Issues related to market failure:

Common pool resource and sustainability:

Common pool resources refer to those which are in access of all individuals who do
not have to pay any fee to authorities, in general, to utilize the resources. But the
users tend to overuse the resources due to uncontrolled checking system, which
could lead to a fall in benefit to the users later on along with the creation of negative
externalities including the environmental hazards. Therefore, these resources are
subjected to non-excludability but rivalry.

The sustainable use of environmental, social and technical resources has become a
significant global challenge. Resource misuse, such as over-fishing or
deforestation can potentially result in supply problems and lead to both economic
and ecological damage. When the harvesting (or use of) a shared social-economic
resource diminishes the value of the resource for other users (negative externality),
and it is difficult to control access to the resource in the absence of well-defined
property rights (non-excludability), the resource is typically referred to as
a common pool resource.

Common pool resources are characterized by a social dilemma – the tragedy of the
commons. That is, the goal of an independently-acting individual is to maximize their
use of the resource (gain higher portions of the harvest). With a greed for securing
maximum benefits, there is over use of the resources resulting in the possible
unsustainability.

Sustainability refers to the ability of something to be maintained or preserved over

time. It can be explained in terms of the joint preservation of the environment and
the economy: for the environment it refers to environmental preservation (lack of
destruction); for the economy it refers to the preservation of humankind’s ability to
provide goods and services to satisfy needs and wants into the future. The problem
of sustainability arises because of conflicts between environmental and economic
goals. Economic goals involve efforts to increase the quantities of output produced
and consumed; focusing on economic goals while disregarding the environment may
result in its irreversible destruction. Environmental goals involve the preservation
of the environment; but focusing on environmental goals while disregarding the
economy may result in humankind’s inability to satisfy needs and wants. The
important question, then, is how to strike a balance between environmental and
economic goals, so that both can be satisfied into the future. The answer to this
question is provided by the concept of sustainable development.
The measures to check the negative externalities of common pool resource take into
consideration the social benefits and related costs to future generation. An effective
measure for this is to raise the cost of harvest/use, which can be done through high
fee charge or high tax rate.

Government interventions to correct negative externalities:

Government may look for either market-based policies or regulatory measures to
correct externalities. In market-based policies, the government tries to internalize
the external costs to the private costs by the private sector themselves. Taxes and
tradable permits are example of market-based policies. However, these policies may
not work effectively all the time as mostly the individuals have tendency to turn
apathetic to minimizing external cost by evading taxes.
Government regulations are alternatives to market-based policies in which
government mechanism compels the individuals to comply with the government
rule. Compared to the market-based policies, the regulations are easy to implement,
however are expensive to implement and monitor.
Government interventions can impact externalities in two ways—Effect in demand
side OR Effect in supply side. In demand side, government interventions cause
rightward or leftward shift in demand curves. In supply side, there is a shift in
supply curve.

