Market Failure

What is market failure? Market failure occurs when freely-functioning markets, fail to deliver an efficient allocation of resources. The result is a loss of economic and social welfare. Market failure exists when the competitive outcome of markets is not efficient from the point of view of society as a whole. This is usually because the benefits that the free-market confers on individuals or businesses carrying out a particular activity diverge from the benefits to society as a whole.

There are many instances when the free market fails to deliver an efficient allocation of resources. Markets can fail because of: 1. Negative externalities (e.g. the effects of environmental pollution) causing the social cost of production to exceed the private cost. 2. Positive (or beneficial) externalities (e.g. the provision of education and health care) causing the social benefit of consumption to exceed the private benefit 3. Imperfect information means merit goods are under-produced while demerit goods are over-produced or over-consumed 4. The private sector in a free-markets cannot profitably supply to consumers pure public goods and quasi-public goods that are needed to meet peoples needs and wants 5. Market dominance by monopolies can lead to under-production and higher prices than would exist under conditions of competition 6. Factor immobility causes unemployment hence productive inefficiency 7. Equity (fairness) issues. Markets can generate an unacceptable distribution of income and consequent social exclusion which the government may choose to change Market failure results in


Productive inefficiency: Businesses are not maximising output from given factor inputs. This is a problem because the lost output from inefficient production could have been used to satisfy more wants and needs Allocative inefficiency: Resources are misallocated and producing goods and services not wanted by consumers. This is a problem because resources can be put to a better use making products that consumers value more highly

Options for government intervention in markets There are many ways in which intervention can take place some examples are given below

Government Legislation and Regulation Parliament can pass laws that for example prohibit the sale of cigarettes to children, or ban smoking in the workplace. The laws of competition policy act against examples of pricefixing cartels or other forms of anti-competitive behaviour by firms within markets. Employment laws may offer some legal protection for workers by setting maximum working hours or by providing a price-floor in the labour market through the setting of a minimum wage. The economy operates with a huge amount of regulation. The government appointed regulators who can impose price controls in most of the main utilities such as telecommunications, electricity, gas and rail transport. Regulation may be used to introduce fresh competition into a market for example breaking up the existing monopoly power of a service provider. A good example of this is the attempt to introduce more competition for British Telecom and also for the postal service industry. This is known as market liberalisation. Direct State Provision of Goods and Services Because of privatization, the state-owned sector of the economy is now much smaller than it was twenty years ago. The main state-owned businesses in the UK are the Royal Mail which is still subject to direct price controls and Network Rail. State funding can be used to provide merit goods and services and public goods directly to the population e.g. the government pays private sector health firms to carry out operations for NHS patients to reduce waiting lists or it pays private businesses to operate prisons and maintain our road network. Fiscal Policy Intervention Fiscal policy can be used to alter the level of demand for different products and also the pattern of demand within the economy. 1. Indirect taxes such as changes in VAT and excise duties can be used to raise the price of demerit goods and products with negative externalities designed to increase the opportunity cost of consumption and thereby reduce consumer demand towards a socially optimal level. 2. Subsidies to consumers will lower the price of merit goods such as grants to students to reduce the internal costs of staying on in full-time education and subsidies to businesses employing unemployed workers on the New Deal programme. They are designed to boost consumption and output of products with positive externalities a subsidy causes an increase in market supply and leads to a lower equilibrium price (see the separate revision focus article on producer subsidies). 3. Tax relief: The government may offer financial assistance such as tax credits for business investment in research and development. Or a reduction in corporation tax designed to promote investment and employment. 4. Changes to taxation and welfare payments can be used to influence the distribution of income and wealth for example higher direct taxes on rich households or an increase in the value of welfare benefits for the poor to make the tax and benefit system more progressive. Intervention designed to close the information gap Often market failure results from consumers suffering from a lack of information about the costs and benefits of the products available in the market place. Government action can have a role in improving information to help consumers and producers value the true cost and/or benefit of a good or service.

Examples might include: 1. Compulsory labelling on cigarette packages with health warnings to reduce smoking. 2. Improved nutritional information on high-fat foods to counter the risks of growing obesity. 3. Anti-speeding television and cinema advertising to reduce road accidents. 4. Advertising health-screening programmes / information campaigns on the dangers of drug and alcohol addiction. These programmes are really designed to change the perceived costs and benefits of consumption for the consumer. They dont have any direct effect on market prices, but they seek to influence demand and therefore the level of final output and consumption. The effects of government intervention

Decisions on our future energy sources government policy intervention can have huge effects on both the short term and the long term allocation of resources in the future One important point to bear in mind is that the effects of different forms of government intervention in markets are never neutral since financial support given to one set of producers rather than another will always create winners and losers. Taxing one product more than another will similarly have different effects on different groups of consumers. Judging the effects of intervention a useful check list To help your evaluation of government intervention it may be helpful to consider these questions: 1. Efficiency of a policy: i.e. does a particular intervention lead to a better use of scarce resources among competing ends? E.g. does it improve allocative, productive and dynamic efficiency? For example - would introducing indirect taxes on high fat foods be an efficient way of reducing some of the external costs linked to the growing problem of obesity? 2. Effectiveness of a policy: i.e. which government policy is most likely to meet a specific economic or social objective? For example which policies are likely to be most effective in reducing the scale of the UK road congestion problem? Which forms of intervention are most effective in improving the incentives of consumers to actively search for work in the labour market? Which policies are more effective in preventing firms from exploiting their monopoly power and damaging consumer welfare? Evaluation can also consider which policies are likely to have an impact in the short term when a quick response from consumers and producers is desired. And which policies are likely to prove most cost-effective in the longer term? For example, how

best to encourage recycling in the long run and also provide incentives to increase the supply of energy in the long run that comes from renewable sources such as wind power. 3. Equity effects of intervention: i.e. is a policy thought of as fair or does one group in society gain more than another? For example it is equitable for the government to offer educational maintenance allowances for 16-18 year olds in low income households to stay on in education after GCSEs? Would it be equitable for the government to increase the top rate of income tax to 50 per cent in a bid to make the distribution of income more equal? 4. Sustainability of a policy: i.e. does a policy reduce the ability of future generations to engage in economic activity? Inter-generational equity is an important issue in many current policy topics for example decisions on which sources of energy we choose to rely on in future years.

