Chapter 10 Market Failures Geog 3890: Ecological Economics Our founding fathers did put this into the Constitution….. We hold these truths to be self-evident:

Chapter 10Market FailuresGeog 3890: Ecological Economics

Our founding fathers did put this into the Constitution…..

We hold these truths to be self-evident: that all men are created equal; that they are endowed by their Creator with certain unalienable Rights; that among these are Life, Liberty, and the pursuit of Happiness. That, to secure these Rights, Governments are instituted among Men, deriving their just powers from the consent of the governed, That, whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it, and to institute new Government....

And, these were also put in the Constitution as legitimate functions of government…

"... establish Justice, insure domestic Tranquility, provide for the common defense, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity."

Outline of Topics

• Characteristics of Market Goods Coase Theorem• Excludability Rivalness• Congestible Goods Wealth Effects• Public Goods Missing Markets• Open Access Regimes Externalities• Nonrival, excludable resources Inalienable Rights• Intertemporal discounting and Net Present Value

Markets only function efficiently for a narrow class of goods.• Monopoly is a market failure of a structural nature• No competition

• Clearly defined and enforced Property Rights• Open access regimes

• Public Goods• Common Property• Externalities• Big Question: How common and significant are the

market failures outlined here relative to the market goods that markets work so well for?

Excludability• An excludable good is one for

which exclusive ownership is possible.

• It must be possible for the person or community that owns the good to use the good or service and present others from using the good or service.

• Excludability is virtually synonymous with property rights.

• Markets forces tend to not produce nonexcludable goods.

• Why would an entrpreneur interested in profit build a lighthouse?

Excludability & Institutions• Or… Why libertarians are such property

rights enforcement fanatics• Excludability is the result of institutions.• Excludability is not a property of the

resource per se but rather of the regime that controls access to the resource.

• Intellectual and Creative property – patents and copyrights

• Ecosystem services such as bee pollination, climate regulation, timber generation.

• For markets to operate efficiently the goods must be excludable

What property rights institutions are better funded:Copyright enforcement for singer songwriters or patent enforcement for pharmaceutical companies? Who paid for the Research & Development?

Rivalness• Definition: A rival good is a good such that use of a unit of the good by

one person prohibits use of the same unit at the same time by another.

• Rivalness may be qualitative, quantitative, or spatial in nature.• Rival goods: Food, Clothing, Cars, and houses• Nonrival goods: streetlights, information, and sunny days.• All stock-flow goods are quantitatively rival.• Fund-service goods may be rival or nonrival.• Bicycle, car, clothes, house – spatially rival at each point in time.

• All nonrival resources are fund service.• Market efficiency requires that the marginal cost to society of

producing or using an additional good or service be precisely equal to the marginal benefit. The marginal cost of nonrival goods to additional users is zero.

• Goods MUST BE RIVAL in order to be efficiently allocated by the market.

Excludability and Rivalness

What might make you think this figure was taken from a standard econ textbook?

Congestible Goods• Some nonrival goods such as UV protection by the ozone layer are not

affected by how many people use them.• Other nonrival goods can have degraded quality if they are used by large

numbers of people: Bridges, roads, the internet.• KEY POINT: Goods that are nonrival , nonexcludable, or both will not be

provided or allocated effciently by the market.

A vital concern of

ecological economics is the

development of policies

and institutions that will

lead to the efficient

allocation and production

of nonrival and/or

nonexcludable resources

Don’t say “Tragedy of the commons”say “Open Access Regimes” (EE PC)

“Rational self-interest does not create an invisible hand that brings about the greatest good for the greatest number, but rather creates an invisible foot that kicks the common good in the rear!”

Hardin’s paper is so very important because it is a profound criticism of neo-classical economic theory.

Is the Open Access Regime problem really just a property rights problem?• Many traditional economists argue that the open access

problem is simply a lack of enforceable property rights.

• Unfortunately for many of the resources o concern to us, the ability to bestow individual or corporate property rights is more the exception than the rule and in some cases even if property rights are granted and enforced it does not lead to efficient outcomes.

• This idea is the force behind the push for “Privatization”. It raises some pretty important questions: Should clean air be sold to the highest bidder? How about potable water? How about access to a nice day at the seashore?

Provocative Question for discussion………..