Pigouvian tax
Pigouvian tax is an indirect tax that is imposed to check adverse side effect to the
society created by individual/private activities to prevent the market failure. It is
meant to discourage activities that impose a cost of production onto third parties
and society as a whole.
Pigouvian tax, common in Europe, is a tax on plastic bags, and sometimes even
paper bags. This encourages consumers to bring their own reusable bags from home
to deter the use of plastic and paper. The implemented taxes are a measure to
redistribute those costs back to the producer and/or user that generate the negative
externality.
Since external costs are difficult to calculate precisely, the estimation of Pigovian tax
seems unjustifiable most of the time and is subjected to arbitrary decision of the
government authorities.
Carbon tax/tax on pollutants
It is also a type of Pigovian tax, however its impact somewhat is different from other
ordinary types of indirect taxes.
Carbon tax is a tax per unit of carbon emissions of fossil fuels. Fossil fuels do not all
emit the same amounts of carbon when burned, therefore the carbon tax is
calculated on the basis of how much carbon the fuel emits: the more the carbon
emitted, the higher the tax. Following the imposition of the tax, firms must pay the
higher price to buy the fossil fuel.
Since there are other substitute energy sources with lower carbon emissions (thus
taxed at a lower rate), or that do not emit carbon (if they are not fossil fuels, thus not
taxed at all), the increase in the price of the high-carbon fuel creates incentives for
firms to switch to other less polluting or non-polluting energy sources. Hence in this
case, there is less likely that the negatively externality is completely removed.
Legislation/regulation:
Government enforces various laws/rules that could influence activities related both
to production and consumption. Through offering various incentives, the
government may make the organisations to invest some portion of their profit, in
the form of corporate social responsibility, for the protection of environment and
welfare of people.
Education/Awareness:
Through this method, the government tries to influence the demand side such that
the people may reduce quantity of consumption.
Tradable permits:
Tradable permits, also known as cap and trade schemes, are a relatively new policy
involving permits to pollute issued to firms by a government or an international
body. These permits to pollute can be traded (bought and sold) in a market. The
government grants each firm a particular number of permits (or rights) to produce a
particular level of pollutants over a given time period. The permits to pollute can be
bought and sold among interested firms, with the price of permits being determined
by supply and demand. If a firm can produce its product by emitting a lower level of
pollutants than the level set by its permits, it can sell its extra permits in the market.
If a firm needs to emit more pollutants than the level set by its permits, it can buy
more permits in the market.
International Agreement:
Because environmental problems are often not confined to a single country,
international agreements are sometimes needed for effective environmental policy.
In addition, the illegal activities also cause the harmful impacts in other countries.
International agreements look for controlling the negative externalities that could
spread cross border.
The Montreal Protocol on Substances That Deplete the Ozone Layer, United Nations
Environment Programme, Kyoto Protocol to the United Nations Framework
Convention on Climate Change, Copenhagen Accord: United Nations Framework
Convention on Climate Change, the Water Convention and the Protocol on Water
and Health, the United Nations Convention Against Illicit Traffic in Narcotic Drugs
and Psychotropic Substances, International Convention for the Suppression of the
Financing of Terrorism etc.
Collective self-governance
Neither markets nor government enforced rule could be as effective as self-created
and enforced rules of communities. It is a process to encourage altruism in people
such that they care about the well-being of others as well as themselves. This may
take place because of persuasion and peer pressure—if your friends behave in an
environmentally conscious way, then there is pressure for you to do the same thing.
In addition, people themselves may find feeling of satisfaction associated with such
behavior. In this regard, people feel more satisfied to incorporate some of the social
cost into their own private costs.
In the environmental context, people sometimes purchase products from
environmentally responsible firms even if those products are more expensive.
Companies often find it worthwhile to advertise the fact that they are
environmentally responsible. Purchase of electric cars than petroleum vehicles is
another example.
Governments, through advertising campaigns, can encourage such altruistic
behaviour.
Subsidies:
Government offer subsidies as a support to help increase supply of merit goods that
are under produced. It might also help reduce prices of products by bringing down
costs of production to the suppliers. This helps promotion of merit goods while
discouraging the use of similar other goods that produces negative externalities. For
an example, the government can provide subsidies to users of electric vehicles to
minimize the negative externalities caused by fossil fuel using vehicles.
Evaluation of government policies to check the externalities
a. Difficulties with Environmental Policy
Government authorities simply need to calculate the difference between marginal
private costs and marginal social costs and between marginal private benefits and
marginal social benefits, to enforce the environmental policies.
In practice, a major difficulty is knowing how to place values on externalities.
Environmental policies to combat air or water pollution require the government to
monitor the amount of emissions effectively and accurately. If emissions cannot be
monitored, then tax or permit schemes are impossible to implement. Effective
environmental policies also require the government to measure the damage
incurred by the victims of the pollution.
How can we value damage to the natural environment? How to estimate the loss in
terms of lost earnings by environmental damage. This means that the lives of skilled
and high-paid individuals may end up being valued more than the lives of unskilled,
lower-paid individuals.
Questions also arise concerning the distribution of resources. Should the firm be
required to compensate the residents of the town directly or through assigning the
property right? Should the firm be given pollution permits to auction?

b. Whose Welfare Should Be Included?

It is not always clear whose opinions should be taken into account when making
environmental policy. Disagreement may arise to different views about how to
account for the welfare of future generations. It is also very difficult to which group
of people to consider. Like if the government tries to minimize pollution by taxing
more on factories, the employment opportunity and daily earners’ economic welfare
is affected.
c. Effectiveness of policies:
Since external costs are difficult to calculate precisely, the estimation of Pigovian tax
seems unjustifiable most of the time and is subjected to arbitrary decision of the
government authorities. So the cent percent effectiveness may not be seen.
Effectiveness also depends upon the price elasticity of consumers (in case of indirect
tax and subsidies) or level of awareness (absorptive capacity) of people in an effort
to increase demand or supply in positive externalities.
Importance of international cooperation:
To ensure global collective action to have efficient utilization of global public goods
To prevent any conflicts arisen due to lack of policy coherence among countries that
could disrupt global commerce
To prevent international cartels which determine prices affecting consumers in
national markets.
Left to their own devices, national authorities will not possess all the incentives to
curb the harm to the global commons, since part of the cost is borne by foreigners.
International coherence is also required to avoid conflicts between differing
systems of international law, such as between multilateral environmental
agreements and multilateral trade rules.
To conduct joint monitoring/international arbitration in case if any country
concerned is breaching the international norms (like nuclear power)
To invite necessary capital funds and technical support mainly for the
underdeveloped countries that cannot fight back on their own to control
externalities.
To address sustainability issues which incorporates sustainable development with
tackling of a number of inter-related global issues such as poverty, inequality,
hunger, terrorism and environmental degradation.
Challenges of international cooperation:
a. Economics of Innovation and New Technologies: With fast advancing
technology, developing countries may not have preparedness to adopt the
change.
b. Structural Change and Economic Development: While adopting the
international standards along with the economic development, the change in
economic and social structure cannot be denied.
c. Governance and institutions: Institutional set up, bureaucratic system, and
political condition should be cohesive to implement the norms of
international agreements.
d. Innovation and Entrepreneurship for Sustainability Transitions: Outcomes of
international cooperation needs to be compatible with innovation and
sustainable entrepreneurship in regard to the local context of the reporting
country.
e. Social Protection: International agreement sees the global welfare as a whole,
so the provisions may or may not be feasible in relation to the diverse
community people in wide variation of geographic conditions.