Government Failure
Government intervention can sometimes fail to meet the desired outcomes, or can make existing policy problems worse. In this note we look at the idea of government failure. The idea of government failure Even with the best of intentions governments seldom get their policy application correct. They can tax, control and regulate but the eventual outcome may actually be a deepening of the market failure or even worse a new failure may arise which requires corrective action. Government failure may range from the trivial, when intervention is merely ineffective, but where harm is restricted to the cost of resources used up and wasted by the intervention, to cases where intervention produces new and more serious problems that did not exist before. The consequences of this can take many years to reverse. Over the last fifty or sixty years, Western governments have intervened to try to improve the social and economic life of their countries on a scale unimaginable to previous generations. Yet social and economic problems persist. Policies fail. Adapted from Why Most Things Fail, Paul Ormerod Government failure in a non-market economy The collapse of the Soviet Union in the late 1980s and early 1990s marked, for many people, the final failure of command or planned economies as a means of allocating resources among competing uses. The essence of a command economy was that the state-operated planning mechanism would decide what to produce and how to produce it and for whom to produce. Government failure occurred when the central planners supplied products that were simply not wanted by consumers showing a loss of allocative efficiency, since there was no price mechanism to signal changes in consumer preferences and demand. John Kays book The Truth about Markets has excellent sections on the basic fault-lines in the planning process. Another fundamental failing of the pure command economy was that there was little incentive for workers to raise productivity; few incentives to prevent poor quality control; and little innovation by firms as no profit motive existed. Command economies also suffered environmental de-gradation because they did not posses structures for valuing the environment and giving consumers and producers the right incentives to protect their environmental heritage.

All of these economies are now moving towards the western mixed economy, though at varying speeds and with varying success. Eight former eastern Bloc countries joined the European Union in May 2004, some of them former state-run economies in the Eastern Bloc. Countries such as Hungary, the Czech Republic and Poland are all moving towards a market based system for the allocation of resources for example through programmes of privatisation and market liberalisation. Many of them have enjoyed fast rates of economic growth and a rise in relative living standards both before and since their accession to become members of the European Union. Possible Causes of Government Failure Government intervention can prove to be ineffective, inequitable and misplaced. There is a growing body of research in the economics literature on this topic some of which uses highly mathematical techniques to analyse public policy-making. We will focus instead on the underlying reasons and consider some topical examples along the way. (a) Political self-interest The pursuit of self-interest amongst politicians and civil servants can often lead to a misallocation of scarce resources. For example decisions about where to build new roads, bypasses, schools and hospitals may be decided with at least one eye to the political consequences. The pressures of a looming election or the influence exerted by special interest groups can create an environment in which inappropriate government spending and tax decisions are made. - e.g. boosting the level of welfare spending in the run up to an election, or bringing forward major items of capital spending on infrastructural projects without the projects being subjected to a full and proper cost-benefit analysis to determine the likely social costs and benefits. Critics of current government policy towards tobacco taxation and advertising, and the controversial issue of genetically modified foods argue that government departments are too sensitive to political lobbying from the major corporations. (b) Policy myopia Critics of government intervention in the economy argue that politicians have an in-built tendency to look for short term solutions or quick fixes to difficult economic problems rather than making considered analysis of long term considerations. The risk is that myopic decision-making will only provide short term relief to particular problems but does little to address structural economic difficulties. Consider for example the long term problems facing the UKs transport network. To what extent has transport suffered from a lack of long-term planning and joined up thinking about how to create a properly integrated transport network which can provide proper solutions to the issues of traffic congestion and the environmental consequences of rising transport use. Critics of government subsidies to particular industries also claim that they distort the proper functioning of markets and lead to deeper inefficiencies in the economy. (c) Regulatory capture. This is when the industries under the control of a regulatory body (i.e. a government agency) appear to operate in favour of the vested interests of producers rather than consumers. Some economists argue that regulators can prevent the ability of the market to operate freely.

Olive growing in Spain has the CAP encouraged over-production, a waste of resources and caused damage to the economies of many developing countries? For example, to what extent has the European Unions Common Agricultural Policy operated mainly in the interests of farmers? Has the CAP worked against the long-term interest of consumers, the environment and developing countries who claim that they are being unfairly treated in world markets by the effects of import tariffs on food and export subsidies to loss-making European farmers? The CAP is widely criticised as a classic example of government failure and there are many who claim that the current reform process does not go far enough. (d) Government intervention and disincentive effects Free market economists who fear government failure at every turn argue that attempts by the government to reduce income and wealth inequalities can actually worsen incentives and productivity in the economy. They would argue against the National Minimum Wage because they believe that it can lead to real-wage unemployment. They would also argue against raising the higher rates of income tax because it is deemed to have a negative effect on the incentives of wealth-creators in the economy and generally acts as a disincentive to work longer hours or take a better paid job. They are critical of the government focusing welfare benefits on the poorest using means-tested benefits because they might damage the incentive to find work. The opposite point of view is that a lack of effective government policies to reduce the scale of income and wealth inequality is also a cause of government failure since inequality can, over the longer term; create many deep-rooted problems for society once social cohesion starts to break down. (e) Government intervention and evasion A decision by the government to raise taxes on de-merit goods (such as cigarettes) might lead to an increase in attempted tax avoidance, tax evasion, smuggling and the development of grey markets where trade takes place between consumers and suppliers without paying tax. Equally a decision to legalize and then tax some drugs might lead to a rapid expansion of the supply of drugs and a substantial loss of social welfare arising from over consumption. (f) Policy decisions based on imperfect information How does the government establish what citizens want it to do in their name? Can the government ever really know the true revealed preferences of so many people? Our current