Kenneth Boulding’s market solution to the population problem

Kenneth Boulding actually proposed a

solution to the overpopulation problem

based on awarding all women the

“Property Right” to 2.1 children

(replacement fertility level) in the

form of tradable permits. Needless

to say, many people object to such a

system. Or, you could give each man

and woman 1.05 tradable permits for

procreation. Can you suggest a better

solution?

• What do you think of this idea?

Excludable & Nonrival Goods• “Trade Secrets” as a type of Monopoly• Patents, Copyrights, and Information• Patents are a mechanism to make trade secrets legally

excludable with institutional support paid for by the taxpayer. • The rationale being essentially this: Without excludable

property rights, people would not profit from inventing new things. Inventors would have no incentives, and the rate of advance of technology would slow, to the detriment of society. • Once a patent expires the knowledge embodied in it

becomes a pure public good.

Counterpoint: “The efficiency of the commons”• Programmer’s adage: The grass grows greener when grazed on.• Intellectual progress is invariably a collective process. • In academia, people have freely shared and built upon each other’s ideas

for centuries. (Issac Newton quote)• The internet and much of its associated software were primarily the result

of freely shared knowledge.• In many ways the free flow of information and ideas creates an efficiency of

the commons. (and is vital for ‘information’ assumption)• Keeping existing knowledge artificially expensive during the life of a patent

can make the production of new knowledge more expensive. • There was a Supreme Court case involving the argument that extention of

patent rights to 95 years for a corporation and life plus 70 years for an individual actually deters the progress of science. (the argument failed)

• Conspiracy Theory: What would happen to a patent on a motor that could allow cars to get 200 mpg?

Open Source SoftwareTough row to hoe in a purely capitalist world

Profits, Patents, & PharmaMarket Failure or Moral Failure?

• Medical Patents can also generate serious inefficiencies.

• Imagine an AIDS drug that mitigates symptoms and significantly reduces risk of transmission of the disease.

• The ‘reduced transmission rates’ benefit of this drug are a nonexcludable positive externality.• Currently drug companies hold patents on these

medicines, making them prohibitively expensive for 3rd World Countries, decreasing their ability to control the disease, and increasing the risk of everyone contracting the disease. • From the drug company perspective – total

elimination of the disease would be a very UNPROFITABLE outcome.

• The irony is that patent rights are protected in the name of the free market, yet patents simply create a type of monopoly – the total antithesis of a free market.

Excludable Congestible Goods• Congestible goods are nonrival at low levels of use and rival at high

levels of use (e.g. Beaches, Roads, Parks, Broadband, etc.)• A solution: Treat congestible goods as market goods during peak

usage and nonmarket goods otherwise. • Is it ‘fair’ to do this with National Parks?• Is it ‘fair’ to do this with roads and public swimming pools?

Pure Public Goods• Pure public goods are both nonrival and nonexcludable.• The Public Park Example• Assume $100 Million for a nice public park.• Society is willing to pay $150 million for the park.• Would market forces (i.e. the private sector) build the park?• $150 for a Lifetime pass would not generate enough revenue (why?)• $ 1 for each use would not generate enough revenue (why?)• If the park were free, more people would use it, increasing the total

welfare of society while imposing no additional costs on society.• The market will not provide the park even as a private good, and if it

did, id would not be efficiently allocated.• Despite the fact that Benefits are $50 Million greater than Costs, this

Public Good would not be built without a social contract to make it happen – e.g. A Government.

Free Riders & Prisoner’s Dilemma

Subsistence Farmers and Ecosystem ServicesA small sharecropper in Southern Brazil is kicked off his land share so that the landowner can grow soybeans under a heavily mechanized system requiring little labor. The soybeans are exported to Europe as cattle feed for higher profits than the landowner could make using sharecroppers to produce rice and beans for local markets. The sharecropper heads to the Amazon and colonizes a piece of land. He whacks down way more ecosystem services provided by that rainforest than he reaps in timber sales and subsistence farming.

Why not just pay the farmer

for the ecosystem services?

Many obstacles prevent this sort of exchange from happening.

1) Most people are ignorant of the value of ecosystem services.

2) Free-rider effects means many beneficiaries of public goods will not pay for their provision.

3) We lack the institutions suitable for transferring resources from beneficiaries of ecosystem services to the farmer who suffers the opportunity cost of of not deforesting.

Public Goods and Scarcity• “Anyone who accepts the premise that global ecosystems

create life sustaining ecosystem services must believe that public goods are critically important. Yet market economic theory offers little advice concerning the production and allocation of public goods.”

