ENVIRONMENTALITIES AND MARKET FAILURE. INTRODUCTION Markets allocate scarce resources with forces of supply and demand Equilibrium of supply and demand.

ENVIRONMENTALITIES AND MARKET FAILURE

INTRODUCTION

• Markets allocate scarce resources with forces of supply and demand

• Equilibrium of supply and demand is typically an efficient allocation of resources

• Equilibrium market prices signal information and allocate resources

• Markets sometimes fail to allocate resources efficiently

• Examine in this chapter a type of market failure called externalities

INTRODUCTION

• Market Failure and the Environment For environmental assets, markets can fail if prices do

not communicate society’s desires and constraints accurately

Prices often understate full range of services by environmental assets or do not exist to signal the value of the asset to the market Incomplete or absent markets for environmental assets

Market failure occurs when private decisions based on prices, or lack of them, do not generate Pareto-efficient allocation of resources

INTRODUCTION• Market Failure and the Environment

Inefficiency (Pareto) implies that resources could be reallocated to make at least one person better off without anyone worse off

Wedge is driven between what individuals want privately and what society wants collectively

Due to Market Failure: 1. Inefficient resource allocation 2. Leads to regulation or other public policies Divergence between interests of individual or group from

those of society at large

EXTERNALITIES• Externalities are special case of market failure • Externality

The uncompensated impact of one person or firm’s action on the well-being of a bystander

Creates a cost or benefit Outcome is external to any market transaction (if any)

• Negative Externality or External Cost An adverse impact on bystander Imposes a cost on that bystander

• Positive Externality or External Benefit A beneficial impact on bystander Imposes a benefit on that bystander

EXTERNALITIES• Technological vs. Pecuniary Externality

Externalities can be either technological or pecuniary

Technological Externality External effect is not through market price, but

through its effect on consumption (utility) or production (profit)

Real effect: one person or firm’s gain/loss is not another’s loss/gain

EXTERNALITIES

• Technological vs. Pecuniary Externality Pecuniary Externality

External effect is through market price Leads to transfer or redistribution of income Gain or loss to one party is exactly offset by gain

or loss to another Pecuniary effects cancel out

EXTERNALITIES• Types of Externalities

Symmetric Externality Economic agents who generate externalities receive

reciprocal external effect Each consumer or firm imparts external effect to all other

consumers or producers, who in turn impart reciprocal external effect on initial consumer or producer

Asymmetric (Downstream) Externality Economic agents who generate externality are distinct from

those who experience them Production or consumption decisions of producers or

consumers enter production or utility functions of others, but recipients of the externalithy do not cause any reciprocal effect

EXTERNALITIES• Types of Externalities

Transferable Externality Individual or firm protects itself from external

damages by transferring an environmental risk through space to another location or through time to another generation

Differs from traditional view of external cost in that transferability motivated by intentional behavior, not by unintentional behavior

Example Example through space and time is dumping of

radioactive wastes at sea

EXTERNALITIES

• Types of Externalities Depletable Externality

Also called rivalrous or private Experience of externality by one agent reduces the

amount experienced by other economic agents Share depletable charactistic of usual (private)

goods Example

Dumping of oil to clean oil tankers’ tanks with seawater in one area leaves that much less to be dumped in other areas

EXTERNALITIES

• Types of Externalities Nondepletable Externality

• Also called nonrivalrous or public• Experience of the externality by one agent does

not affect the amount experienced by other agents• Have characteristics of gpublic goods or bads• Example

• Amount of air pollution experienced by one agent does not affect others’ experiencing it

EXTERNALITIES AND MARKET INEFFICIENCY

• Welfare Economics: A Recap Supply and demand curves contain important

information about costs and benefits Demand Curve

Demand curve reflects value to consumer, as measured by the prices they are willing to pay

At any given quantity, height of demand curve shows willingness to pay of marginal buyer

It shows value to consumer of the last unit of the good


• Welfare Economics: A Recap Supply Curve

Supply curve reflects costs of seller At any given quantity, height of supply curve

shows cost of the marginal seller It shows cost to seller of last unit of good sold

In absence of externalities, price adjusts to balance supply and demand

Quantity produced and consumed in market equilibrium is efficient in the sense that it maximizes consumer and producer surplus


• Welfare Economics: A Recap

Price

Quantity

Supply

Demand

Equil.Price

EquilibriumQuantity

Demand curve reflects valueto consumer by willingness to pay

Supply curve reflects costs ofsellers

•Equilibrium quantity maximizes total value to buyers minus the total costs of sellers.•In absence of externalities, therefore, market equilibrium is efficient and socially optimal.