electoral system is not an ideal way to discover this! Turnout in every type of election, (local, national, European etc) is falling, there is general disinterest in the political process. Furthermore, people rarely vote purely out of their own self-interest or on the basis of a well informed and rational assessment of the costs and benefits of different government policies. Proponents of government failure argue that the free market mechanism is, in the long-run, the best way of finding out (a) What consumer preferences are and (b) Aggregating these preferences based on the number of people that are willing and able to pay for particular goods and services. Often a government will choose to go ahead with a project or policy without having the full amount of information required for a proper cost-benefit analysis. The result can be misguided policies and damaging long-term consequences. How does the government know how many extra houses need to be built in the UK over the next twenty years? Is building thousands of extra homes in an already congested South-east the right option? Are there better solutions? There have been plenty of instances of government housing policy having failed in previous decades! (g) The Law of Unintended Consequences! This law lies at the heart of many of the possible causes of government failure in markets! The law of unintended consequences says that a government policy will always lead to at least one reaction from either consumers or producers that are unanticipated or unintended. Economic agents do not always act in the way that the economics textbooks would predict this is of course the essence of a social, behavioural science we do not live our lives in sanitised laboratories where all of the conditions can be controlled. The law of unintended consequences is often used to criticise the effects of government legislation, taxation and regulation. People find ways to circumvent laws; shadow markets develop to undermine an official policy; people act in unexpected ways either because or ignorance and / or error. Unintended consequences can add hugely to the financial costs of some government programmes so that they make them extremely expensive when set against their original goals and objectives. (h) Costs of administration and enforcement Government intervention can prove costly to administer and enforce. The estimated social benefits of a particular policy might be largely swamped by the administrative costs of introducing it. A summary of the arguments
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Free market economists are naturally distrustful of government intervention in the economy They believe that the signalling, incentive and rationing functions of the price mechanism should be given more freedom to operate They believe that government failure can occur at a microeconomic level (e.g. introducing minimum prices in markets, rent controls, producer subsidies etc) and at a macroeconomic level (pursuing inappropriate exchange rate, tax or interest rate policies etc) When government failure exists, the result can be a deepening of an existing market failure The result is a further loss of allocative and productive efficiency because of the waste of scarce resources leading to a reduction in consumer and producer welfare

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Often we can accuse the government of policy failure only with the benefit of hindsight Limited information - no government has the resources and information available to it to make fully-informed, objective judgements. That is the nature of politics. Government failure is most likely to occur when decisions are made in the vested interest of special interest groups, at the expense of other groups (the result is a loss of equity) But government failure is rarely total. Policies may be ineffective, expensive and inefficient but providing that policies are flexible and adaptable, (i.e. lessons are learned) then intervention can often work in the interests of the majority Advances in our understanding of how consumers and businesses behave and respond to changing incentives are helping government policies to evolve. For example the growing interest in auctions and traded permits as a means of controlling pollution and other forms of environmental damage

Externalities Overview
We now consider in more detail than at AS level, the economics of externalities and policy approaches to controlling and correcting for market failure caused by the existence of externalities. Environmental economics is now a huge area of the subject. The economic importance of the environment The environment plays an absolutely essential role in shaping our economic and social welfare. The environment
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Provides services to consumers in the form of living and recreational spaces and the opportunity to enjoy utility from experiencing natural landscapes and habitats It provides us with the natural resources necessary to sustain production and consumption including the basis for renewable and non-renewable sources of energy It is a dumping ground for the waste products of our society - be it waste from producers in different industries or from households and consumers

The link between economic activity and our environment is fundamental. We hear constantly about the need for sustainable economic welfare, for growth to take into account the direct and indirect effects on our resources. And increasingly we, as producers and consumers, are affected by many government policies and strategies designed to promote environmental protection and improvement. What is the commonly accepted definition of sustainability? Development which meets the needs of the present without compromising the ability of future generations to meet their own needs World Commission on Environment and Development Our Common Future (1987) Externalities and the environment the basics For environmental economics, one of the most important market failures is caused by negative externalities arising from either production or consumption of goods and services. A negative externality occurs where a transaction imposes external costs on a third party (not the buyer or seller) who is not compensated by the market. The result is a loss of allocative efficiency and shown by a reduction in economic welfare Environmental externalities generally arise for three reasons:

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Common resources (not privately owned - e.g. ocean fisheries) commonly owned resources may lack the protection of property rights and are susceptible to overexploitation because the marginal cost of extracting the resource for a private economic agent is close to zero. This is known as the tragedy of the commons Public goods (indivisible common resources - e.g. the air) Future generations (sources of externality including carbon emissions greenhouse effects contributions to global warming which threatens future sustainability)

Dead fish on a polluted beach the external costs of pollution but who should pay? In these cases, the private equilibrium of supply and demand is not the same as the social equilibrium which includes all costs. In a completely free market, a producer will have no incentive to control pollution because it is external i.e. the producer only considers his/her own private costs and benefits. The market failure arising from negative externalities is shown in the diagram below.

Economists argue that market failures provide a rationale for policy intervention to improve economic efficiency. But since market failures are pervasive, intervention is only justified if the benefits exceed the costs The Tragedy of the Commons The contribution of each economic agent is minute, but summed over all agents, these actions degrade the resource and may cause severe long term damage The tragedy of the commons is a metaphor used to illustrate the potential conflict between individual self-interests of producers and consumers and the common or public good. In the original version of the term, the example is used of a stock of common grazing land used by all livestock farmers in a small village. Each farmer keeps adding more livestock to graze on the Commons, because the marginal cost of doing so is zero. But because the commonly-owned resource is then over-exploited, the result is a depletion of the soil and a fall in the value of the resource for all users. The resource may become irretrievably damaged, an example of a public bad. The root cause of any tragedy of the commons is that when individuals use a public good, they do not bear the entire social cost of their actions. If each seeks to maximize individual benefit, he or she ignores the external costs borne by others. The absence of well defined and legally protected property rights lies at the heart of the problem. A tragedy of the commons can occur even without complete and permanent destruction of a resource the term can be used to describe any situation where what was perceived as a renewable resource becomes less valuable because of over-exploitation. Good examples of the tragedy of the commons: Game theory and the tragedy of the commons The tragedy of the commons can be linked to the prisoner's dilemma that is a core part of game theory. Individuals within a group have two options: cooperate with the group or defect from the group. Cooperation happens when individuals agree to protect a common resource. Defection happens when an individual decides to use more than his share of a public resource. Cooperation has the potential to maximize every individual's benefit in the long run (i.e. the 'tragedy' does not happen, the commons are preserved and can be used indefinitely), while defection maximizes an individual's benefit in the short run at the expense of destroying it in the long run. Thus in the case of fish stocks, suppliers need to cooperate over a period of time so that fish stocks can start to rise again. This is the essence of attempts to reform the European Union Common Fisheries Policy. An alternative to regulation by government is to create a market in property rights in order to control the impact of economic activity on the environment for example establishing a carbon trading emissions scheme or introduction tradable fishing permits for the EU fishing industry. The Economics of Waste The UK government wants more waste being disposed of through incineration rather than dumped in landfill sites. It has restated its strategy and at the top of the waste hierarchy is the desire to reduce the amount of waste created in the first place from the production and consumption of goods and services. The main aim is for the volume of waste to grow less quickly than GDP, in other words to achieve a de-coupling of waste generation from rising