• “One of the underlying assumptions of ecological economics is that many of the scarcest and most essential resources are public goods (services provided by natural resource funds), yet the existing economic system only addresses market goods”

Do we have the incentives right?• If new inventions are driven primarily by

the pursuit of profits, then we have a serious bias against the invention of public goods or technologies that preserve or restore public goods.

• When we spend more money on elective breast augmentation surgeries than we do on the prevention of Tuberculosis we have perhaps crossed a threshold of insanity – driven by market forces.

• If the market is extremely effective at producting market goods but very poor at producing or preserving public goods, then over time, public goods inevitably become scarce relative to private goods, giving rise to a problem called macro-allocation.

IMAGE ABOVE32,000 Barbies, equal to the

number of elective breast augmentation surgeries performed

monthly in the US in 2006.

Public Goods and Substitution• NCEs posit that manmade capital and

natural capital are infinitely substitutable.

• NCEs posit that price signals spur invention and innovation of substitutes for scarce goods.

• What happens when the resources becoming increasingly scarce are public goods?

• Public goods have no price, and there will therefore be no price signal telling our entrepreneurs that we need substitutes, nor is there any profit to be made by creating such substitutes.

• Conventional market economics does not address this question.

Distribution of Public Goods in Space• Local, Regional, national, and

global provision of public goods in the form of ecosystem services.

• These spatial effects complicate who benefits from what services.

• This complicates how and who should be compensated for the preservation of ecosystem services.

• Examples: Storm protection, soil erosion prevention, urban cooling by transpiration, carbon sequestration, etc.

Market Failure: Externalities• An externality occurs when an

activity or transaction by some parties causes an unintended loss or gain in welfare to another party, and no compensation for the change in welfare occurs. If the externality results in a loss of welfare, it is a negative externality, and if it results in a gain, it is positive. The Marginal External Cost is the cost to society of the negative externality that results from one more ‘unit’ of activity by the agent.

• Examples: Water polluting widge manufacturing, Sprucing up the neighborhood, air pollution, water pollution, etc.

The Coase Theorem & Externalities

Internalizing costs will make the externalities problem go away. Who you give the‘rights to pollute’ or ‘rights to clean air/water’ are is the ‘Wealth Effect’ problem.

The problem is well behaved with one power plant and one laundry. However whenMore players enter the game the solutions get way more complicated.

Problems….1) Ignorance of outcomes2) Transaction costs3) Multiple actors and Free riders

Missing Markets• Everyone who might want to produce or consume a good must be

able to participate in order to insure efficient allocation of resources. (This is problematic for future generations)

• Auctioning the Mona Lisa in Waco Texas. Will it get best price?• How can we provide future generations with property rights to

resources? • How we handle intergenerational gambles with unknown reward

structures is an ethical issue, but it would certainly seem that most ethical systems would demand at the very least that we do not risk catastrophic outcomes for the future in exchange for nonessential benefits today.

• What have future generations ever done for us?

Intertemporal discounting• Most conventional economists assume

that money is an adequate substitute for anything, and therefore anything in the future is worth less than the same thing today. In general, the present value (PV) of a sum of money t years in the future, Xt, when the interest rate is ‘r’, will be given by:

• PV = Xt / (1 + r)t

• What would I pay you a year from now for a $2 hamburger today?

Cost Benefit Analysis (CBA)• The farther off in time that a

cost or benefit occurs, the more we discount its present value. The basic equation for this is on the right.

• ‘r’ is called the discount rate.

• Question: Do you think the convention of estimating net present value ignores the rights of future generations? Why or why not?

Uluru (aka ‘Ayer’s Rock’) is a national treasure of the Australian NP system. Suppose it costs $3 million a year to operate this park and brings in $4 million of revenue each year. What is the value of the rock for a year 100 years in the future? Assume a 3% discount rate.

Big Concept of this chapter• “We must recognize that the ‘optimal’ production of pure

public goods cannot be based on the criterion of Pareto efficiency. The public good problem appears to be beyond the scope of market allocation. You might think about policies and institutions that could be effective mechanisms for allocating public goods and the ecological fund-services the provide many of them. One possibility worth considering is a participatory demoncratic forum that captures a broader spectrum of human values than self-interest, and does not weight participant values solely by the purchasing power at their disposal.”

• Pg 183 Ch 10 Market Failures

What is Nature Worth?Video from University of Minnesotahttp://www.ecoguerilla.org/video/big-question-what-is-nature-worth/87/2041