Need for monitoring in international cooperation

Monitoring helps to track progress against development

cooperation commitments provides information for review processes and
informs dialogue among stakeholders. It identifies lessons and best practice
examples and provides an evidence base to improve results. The Integrated
Monitoring Guide provides a basis for national governments to monitor
progress towards the new Sustainable Development Goal.
The methodology assesses capacity and resource availability in countries
along with promoting harmonization in formulation and implementation of
international standards. It also gives necessary guidelines to a member
country which may not judge on its own about proper mobilization of its
resources due to existing systemic flaws.

Problems with public goods

Goods that are non-rivalrous and non-excludable are also known as pure
public goods. For example, a lighthouse is non-rivalrous, because its use by
one person does not make it less available for use by others.
Also, it is non-excludable, because there is no way to exclude anyone from
using it. Other examples of public goods include the police force, national
defence, flood control, non-toll roads, fire protection, basic research, anti-
poverty programmes and many others.
Most of the time, a public good is a merit good, with having positive
externalities. Although it is mostly produced and supplied by the government
agencies, it is not necessary that it should be produced by the government. OR
else, the good produced by the government may also be a private good, when
it includes costs (excludability) or/and rivalrous. Failing to bear any one of
the two features make the good a private good.

Public goods and market failure:

Public goods illustrate the free rider problem, occurring when people can
enjoy the use of a good without paying for it. The free rider problem arises
from non-excludability: people cannot be excluded from using the good.
Public good is provided to some people free (without being needed to pay) at
the high costs of few payers (tax payers).
Public goods are a type of market failure because due to the free rider
problem, private firms do not produce these goods: the market fails to
allocate resources to their production. Due to the reason, the public goods are
always in short supply (low supply compared to excessive demand).

Some goods do not fit neatly into the category of private goods or public
goods. They can be considered to be ‘impure’ public goods, also known as
‘quasi-public goods’.
These goods are: • non-rivalrous (like public goods), and • excludable (like
private goods).

Examples include public museums that charge an entrance fee and toll roads.
All these are excludable because consumers must pay to use them. Since the
price system can be made to work here to exclude potential users, they could
be provided by private fi rms. However, they all have very large positive
externalities, thus justifying direct government provision.

Correcting the market’s failure in relation to public goods:

a. Implications of direct government provision
The government steps in to the market to ensure that public goods are
produced at socially desirable levels. When public goods are directly
provided by the government, they are financed out of tax revenues and are
made available to the public free of charge (or nearly free of charge).
The government carries out cost-benefit analysis to find out whether or
not to provide the public goods. If overall benefits are higher than the
costs, it is worthy to invest in such public goods. For how much to provide,
it is decided by comparing marginal benefits with marginal costs: the
public good should be provided up to the point where MB = MC
b. Contracting out to private sector: Contracting out or outsourcing is a part
of public sector reform strategy wherein government engages a private
entity to provide a service within a set of specific conditions.
Dissatisfaction with the government delivery of services and search for a
low-cost, high-quality alternative drove the movement for privatization
and contracting out during the1960–70s.
Contracting out reduces the direct provision of services by the state; thus,
rolling back the state and creating more space for the market mechanisms
to allocate society's resources.
 Supporters of contracting argue that it introduces competition, controls
political interference, reduces public expenditure and improves
government performance. Opponents, on the other hand, claim that
superior efficiency of contracting is overstated as factors such as loss of
skills, unproductive signaling effort, lower quality and reduction in real
wages of workers are rarely taken into account.