economic activity. Because waste is normally regarded as a de-merit good creating external costs, there is justification for some form of government intervention in the market to change market prices, alter incentives and, hopefully, cause a change in the behaviour of consumers and producers. Over two million tonnes of edible food is dumped by retailers in Britain each year, usually into landfill sites According to data released by DEFRA, less waste in the UK is being land-filled down from 82% to 72% for municipal waste between 1999 and 2004 and from 50% to 44% for industrial and commercial waste between 1999 and 2003. A successful waste strategy will bring about sizeable increases in waste recycling and composting. Some local authorities have a superb record in raising awareness and interest in recycling products. But in other areas of the UK, recycling rates are abysmally low and well below the levels needed to meet UK and European Union targets. Government policy needs to be more effective in enhancing the incentives for individuals and businesses to recycle more of their waste products.

The vast majority of UK household and industrial waste is disposed of in landfill sites Hierarchy of principles of waste management:
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Prevention of waste - reduce the amount of waste created in the first place Reuse the product Recycle or compost the product Recover the energy by incinerating Disposal of the product using landfill

What are the best incentives for households and businesses to reduce the amount of waste created? Suggestions for further reading and research Friends of the Earth Guardian special report on waste and pollution If the toxic time bomb goes off (BBC) Norway gets soft drinks eco-tax (BBC) Recycling around the world (BBC) Sustainable Development Commission (UK) Tesco offers carrot to reduce use of plastic bags (Guardian) and Green grocers favour reusable bags UK 'refuseniks' tackle Big Waste (BBC news Feb 2006) Waste facts behind the fiction Waste incineration set to rise (BBC) Waste online Waste problem needs many solutions (BBC) Wasteful homes threaten eco-targets (BBC)

Externalities - Government Policy Options

Government intervention to reduce market failure from negative externalities Traditionally, government policy towards the environment has concentrated in two main areas
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Intervention in the price mechanism for example through environmental taxes Command and control measures for example direct regulation and legislation

These policies are designed to: Achieve a more efficient use of resources Promote substitution between resources (e.g. abundant for scarce, renewable for non-renewable) o Provide incentives for a reduction of pollution emissions or change from harmful to benign
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Environmental taxation

An environmental tax is a tax on a good or service which is judged to be detrimental to the environment. It may also be a tax on a factor input used to produce (supply) that final product. The main aim of environmental taxation is to:
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Increase the private cost of producing goods and services so that the producer / consumer is paying for some of the negative externalities that their actions are creating (i.e. the externality is internalised) this promotes allocative efficiency In this way, the government is providing a continuous incentive for the producer / consumer to take the externalities into account, thereby correcting a failure of the signalling function of the price mechanism Raise the price of the product so that the level of demand contracts (there is normally a direct link between the level of output / consumption and the total pollution created) Reduce output levels towards the estimated social optimum level of production which contributes to a more sustainable economy in the long term Well designed environmental taxes may encourage innovation and the development of new technology which reduces the dependency of an economy on pollution inefficient forms of energy. This can help to promote dynamic efficiency Revenue derived from these taxes can be earmarked for lower taxes elsewhere in the economy (e.g. a reduction in employers national insurance contributions) or to fund increased government spending on environmental projects / an expansion of provision of public and merit goods. Well designed environmental taxes can provide a source of revenue while correcting an economic distortion Inter-generational equity justification: Consider what might happen if the government refuses to introduce some environmental taxes so that current producers and consumers do not pay directly for some of the external costs they create. A refusal to impose tax displaces the environmental costs to future generations (implying a lack of intergenerational equity)

The Durham congestion charge a means of reducing traffic congestion Examples of environmental taxes include: petrol duty, vehicle excise duty, the landfill tax, the new carbon tax and the London Congestion Charge. The Irish Government also introduced a tax on plastic bags in a bid to reduce consumption and encourage recycling. The main aim of an environmental tax is to increase the firms private marginal cost (PMC) until it equates with the social marginal cost curve (SMC). Evaluation problems with environmental taxation

There is a growing body of economists who argue that reliance on environmental taxation is an ineffective way of promoting environmental improvement, indeed that some taxes are prone to government failure. And, that the focus should now switch to alternatives ways of changing the incentives of producers and consumers through the market mechanism. The main criticisms of environmental taxes are discussed below:
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Valuing the environment: There are fundamental problems in setting taxes so that marginal private costs will equate with the marginal social costs. The government cannot accurately value the private benefits and cost of firms let alone put a monetary value on externalities such as the cost to natural habitat, the long-term effects of resource depletion and the value of human life. Frequent adjustments of tax levels may be required and this involves substantial organisational costs Consumer welfare effects: Taxes reduce output and raise prices, and this might have an adverse effect on consumer welfare. Producers may be able to pass on the tax to the consumers if the demand for the good is inelastic and, as result, the tax may only have a marginal effect in reducing demand and final output Achieving a target quantity of pollution reduction: Taxes do not lend themselves to the government achieving an accurate reduction in total pollution. This is because no government can ever predict how consumers and or producers will respond to higher costs and prices. The elasticity of demand may vary over time. Income distribution: Taxes on some de-merit goods (for example cigarettes) may have a regressive effect on low-income consumers and lead to greater inequalities in the distribution of income. Having said this, it should be possible for authorities to develop smart tariffs or taxes where account is taken of the impact of pollution taxes on vulnerable households such as low low-income consumers. The current Labour government has reduced the rate of VAT on domestic fuel to the EU minimum rate of 5%, but the government has no plans to introduce a domestic energy tax (which would be an explicit environmental tax) because of the huge numbers of low-income households that currently live in fuel poverty. In the UK, the poorest 10% of households spends 13.2% of income on energy whereas the richest spends 3.5%. Employment and investment consequences: If pollution taxes are raised in one country, producers may shift production to countries with lower taxes. This will not reduce global pollution, and may create problems such as structural unemployment and a loss of international competitiveness. Similarly, higher taxation might lead to a decline in profits and a fall in the volume of investment projects that in the long term might have beneficial spill-over effects in reducing the energy intensity of an industry or might lead to innovation which enhance the environment More efficient alternatives? It might be more cost effective for governments to switch away from pollution taxation to direct subsidies to encourage greater innovation in designing cleaner production technologies. Eco-tax reformers often argue that pollution taxes should be revenue neutral so for example, an increase in environmental taxation might be accompanied by reductions in employment taxes such as National Insurance Contributions so that the employment consequences of higher taxation are minimised. The impact of green taxes depends crucially on what is done with the revenues. If they are balanced by reducing other taxes through revenue re-cycling, research suggests that green taxes could result in an overall economic improvement

