market is competitive, then
to achieve the socially optimal level
of pollution, what can the
government do?
(c) What will happen if the market
is competitive, and the government
institutes a $100 specific tax on
steel?
 Answers
(a) Area c
(b) institute a specific tax of $50.
(c) less than the socially optimal quantity of steel is produced.