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Economics - Market Failure

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Environmental Market

Negative Externalities
Costs imposed on a 3rd party not involved with the consumption or production of the good (the external cost)
 Divergence between private and social cost
 The MEC = the negative externality  The free market price is less than the optimum price leading to over consumption
 Welfare loss

Q: The market generated quantity
(where privates crosses private)
Q1: The optimum quantity
(where social crosses social)
Over consumption of Q-Q1

Unequal Distribution Effects

Citizens in poor countries are more likely to be affected by the consequences of global warming that those in rich countries

E.g. drought/flooding

They are also a lot less likely to have consumed the goods and services which caused the global warming

And a loss less able to protect them selves e.g. through insurance policies

There are inequities between those who contribute to global warming and those who suffer from it

Citizens of developed (polluting) countries pay less for their goods and services than the social costs of their production 


Government Intervention to correct
Environmental Market Failure
2 main types:
 Market based measures
Designed to modify the price mechanism using strategies such as taxes and subsidies
 Government regulation
Sometimes referred to as “Command and
Control”, designed to create incentives for firms to reduce harmful emissions, such as pollution permits which allow pollution to a certain level

Environmental Taxation
A tax placed on the producer of a good or service which is deemed to have a negative impact on the environment
 Designed to “internalise” the negative externality by increasing the private cost of production
 Tax aims to increase the private cost until it equals the social cost – to reach optimum P and Q (see dia on next slide)  Tax revenues can be used to fund spending on “clean ups” and invested in new technology that are designed to have a lower environmental impact, e.g. “clean” energy sources  Examples of environmental taxes: fuel duty, air passenger duty, landfill tax, London congestion charge

Problems with Environmental Taxation

Vary difficult to place accurate monetary values on the environment and externalities e.g. loss of habitat, so very difficult to decide on tax levels

Price elasticities of demand and supply are often not known and vary over time, meaning that it is very difficult to know how much to increase tax by to achieve a certain reduction in pollution

If the demand for a product with adverse environmental effects is inelastic, the tax may raise revenue which can be put to good use but will only reduce consumption slightly

Imposing taxes on some environmentally harmful goods such as cigarettes may be seen as regressive and worsen the distribution of income and wealth

Increasing environmental tax in one country may reduce the countries international competitiveness and encourage firms to move to countries with lower environmental taxes, which may perversely act to increase global pollution as firms take advantage of low pollution taxes in rapidly developing countries such as China and India

Pollution Regulation
 Instead of using taxation the government could regulate
 The government could set a quota they believe corresponds with the optimum level or ban certain pollution generating activities
 In the UK the Environmental Protection Act of 1989 set minimum environmental standards for industries such as waste incineration and oil refining
 Regulatory Bodies e.g. Her Majesty's Inspectorate of
Pollution inspect and fine firms that do not conform to the emission standards that have been set
 However, monitoring regulations can be difficult and expensive  In addition, regulation does not generate tax revenues that could be used to support environmental improvement schemes or compensate those who have been adversely affected by pollution

Extending Property Rights
Tragedy of the Commons
The over exploitation of natural resources that are not owned by single individuals or organisations
 Because no-one owns the air or sea no-one takes responsibility for them and they are over exploited  This is called the tragedy of the commons
 Instead of using taxation or regulation the government could create a market in property rights – the
 This internalises the negative externality through making the polluters pay and helps to limit the negative impact on the environment
 Examples: tradable pollution permits, emissions trading, carbon trading
 Popular in developed countries

Pollution Permits

What is it?
These is a permit sold to firms by the government allowing them to pollute up to a certain limit. These can be bought and sold between firms. Exceeding your legal limit will result in huge fines.