Alternatives to environmental taxes An effective use of environmental taxation Most power stations are surrounded by coal tips or pipes carrying gas. But round the plant that powers the Swedish town of Enkping, some 70 kilometres west of Stockholm, there is willow coppice stretching as far as the eye can see. Enkping is probably the only town in Europe that is powered by bio-fuels. The plant's director, Eddie Johansson, says willow is as economic as coal or gas because Sweden levies a tax on carbon emissions from most power plants. Under the government's rules, he does not have to pay the tax because for every tonne

of carbon dioxide that disappears up the stack, the plant's willow trees soak up a tonne from the air as they grow. Hundreds of willow-powered plants could operate across Europe, he says if power companies had similar incentives to cut carbon emissions. Source: Business Week, September 2005 Carbon Emissions Trading Emission trading is regarded by many as the future of environmental protection and improvement in the UK, European and international economy. Carbon trading is another form of pollution control that uses the market mechanism to change relative prices and the incentives of producers and consumers. There is also growing interest in the idea of personal carbon trading, the UK government is currently looking at the issue . Carbon allowances for consumers! The environment minister, David Milliband has unveiled a radical plan to cut greenhouse gas emissions by charging individuals for the amount of carbon they use. Under the proposals, consumers would carry bank cards that record their personal carbon usage. Those who use more energy - with big cars and foreign holidays - would have to buy more carbon points, while those who consume less - those without cars, or people with solar power - would be able to sell their carbon points. Under the scheme, all UK citizens would be allocated an identical annual carbon allowance, stored as points on an electronic card similar to Air Miles or supermarket loyalty cards. Points would be deducted at point of sale for every purchase of non-renewable energy. People who did not use their full allocation, such as families who do not own a car, would be able to sell their surplus carbon points into a central bank. High energy users could then buy them - motorists who had used their allocation would still be able to buy petrol, with the carbon points drawn from the bank and the cost added to their fuel bills. To reduce total UK emissions, the overall number of points would shrink each year. Source: Adapted from the Guardian, July 2006 The basics of cap and trade - emissions trading
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A fixed number of emission permits is allocated each year to polluting factories Usual denomination: 1 permit = 1 tonne (e.g. of CO2 emissions) Total number of permits is the limit on pollution the cap Annual emissions of each factory must be less than or equal to permit holdings Permits can be traded i.e. cap and trade Factories which can reduce (abate) pollution for less than the price of a permit can sell spare ones for a profit Factories which find it more expensive to reduce pollution can buy extra permits instead Gradually the supply of permits is reduced the market price rises. This gives firms who find it expensive to cut pollution, more of an incentive to seek new technologies / process that will reduce their pollution emissions

A marketable pollution permit gives a business the right to emit a given volume of waste or pollution into the environment. Ideally, the number of permits that are issued corresponds with the total level of pollution that is admissible at the social optimum level of output i.e. where the MSB = MSC. Once this has been determined the permits are issued by auction and firms that pollute the environment can bid for them and then buy and sell them amongst themselves. Pollution permits should, in theory, give firms an incentive to control pollution emissions for less than it would cost to buy permits, and there is evidence from cap and trade pollution permit schemes in the UK and the United States that the costs of monitoring pollution reduction and administration of the permits system is smaller than when an industry is subject to direct regulation. In the United States cap and trade scheme, it was found that many high-

polluting businesses invested in fitting new pollution control equipment (e.g. Flue Gas Desulphurisation) and other polluters switched from high to low sulphur coal. Consequently the use of marketable permits allows the cost of pollution control to be minimised. Another advantage is that the revenue from a traded pollution permits scheme can be re-cycled into other schemes for environmental improvement. Incentives matter create a market in the right to pollute - The basic idea behind traded pollution permits is to through the incentive to cut pollution directly to the producers themselves. Companies can then make their own decisions about the costs and benefits to them of particular routes to emission reductions. In other words, market forces are brought to bear on the issue of pollution and potential market failure. Emission trading is likely to be most effective when:
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There is an easily measurable pollutant The government sets a clearly defined and stable emissions target There are a large number of participant firms, with companies sufficiently sophisticated to deal with the technicalities of trading at auction Wide variation in costs of reducing pollution so that trading of surplus permits can take place The transactions costs of trading permits are low and there is clear pollution data availability at the start and during trading Strict enforcement of permits (i.e. a high compliance rate among participating businesses)

Kyoto Emission trading was a key feature of the Kyoto Protocol as a strategy to address some of the threats posed by climate change in 1997. Kyoto allows trading of permits for carbon dioxide between industrialised countries but the United States withdrew from the agreement in 2001 and since the USA represents 32% of emissions amongst developed countries with emission targets, the absence of the USA from an embryonic trading system will seriously reduce demand for permits and therefore drive down their price and effectiveness. Pollution regulation Instead of relying on intervention in the market mechanism by using taxation, subsidies or pollution permits, the government and its appointed agencies can regulate the level of output and pollution in a market. In theory, the government could set a quota so that output is set at the social optimum. More frequently, minimum or environmental / emission standards are widespread in many industries. This requires regulatory bodies to monitor (inspect) and fine firms that do not meet the standards set for water and air quality. The 1989 Environmental Protection Act for example set standards on emissions for firms that carried out chemical processes, waste incineration and oil refining. There will be a ban on smoking on public places in England from the summer of 2007. A ban came into force in Scotland in March 2006. Compliance with environmental regulations can be very costly to enforce and it may be impossible to monitor all firms accurately because of imperfect information. Regulation also does not bring in any direct tax revenue flows that can be used to fund environmental improvement schemes or compensate those who have been negatively affected by pollution. Suggestions for further reading on carbon emissions trading Airlines and environmental policy

