Market failures

Distinguish between a negative externality and a positive externality, and classify these cases: smoke from a factory, childhood vaccination, a neighbour's loud music in the early hours of the morning, and a botanical garden open to the local neighbourhood.

The figure represents the market for a product whose manufacture pollutes: it shows the private cost to producers and the social cost, which also includes the environmental damage suffered by third parties.

1. a) Identify which curve is which and explain the difference between private cost and social cost.
2. b) Compare the quantity produced by the market with what would be socially desirable and explain the difference.

Define externality in your own words. Give an example of a negative externality and one of a positive externality related to your school (building works next door, a new library also used by the neighbourhood) and explain who receives the effect without paying for it or being paid for it.

The City Council of Ribera Alta faces river pollution caused by two paint factories (factory A and factory B). Currently, each discharges $100$ tonnes of waste per year. To restore the river, the municipality needs to reduce total discharges by half ($100$ tonnes in total between the two). Technical studies reveal that reducing each tonne of discharge costs $30\ \text{€}$ for factory A (which has modern filters), but costs $90\ \text{€}$ for factory B (which uses outdated machinery).

A councilor proposes: “The fairest and most ecological solution is to legally mandate both to reduce exactly $50$ tonnes each, penalizing any non-compliant factory with closure”.

1. a) Evaluate the councilor's proposal: calculate the total cost to the firms of implementing this command-and-control regulation (symmetric reduction of $50$ t per factory).
2. b) Design a more efficient alternative based on a Pigouvian tax per tonne discharged or a system of $100$ tradable emission permits (allocating $50$ to each factory and allowing them to trade with each other). Demonstrate numerically what reduction each firm will undertake and what the total cost to society will be.
3. c) Economically justify why the free market, without public intervention, would not have managed to reduce a single tonne of discharges.

A sawmill generates high-intensity noise that severely harms an adjacent rural hotel. The sawmill earns an annual profit of $50.000\ \text{€}$ operating normally; if it installs a soundproofing system, its profit is reduced by $14.000\ \text{€}$ (it would earn $36.000\ \text{€}$). For its part, the hotel loses $20.000\ \text{€}$ annually in cancelled bookings due to the noise.

1. a) Apply the Coase theorem (according to which, if property rights are well defined and transaction costs are zero, the parties affected by an externality can bargain privately until they reach an efficient outcome) to determine the economically efficient outcome and describe the agreement both companies would reach in the following two legal scenarios (assuming zero transaction costs):

1. The law grants the hotel the legal right to enjoy absolute silence.

2. The law grants the sawmill the legal right to emit noise on its property.

Does the final noise level change between one legal framework and the other? What changes between them?

1. b) Now imagine that, instead of a single hotel, the affected parties are $400$ families in a nearby housing development, each of whom values the harm of the noise at $50\ \text{€}$ per year (totaling $20.000\ \text{€}$). Predict what will happen in practice if the law grants the sawmill the right to emit noise. What market failures and obstacles prevent the Coase theorem from holding, and what role should the State assume?

A flight between two Spanish cities emits on average $0,1$ tonnes of CO₂ per passenger. The cost of the climate damage generated and not accounted for is estimated at $50\ \text{€}$ per tonne emitted. The current ticket price is $60\ \text{€}$. The government is considering introducing a Pigouvian environmental tax of $50\ \text{€}$ per tonne of CO₂ (which amounts to a $5\ \text{€}$ surcharge per ticket).

The following data are available regarding the price elasticity of demand on two different routes:

• Route 1 (mainland connection with high-speed rail in $2,5$ hours): price elasticity $\varepsilon_p = 2,2$.

• Route 2 (connection to an island territory with no land alternatives): price elasticity $\varepsilon_p = 0,25$.

1. a) Assuming that airlines pass on the entirety of the tax to the ticket price, calculate the expected percentage change in price and predict the percentage drop in passenger demand on each route.
2. b) Interpret the results: on which route does the tax act more effectively as an environmental correction instrument, and on which does it act primarily as a revenue-raising mechanism? Justify your answer.
3. c) An island Member of Parliament argues: "This tax is regressive and unfair to island residents, who have no transport alternative." Assess this objection from the perspective of equity and design an adaptation of the measure (through exemptions or the allocation of the revenue raised) that combines ecological efficiency with territorial cohesion.

A public good is non-rival (one person using it does not take it away from others) and non-excludable (those who do not pay cannot be kept out). Classify the following according to whether they meet those two characteristics: a lighthouse, a pizza, street lighting, a cinema ticket and clean air.

Lighthouses and national defence are the classic examples of public goods.

1. a) Explain the two characteristics that define a public good.
2. b) Reason why a private firm would have difficulty selling these services: what does the 'free rider' problem consist of?

Classify these goods in the rival/non-rival and excludable/non-excludable grid: a cinema ticket, national defence, fish on the high seas and a streaming platform for series.

1. a) Place each one in its cell (private good, public good, common good, club good).
2. b) Explain what provision problem each of the two "difficult" ones has (the public good and the common good).

Explain what asymmetric information is. Illustrate it with this case: you buy second-year notes from a stranger without knowing whether they are complete and well done. Who has more information and what problems does that create in the market?

In the second-hand car market, the seller knows whether their car has hidden faults and the buyer does not.

1. a) Explain what this market failure is called and what consequences it has on prices and the quality of goods offered.
2. b) Propose two solutions, market-based or legal, that help reduce it.

In one country, private health insurance is voluntary: healthy young people do not take it out because "it is not worth it for them", so premiums rise and even more healthy people drop out.

1. a) Explain what this spiral is called (adverse selection) and what information failure causes it.
2. b) Reason why some countries make insurance compulsory for everyone and what effect that has on premiums.

What is market power? Explain why the only petrol station in $50$ kilometres of road can charge higher prices than a petrol station on a street with three others, and what market failure it illustrates.

Common goods are rival but hard to exclude: fishing grounds on the high seas or an overcrowded beach. Explain what the "tragedy of the commons" consists of using one of those examples: why does each user have an incentive to make the most of it even though everyone ends up losing?

The only two telephone companies of a fictitious country announce that they are merging.

1. a) What market failure can the merger make worse? Explain its foreseeable effects on prices, quality and innovation.
2. b) What instruments does the competition authority have (banning the merger, imposing conditions, fining practices)? Assess each one.