The government can cap the total emissions allowed within a time period by limiting permissions sold

The firm’s which cause the most emissions pay the most 

Gives firms an incentive to reduce emissions

Generate revenue which can be used to further
R&D into sustainable energy – intergenerational equity (fairness)

Uses market forces to limit emissions rather than regulation Disadvantages

The system must be enforced to be effective

Requires teams of factory inspectors

Careful thought is required regarding the fines imposed if limits are exceeded

Extending Property Rights to overcome the Tragedy of the Commons
 Activity page 113
Tradable carbon pollution permits
Giving internet service providers the right to claim damages from distributors of spam for the extra cost incurred from the damage from spammers operations

Tradable quotas for water pollution
Granting property rights to local citizens who can then claim damages from offenders Tradable quotas for fishing Grant licenses for short term logging / logging quotas Environmental Market Failure
Intervention Options Summary
 Taxation
Fuel duty, air passenger duty, landfill tax, London congestion charge  Regulation
Environmental Protection Act of 1989 - minimum environmental standards for industries such as waste incineration and oil refining
Regulatory Bodies - Her Majesty's Inspectorate of
Pollution inspect and fine firms
 Extending Property Rights
Tradable pollution permits, emissions trading, carbon trading

Kyoto Protocol
 An international agreement
 Signed by government representative in
 Designed to deal with climate change problems  Developed nations agreed to reduce greenhouse gas emissions by 5% of 1990 levels by 2012
 Allows carbon trading between industrialised countries
 Worryingly the US, who accounts for one third of all carbon emissions, withdrew from the agreement in 2001
 Rapidly developing countries such as
China and India were also not bound by the protocol, which seriously reduces the effectiveness of the agreement

Solar Panels
Reducing negative externalities
& thus reducing Market Failure
 Feed-in tariff
 Home owners receive 41.3p for every unit they generate, regardless of whether they use it or feed it back to the national grid
 Cost between £6k and 12k to buy and install
 Can earn home owners about £700 a year in feed back revenue plus £100 off electricity bills


Key Terms
Pollution Permit: a right to emit a given volume of waste or pollution into the environment
Kyoto Protocol: an agreement made at a global summit meeting in Kyoto, Japan, to cut world carbon emissions

Past Exam Questions
“Taxation and carbon trading can both be used to price carbon emissions” (Extract B, line 12)
Explain how a government can use taxation and carbon trading to price carbon emissions
(10 marks)

Up to 3 marks for relevant point explained:
Using taxation:
 Identifying the sources
 Placing a monetary value on the emissions
 Imposing a tax on the polluter to internalise the external cost
 Using tax to increase the price and reduce consumption
Using carbon trading:
 Imposing a ceiling or max limit on emissions for activity or firm
 Granting pollution permits
 Creating a market in which unused allowances can be traded

Past Exam Questions

Jan 2011
“Imperfect information may lead to market failure”
Explain how imperfect information may result in the failure of markets for merit and demerit goods
(15 marks)

Past Exam Questions
Using the data and your economic knowledge, discuss whether government policies that aim to reduce the rate at which climate change is occurring benefit or harm the UK.
(25 marks)
Issues and areas for discussion include:
Tax policies
Carbon trading policies
Effective policies require international co-operation with other governments
Costs incurred in the absence of policies
Costs created by the policies themselves
Benefits experienced as a result of the policies
Social versus private costs/benefits
Government failure issues e.g. risk of too high carbon limits actually encouraging pollution

Past Exam Questions

Jan 2011
Discuss whether markets alone can be relied upon to reduce the problems of environmental pollution.
(25 marks)

Past Exam Questions
Jun 2011
“The UK’s strong reliance on landfill indicates the existence of widespread environmental market failure” (Extract B, lines 16-17)
Using the data and your economic knowledge evaluate alternative methods of correcting market failure arising from waste disposal.
(25 marks)

Past Exam Questions
Jun 2010
“It is difficult to judge whether GM crops will boost productivity to feed the world and create social benefits or cause market failure through monopoly, environmental damage and adverse side effects on human health” (Extract
B, line 38-40)
Using the data and your economic knowledge, evaluate the view that the UK Government should support the production and use of GM crops.
(25 marks)…...

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