Over the past 20 years, there has been huge growth in the airline industry. The number of passenger kilometres has risen from 125 billion worldwide in 1990 to 260 billion in 2000, while air freight grew even faster, at 9% per year. In 1970, British airports were used by 32 million people. In 2004, the figure was 216 million. In 2030, according to government forecasts, it will be around 500 million. Several factors have contributed to rising demand for airline travel The emergence of low-cost flying, such as EasyJet and Ryanair which have brought prices down allowing lower-income families to fly and creating a new effective demand for flying New technologies have also made long-haul flights with flagship-carriers, such as BA, cheaper and more enjoyable Increased demand for business air travel Aviation creates external costs. The main external cost of flying is the damage to the environment. It is estimated that one return flight to Florida produces as much carbon dioxide as a years motoring, while a return flight to Australia the same amount as 3 cars in one year. And flying from London to Edinburgh produces 8 times as much carbon dioxide as taking the train. Aviation currently contributes 5% to the UKs carbon dioxide emissions. With air travel growing at 3-5%, it is expected that planes will contribute 15% to the UKs carbon dioxide emissions in the next ten years For some time, there has been a debate over the merits and de-merits of introducing an aviation tax on airlines. Is this the best way of controlling the environmental damage created by the rapid expansion of the UK and European airline industry? Or will it simply create more problems and damage the competitiveness of the European airline sector? Are there better more effective ways of reducing pollution? For example bringing the airlines into the newly established EU carbon emissions trading scheme? Suggestions for wider reading and research Airlines sport their green colours Aviation Environmental Federation Aviation 'huge threat to CO2 aim' (BBC): Blair says cutting air travel is unrealistic: Calls to control low cost flights Department for Transport Easy Jets environmental policy EU plans airline CO2 reductions (BBC): Friends of the Earth:

Public Goods
When the market fails to provide certain goods and services, there is a clear case for government intervention. The nature of public goods Public goods are services which must be provided collectively for two main reasons:
y y

Non-excludability - the goods cannot be confined to those who have paid for it Non-rivalry in consumption - the consumption of one individual does not reduce the availability of goods to others

Examples of pure public goods include flood control systems, street lighting and national defence. A flood control system, such as the Thames Barrier, cannot be confined to those who have paid for the service. Also, the consumption of the service by one household will not reduce its availability to others. If left to the free market mechanism, no public goods would be provided and, as a result, there would be a clear market failure. No individual consumer

would pay for a product that could be consumed for free if another household decided to purchase it.

The benefits of the Thames Barrier cannot be confined only to those people who have paid for it Quasi-public goods: These are products that are essentially public in nature, but do not exhibit fully the features of non-excludability and non-rivalry. The road network in the UK is currently available to all, but could be made excludable via a system of electronic road pricing. There is also non-rivalry in consumption, but only up to an extent. Once the road becomes congested there is rivalry in consumption. Environmental public goods: An example of an environmental public good is public open space, which nobody would provide on their own, even though everybody benefits from it being available. Street lighting is another example of a public good. The Air-Waves a Quasi Public Good The airwaves are essentially owned by the government of a particular country. Do they count as a pure public good? Normally the answer would be yes. One persons use of the airwaves rarely reduces the extent to which other people can benefit from utilising them. But when demand for mobile phone services is high at peak times, the airwaves become crowded and access to the networks provided by the main mobile phone companies can become slow. In this sense the airwaves can be treated a crowded non-pure public good. The government controls the issue of licences needed to operate mobile phone services using the airwaves in the UK. In 2000, they auctioned off five licences for 3rd generation mobile phone services and raised 22 billion in doing so. The government was using the auction process to ration the airwaves through a licence system. Although the government has monopoly control in the sense that it controls the issue of licences, it did not set the market price. This was determined by the auction process, and the fact that at the end of a bidding war, the major mobile phone companies were prepared to pay such a high price for a licence to allow them to operate in the market, is evidence of the private benefit (or anticipated future profit) that the companies expected to make from selling 3rd generation contracts to customers. The fact that these telecoms companies may have greatly misjudged the actual market demand for third generation mobile phone services is not the result of the auction process itself. The government decided that the income from the sale of these licences would be used to repay a slice of the national debt, providing a bonus for current and future generations in terms of reducing the annual interest payments on government debt.

An example of a quasi public good - the air-waves can become congested Finding an Equilibrium Allocation of Public Goods that Maximises Social Welfare Finding the socially efficient level provision of public goods is a hugely difficult process. First we must seek a valuation of the willingness and ability of consumers to pay for public goods which involves estimating the individual demand curves for each consumer and then aggregating to find the market demand curve a reflection of the social marginal benefit (or valuation) that consumers place on each extra unit of a public good that is made available. In the diagram below we consider a non-pure public good whose marginal cost of supply does rise gently as output is increased. If the market fails to provide a sufficient quantity of a public good, then there is a loss of economic (social) welfare.

Case Study: The BBC as a public good Broadcasting is a good example of a public good. Let us remind ourselves of the three main characteristics of a public good. Firstly it is non-rival, meaning that the consumption of a public good or service by one individual does not preclude consumption by another individual. Secondly, consumption is non-excludable. This means that consumption by one individual makes it impossible to exclude any other individual from having the opportunity to consume. Effectively the marginal cost of providing a pure public good to an extra user is zero, and this implies that, in order to achieve allocative efficiency, the charge for the product should be zero. Of course, in this situation, private sector businesses are unlikely to consider providing pure public goods because they will not be able to make any profit at a zero price, and many consumers can take a free ride on such goods because of non-excludability. The provision of pure public goods is therefore a cause of market failure. Left to the free market, public goods are under-provided and under-consumed leading to a loss of social welfare. Traditional analogue broadcasting differs from encrypted digital broadcasting in the sense that digital broadcasters can now exclude non-payers using set-top boxes. But even when Britain moves fully to digital when the analogue signal is turned off in a few years, the broadcasting services will continue to be completely non-rival and it is this that really matters in the context of the services that the BBC provides. One extra person consuming programmes on BBC1 or BBC2 has no effect at all on the ability of people to consume other services provided by the BBC. Paying for a public good - the licence fee debate At the moment, around 23 million households in Britain pay an annual licence fee. All of these people are stakeholders in the debate about the future funding of the BBC and the vast

