02 mrkt failure

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Market failure to take note of environmental impacts of economic activity. Why environmental effects are not included in perfect markets. Concept of public goods, externalities. Role of government.

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02 mrkt failure

  1. 1. 1 Environmental Economics MARKET FAILURE Prof. Prabha Panth, Osmania University
  2. 2. 2Prabha Panth Perfect Market • Neo-classical model of perfect competition is taken as optimum for allocation of resources. • P = MC = MU, • All private costs = private benefits • Maximisation of individual benefits • Social benefit = Σ individual benefits • Pareto optimality
  3. 3. 3Prabha Panth What is Market Failure • Market failure occurs when the market through the price system cannot obtain an optimal allocation of resources, due to the differences between private and social costs and benefits. • SMC ≠ Σ Private MC • SMB ≠ Σ private MB • Inefficiency of the real market
  4. 4. 4Prabha Panth MARKET FAILURE • Market failure: Private decisions based on market prices cannot generate an efficient allocation of resources for Society. • This is especially true of Environmental goods and services. • Difference arises between Private costs and Social costs, and Private Benefits and Social benefits. • Most assumptions of perfect competition do not exist in reality.
  5. 5. 5Prabha Panth ENVIRONMENTAL GOODS AND MARKET FAILURE Three reasons for market failure: 1) No Markets for Environmental Goods: Most environmental goods are “Free” goods – e.g. atmosphere, water, etc.  No one owns environmental goods, so they cannot be bought and sold.  There is no price for their use or misuse.  Therefore they are overused
  6. 6. 6Prabha Panth 2. Pure Public Goods: Environmental goods are pure public goods. Two characteristics of Pure Public Goods: a) Non Rival: one person’s use does not reduce another person’s supply. E.g. oxygen, sunshine, river b) Non-exclusive: Cannot exclude another person from using the environmental good. For e.g. if one person uses the river, he cannot stop another from using it.
  7. 7. 7Prabha Panth 3) Externality: Since environmental goods are non-rival and jointly consumed, one person’s consumption will affect another’s consumption outside the market. One user can impose external costs to others. For example: paper mill cuts the forest, affects biodiversity and forest based industries, climate change, etc. No payment is made for the misuse of the resource.
  8. 8. 8Prabha Panth Qx Rs 0 AR = MRP PMC Q1 E MARKET FAILURE SMC F EXTERNAL COST Q2 G P1 H
  9. 9. 9Prabha Panth • Production adds environmental costs – for e.g. thermal plants produce electricity as well as CO2 which leads to Greenhouse effect. • But the cost of pollution is not added to the private MC of the firm. • Pollution imposes an external cost or externality to society = EF. • If it is included then the new equilibrium is at F, and P = FQ1 • Or else, Q should fall to G, where P = SMC. • Thus perfect competition leads to over production (Q1>Q2), and charges lower price (P< P1)
  10. 10. 10Prabha Panth Correcting Market Failure • Firms don’t pay the External cost, as they are not affected by the pollution. • According to Pigou, if a tax = External cost is imposed (Tax = EF), then the externality can be internalised. • Called Pigovian tax. • Therefore if External cost is internalised, then new equilibrium will be at G, and Q will fall. • Pollution levels or social costs will fall.
  11. 11. 11Prabha Panth How to internalise external costs • Pigovian taxes: • Tax the polluter or the creator of the externality. Such as: Green taxes on carbon dioxide releases, or on effluents from factories, – Raising the prices of more polluting or more environmentally damaging goods, – Making polluters bear the cost of controlling or mitigating their pollution.
  12. 12. 12Prabha Panth How to internalise external costs • Pigovian Subsidies: • Reward by lowering the price and cost of environmentally safe products, and techniques. – Green products, – Alternative renewable energy, – Bio degradable plastics, • These measures will send market signals to reduce environmentally unsafe activities, and encourage environmentally friendly ones.

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