Asymmetric Information—cause of market failure

The competitive market mechanism is based on the assumption that all firms and all
consumers have complete information regarding products, prices, resources and
methods of production. However, in the real world some information always is
lagging among the market players most of the time, which is regarded as the
information failure/asymmetric information. Asymmetric information refers to
situations where buyers and sellers do not have equal access to information, and
usually results in an under allocation of resources to the production of goods or
services. Either the buyer or the seller) possesses more information than the other
party.
A. When information is available to sellers but not to buyers:
Sellers often have information about the quality of a good or service that they do
not make available to consumers. Sellers of used cars have information about the
car’s quality that they are unlikely to reveal to potential buyers if the car has a
defect. In a free and unregulated market, sellers of food could sell products that
are unsafe for human consumption, possibly leading to illness and even death.
Sellers of medicines could sell unsafe medications that could be ineffective or
dangerous to human health. Individuals claiming to be doctors, some of whom
have little or no training, could practise medicine and even surgery, resulting in
huge costs in terms of human health and safety.
In such case, either the aware consumers make low demand, causing low
production OR if the consumers are not aware, they may face health hazard or
even death that causes wastage of the resources.
Possible government interventions:
Regulations: Through regulations, government may enforce the rule of quality
standards, and safety measures. Government needs to maintain strong
monitoring mechanism as well in order to make the regulations enforcement
effective.
Dissemination of information: Governments may also respond by directly
supplying information to consumers, or by forcing producers to provide
information, thus protecting consumers in their purchasing decisions. This may
include information about the quality of medical care by different providers,
about communicable diseases, crime rates by neighbourhoods, health hazards
related to different activities, products or substances, nutritional labelling on
foods, and so on. Although the government imposing this rule, there still exists
room for manipulation by the sellers in case of the technical areas like medical
treatment, lawyer and mechanics, among others.
Provision of licensing: This makes the service providers/sellers of professional
skills like plumbing, electrician, teacher, doctor or lawyer to take dedicated
training or sit for some assessment and to receive approval of some
council/associations to work in the market.
Recently, there is a practice of giving credit rating to companies which has
helped standardize the firms on the basis of their quality works. This helps
consumers take proper decision on what level of service/good quality they
pursue and at what price they pay. It is also in a wide practice in stock exchange
market.
B. When information is available more either to buyers or to sellers:
This case is seen often in the insurance and labour market, where the buyers
tend to hide the information to get more benefit from the sellers.
i. Problem of moral hazard:
Moral hazard refers to situations where one party takes risks, but does
not face the full costs of these risks. It usually arises when the buyer of
insurance changes his or her behaviour after obtaining insurance, so
that the outcome works against the interests of the seller of insurance.
For example, buyers of car theft insurance may be less careful about
protecting their car against theft, because they will be reimbursed if
someone steals their car. Some buyers of medical insurance (doctors)
may be less careful about avoiding malpractice, because of the
knowledge that malpractice costs will be covered by the insurer.
Unemployment insurance may lead some people to be less hesitant
about becoming unemployed, in the knowledge that their insurance
will provide them with some income. Another example can be the
borrowers from banks who try to produce low quality (risky)
collaterals to take approval for more bank loan.
In all these cases, the buyers of insurance have information about their
future intentions that is not available to the sellers of insurance.
 To check this problem, the authorities maintains various premium
amount in insurance based on the level of risks, central bank
implements various capping measures for financial institutions to
regulate the loan flow and the government enforces the contribution
based pension and social security system along with some regulations
to control excessive state expenditure in unemployment allowances,
pensions etc.

ii. Problem of adverse selection:

Adverse selection arises when buyers of insurance have more
information about themselves than the sellers of insurance. It arises
most often in the area of health insurance. Buyers of health insurance
know more about the state of their health than sellers of insurance, and
those with health problems are unlikely to tell the full truth to the
insurance company.
In a free unregulated market, adverse selection results in an under-
allocation of resources to health insurance services, as the insurance
company reduces the supply of insurance to protect itself against
having to provide insurance coverage to very high risks, or people who
are more likely to become ill.
To protect themselves against high risks, insurance companies usually
adopt screening measures like refuse to insure people above a certain
age, as elderly people generally have a higher chance of becoming ill.
The result is that those who mostly need health insurance coverage,
poor people who cannot afford to buy health care in the private
market, and elderly people who are more likely to become ill, are left
with little or no insurance coverage.
To deal with this problem, government responses may take the form of
direct provision of health care services at low or zero prices to an
entire population, financed by tax revenues, thus ensuring that the
entire population has health insurance coverage (as in countries with a
National Health Service); alternatively, they make take the form of
social health insurance, which may cover a country’s entire population
(as in many European countries), or which selectively covers only
certain vulnerable groups of the population (as in the United States).