majority use one or more BBC services at least once a week. The fee is a means of providing collective payment for a public good. We know that there are fee-dodgers who try to take a free-ride by avoiding payment, but there are well established although costly means to enforce the licence fee and take non-payers to court. According to research undertaken by the BBC as part of the Charter Review, on rough estimates, about 17 million households value BBC television, radio and internet services at more than the current licence fee of 122. These are gainers from the existence of the BBC. In contrast, the study finds that 6 million people value the BBC at less than the current licence fee. These are losers they are paying more than the utility that they get and many such people may resent having to pay the licence fee when they have paid for their BSkyB subscription and have already deserted the BBC for other digital or commercial channels. The BBC study estimates that the net consumer surplus created by the BBC is well over 2bn/year, or % of GDP. The most likely groups to think the licence fee represents good value for money for their household are those aged over 60 and those in the higher AB social groups. Groups more likely to think the fee represents poor value for money are those with multi-channel television access, people aged 31-45, people in the C2DEs social groups and younger people of Black or Asian origin. People in C2DE social groups are far more likely to have an income below the median, and therefore the question of raising the licence fee becomes important because a sharp rise in its level would affect peoples ability to pay. Television BBC 1 BBC 2 BBC 3 BBC 4 Cbeebies CBBC BBC News 24 BBC Parliament Radio Radio 1 Radio 2 Radio 3 Radio 4 Radio Five Live Five Live Extra 1Xtra 6 Music BBC 7 Asian Network 6 Nations services 40 local and regional services Other BBC Online World Service BBC Scotland BBC Northern Ireland BBC Wales BBC English Regions

For millions of people, the value that they derive from the BBCs output does exceed the price they currently have to pay via the licence fee. Would they be happy to pay a significantly higher fee in the future? Much would depend on the quality and range of broadcasting that the BBC is able to deliver. Assuming a constant range, reliability and quality of services, a large rise in the BBC licence fee would reduce total consumer surplus. The BBC study estimates that if the fee was raised by forty per cent from 122 to 170, up to four million people would no longer value BBC services as much as the higher compulsory fee, consumer surplus would be reduced and the BBCs services might end up being underconsumed. This, in a nutshell, is the argument against the introduction of a subscription-based system for funding the BBC. It would exclude several million people from consuming their services and would probably result in a net loss of social welfare.

What is the best way to finance broadcasting? Should the licence fee remain compulsory? Criticisms of the licence fee Opponents of the licence fee argue that 1. It is a regressive form of taxation everyone pays the same flat charge, regardless of their disposable income, the number of televisions they own or the extent to which they watch television in general and BBC services in particular 2. As fewer people watch the BBC, the case for a licence fee diminishes. Indeed as technology develops, it become even harder to sustain a compulsory licence fee when people have moved predominantly to alternative sources of information through the internet, digital channels, broadband and their mobile phones 3. The costs of collection and evasion are high including 150 million per year chasing licence-fee evaders What are the alternatives for funding the BBC?
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Moving to a subscription base system (technology may allow this in the future). Allowing advertising and sponsorship of programmes similar to the ITV model. Greater emphasis on selling BBC programmes overseas through BBC Worldwide and sales of DVDs to generate increased revenue for the BBC. Funding the BBC entirely through direct taxation and scrapping the licence fee. A tax on the revenues of other commercial broadcasters to part-fund the BBCs services reflecting the public service nature of much of the BBCs output.

Of these alternatives, introducing advertising is least preferred among people surveyed. A sizeable majority of viewers (over sixty per cent according to a recent MORI poll) regard advertising as an intrusion to their enjoyment of programmes, and few think that the BBC should move to this form of finance. And there are worries that the total size of the TV advertising market is not large enough to absorb the entry of the BBC as a supplier of advertising slots. It might well damage the financial viability of ITV for example. In any case, advancing technology now allows viewers to skip advertising when they have prerecorded programmes. On the whole, there is a preference for keeping the licence fee (a system of funding used in many other countries) although there are concerns among older groups about their ability to pay for it. But without a sizeable increase in its value, there is little doubt that BBC revenues

will soon be overtaken permanently by Sky and this will damage the BBCs ability to bid for live television events including the rights for sports such as soccer, cricket and golf. Public Goods and the Free Rider Problem Consumers have an incentive to not reveal their willingness and ability to pay for public goods if they believe that they will be expected or required to contribute to financing the public good accordingly by the government. After all, if the public good is supplied, it will be available to them just as it would be to anyone else because pure public goods are nonexcludable. This is the essence of the free rider problem: the incentive which consumers have to avoid contributing to financing public goods in proportion to their valuation of such good. Good examples to use include TV licence dodgers and people who choose to evade the Council Tax but who still receive local authority services. Another example might be a group of residents in a block of flats who all stand to benefit from the refurbishment of an adjacent playground or better lighting and security systems, but who individually might try to avoid payment and benefit once the improved amenities are in place. Given the nature of the free rider problem, public goods are often financed through some form of enforcement, notably the compulsory nature of the TV licence fee, management fees for residents living in blocks of accommodation or the signing of international treaties on the environment. .

Market Failure - Tuition Fees

The introduction of tuition fees for students in England and Wales has been controversial. It raises important issues about the economics of higher education some of these issues are raised and evaluated in this note. Market failure in education Market failure occurs when markets operating without government intervention, fail to deliver an efficient or optimal allocation of resources - Therefore - economic and social welfare may not be maximised leading to a loss of allocative and productive efficiency (i.e. welfare losses for society). Market failure exists when the outcome of markets is not efficient from the point of view of the economy. This is usually because the benefits that the market confers on individuals or firms carrying out a particular activity diverge from the benefits to society as a whole (i.e. there are externalities not taken into account within the market). This is particularly relevant to the concept of education as a merit good

An aerial view of Oxford should higher education be regarded as a merit good which the government should subsidise directly for students? The idea of positive educational externalities is that the benefits of individually acquired education may not be restricted to the individual but might spill over to others as well, meaning that there will be macroeconomic advantages from a higher level of education spending and attainment. For example, there is compelling evidence that human capital increases productivity and thereby increases an economys trend rate of growth and international competitiveness. Education is found to yield additional indirect benefits to growth for example by stimulating physical capital investments and technological development and adoption across many different industries (creating the potential for gains in dynamic efficiency) The free spill-over effects of improved educational provision can be said to take education away from being purely as a merit good and more towards meeting the characteristics of a public good. The social returns to increasing the average length of time that people spend in education depend in part on the stage of economic development recent studies suggest that an expansion of tertiary/higher education is the most important for growth in countries such as the UK. Imperfect information Markets can also fail when the individual or firm does not have sufficient information to recognise the future returns from undertaking an action again this is relevant to decisions that individuals take as to how much education they should consume or purchase at different stages of their life. Many young people are myopic when making university and degree course decisions. Or they may be averse to taking on debts even though it might be in their long-term financial interest to do so. In this case, there might be an economic case for the government to adopt a paternalistic view on what is best or for younger people. Equity Markets can generate what is perceived to be an unacceptable distribution of income and too high a level of social exclusion where people on low incomes are denied access to essential goods and opportunities considered normal by a society. Education comes into this

category not least on the issue of whether students should make a financial contribution to the cost of their own tuition when they are in higher education. Merit Goods and Market Failure A merit good is a product that the government believes consumers undervalue and underconsume because of imperfect information. A merit good is deemed to be socially desirable and also better for a consumer than the consumer realises a value judgement is involved whenever we talk of merit goods.

How can a monetary value be placed on the additional social value of education overlooked by consumers suffering from information failure? Is it simply the present value of higher income? How can the value to society of a well educated and more skilled and productive work force be estimated both in the short term and the long run? The Private and Social Benefits of Education Private Benefits of Education The fun and enjoyment of learning (personal satisfaction and fulfilment) Accumulation of human capital (qualifications and experience) that will reduce the risk of unemployment and allow people to hurdle over entry barriers to certain occupations Higher expected earnings in work a university degree is a signalling mechanism for employers e.g. in promoting fast-track promotion Blundell (2000) estimated that the average return to completion of a first Social Benefits of Education More literate and intelligent society lower crime rates? Contributes to international competitiveness of economy importance of high-knowledge sectors in international trade continues to grow expansion of scientific research etc Higher tax revenues in the long run can be used to fund other socially beneficial government spending programmes Social benefits from having more doctors and teachers and scientists

degree for a cohort of 33-year-olds in increased provision of public and merit 1991 was around 17% for men and 37% goods for women compared with people with A levels as their highest qualification There is no such thing as a free lunch. Higher education involves costs the main issue is really how best it should be funded. Clearly there are many normative judgements involved but we should also try to bring economic arguments into the discussion. A recent research piece by the Institute for Fiscal Studies made the situation clear: It is important to be clear that higher education is never free, whether the costs are met upfront by students, later in life by graduates or in an ongoing way by taxpayers in general. Altering the system of HE finance changes the incidence and the timing of payments but does not change the fact that the cost of university education must be paid for in one way or another. Adapted from www.ifs.org.uk Summary of some of the arguments on tuition fees and the funding of universities Arguments against tuition fees The benefit-pay-principle A tax on learning? A university education is a valuable and expensive privilege. Why Equity issues should something that is so rewarding and costly be free? Only 7% of children It is equitable for students to make a financial contribution to their from families in the degree teaching they stand to gain financially from a degree lowest social class education is an investment and it is rational for students to borrow at currently go to this stage of their life-cycle to finance such investment. It is rational to university tuition forgo current earnings in return for higher future earnings fees will make it harder for relatively poor families to fund a degree. This will widen educational inequality and create a further widening of the two-tier education system Top up tuition fees or a graduate tax will raise extra revenue but they are not an alternative for a higher level of government funding designed to increase education spending as a share of GDP Extra funding for facilities, teaching & research Student debt may Tuition fees will provide extra finance that will allow the government to deter poorer fund an expansion of the number of students able to enter higher students education promoting wider access to HE. Tuition fees will lead to a huge surge in student debt and Arguments for introducing tuition fees

hardship which in turn will have negative economic and social consequences in the long run Means-testing is costly to monitor and can create disincentive effects Means testing to protect access for poorer students Social benefits Access to higher education to people from less privileged backgrounds (externalities) can be protected. Tuition fees can be means-tested to offset the danger argument that fees will hit lower income students hardest. Maintenance grants can The benefits to also be means-tested participation in higher education accrue not only to the individual graduate but also to society at large. And seeking to expand higher education too much may work against the best interests of the economy the graduate market may become overcrowded Improvements in dynamic efficiency Limits to the Fees will encourage students to be more selective in the courses they market tuition choose and will stimulate an improvement in teaching quality if fees no answer universities are to keep student numbers high and remain viable - tuition A graduate tax fees make parents and students ask hard questions about the purposes of exhibits no higher education relationship between the cost of the course attended and the amount repaid by the student. It therefore introduces no `market-based' element into the higher education sector in terms of students choosing between courses and institutions based on the various prices of attending them Research and international competitiveness Uncertain flow of Extra funding is needed for universities to maintain high levels of tax revenue research offering long term macroeconomic benefits for the economy The amount that tuition fees will raise is uncertain because it depends on the future earnings of

graduates once they enter employment and it will take years for the extra funding to come through Progressive system of tuition fee repayment Education as a Repayment through the income tax system introduces a progressivity basic economic and into the system higher income earners will repay their debt more social right quickly. Belief that access to Specifying that the loans need only be repaid when incomes rise above university should be a certain level should help overcome students reluctance to borrow available to all when they cannot be confident about their future earnings. It is a pay- people who qualify roll deduction scheme rather than a tax independent of their ability to pay (a value judgement) i.e. education as a right not a commodity Is education fundamentally different from providing health care free at the point of need? Fees are more equitable than general taxation Impact on demand Funding tuition from general taxation is an expensive and poorly for certain degrees targeted way of intervening in the market, because graduates, who are It is feared science predominantly found towards the top of the income distribution, benefit and engineering at the expense of everyone else i.e. why should non-graduates pay for among the most the degrees of graduates? expensive courses to The argument that education should be provided free is much stronger run because of for the case of primary and secondary education than for higher equipment costs and education. specialist staff will see a fall in demand threatening long term damage to our manufacturing competitiveness