• Negative Externalities or External Cost A cost of an activity that falls on people or

firms other than those who pursue the activity Private Cost

Cost faced by the economic agent pursuing the activity

Social Cost Total cost to society of pursuing the activity Private cost + external cost


• Negative Externalities or External Costs

Price

Demand

Supply(private marginal cost)

Social cost =Private +external cost

QMARKETQOPTIMUMQuantity

Market Equilibrium

SocialOptimum

POPTIMUM

PMARKET

ExternalCost

•Social cost of good exceeds private cost•Socially optimum quantity exceeds privately optimum quantity•Socially optimum price exceeds privately optimum price


• External Cost

Price

Quantity

Demand


Social cost =Private +external cost

POPTIMUM

PMARKET

QOPTIMUM QMARKET

ExternalCost


Figure 11.1


• Positive Externalities or External Benefits

Price

Quantity

Demand(private value)


QOPTIMUMQMARKET

MBPRIVATE

= PMARKET

MBSOCIAL = POPTIMUM

External Benefit

Social demand =Private demand + external benefit

•Social value exceeds private value.•Socially optimal quantity exceeds private market equilibrium.

A Good Whose Production Generates a Positive Externality for Consumers

Figure 11.2


• Internalizing the Externality Altering incentives so that people and firms take

account of the external effects of their actions

THE OPTIMAL AMOUNT OF EXTERNALITIES IS NOT ZERO

• Optimal amount of negative externalities is not zero Socially optimal policy is to curtail negative

externality until the cost of further abatement just equals the marginal benefit

Clean up pollution to but only up to a certain point

Beyond this socially optimal level, costs more to society than it will benefit Marginal cost > marginal benefit

THE OPTIMAL AMOUNT OF EXTERNALITIES IS NOT ZERO

• Optimal amount of positive externalities is not zero Socially optimal quantity to expand positive

externality until the benefit of further increase just equals the marginal cost

Expand but only up to a certain point Beyond this socially optimal level, costs more

to society than it will benefit Marginal cost > marginal benefit

PRIVATE SOLUTONS TO EXTERNALITIES

• Introduction Externalities lead markets to allocate

resources inefficiently Both private actors and public policymakers

respond to externalities in various ways All remedies share goal of moving allocation

of resources to social optimum


• The Types of Private Solutions Government action not always needed People and firms sometimes develop private solutions Sometimes solved with moral codes and social

sanctions Example: littering

Charities Example: Sierra Club to protect environment due to negative

externalities Example: Universities receive gifts from alumni, etc. in part

because education has positive externalities for society


• The Types of Private Solutions Private market solutions can rely on self-

interest of relevant parties Sometimes can integrate different types of

business Example of bee keeper and orchard owner who integrate

into single firm

Sometimes inerested parties enter into a contract Example of bee keeper and orchard owner Contract specifies number of trees, number of bees, and

perhaps payments


• Coase Theorem The proposition that if private parties can

bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.

Coase theorem says that private economic actors can voluntarily solve the problem of externalities among themselves.

Whatever the initial distribution of rights, the interested parties can always reach a bargain in which everyone is better off and the outcome is efficient.


• Coase Theorem If private parties can bargain without cost over

the allocation of resources (i.e. no transactions costs), then the private market will always solve the problem of externalities and allocate resources efficiently.


• Coase Theorem Real question is should A be allowed to harm

B or should B be allowed to harm A? For example, if by polluter’s activities, a polluter

imposes an externality on someone, by asking polluter to reduce emission of pollutants, pollutee also causes a damage to the polluter.

To whom should the property right be assigned? There are distributive effectives of private

bargaining.


• Coase Theorem Voluntary negotiation will lead to a fully efficiency

outcome provided that: 1. rights are well defined 2. transactions are costless 3. there are no income effects.

When income effects are taken into account, the assignment of property rights will affect resource use.

When damaged party is a consumer, willingness to pay may differ from required compensation, because the former is constrained by the consumer’s income.


• Coase Theorem Implications of Coase Theorem: 1. If markets are incomplete, people will

negotiate and the efficient outcome will result; 2. there is no need for government

intervention; 3. the outcome is independent of the intial

assignment of rights.


• Coase Theorem: Advanced Discussion Inability or unwillingness to assign property

rights such that a complete set of markets can be generated provides rationale for government intervention

But Coase observed that if there are zero transactions costs, the set of markets can be expanded beyond normal private goods to include many non-market environmental assets As long as institutional constraints to assigning

well-defined property rights are removed


• Coase Theorem: Advanced Discussion Coase Theorem posits that disputing parties

will work out Pareto-efficiency private agreement Regardless of intial assignment of property righths

to non-market (environmental) asset

As long as these legal entitlements can be freely exchanged, government intervention is relegated to designating and enforcing well-defined property rights


• Coase Theorem: Illustration Suppose two firms, A and B, who disagree

about optimal level of pollution in bay A produces pulp and paper and discharges

waste water back into bay B owns a boat marina A’s emissions reduce profitability of B’s

marina


• Coase Theorem: Illustration Following figure illustrates socially optimal level of

pollution Q*

Price

Quantity of pollution

Marginal Benefit

Marginal Cost

Q*

MB* = MC*

• MC = marginal cost to B from pollution• MB = marginal benefit to A from pollution• Q* = socially optimal level of pollution, where MB = MC


• Coase Theorem: Illustration But with incomplete markets, no opportunity

for parties to trade for alternative leels of pollution, even though both A and B are better off with trade


• Coase Theorem: Illustration Coast Theorem works as follows 1. Rights to B: for Clean Water

Suppose neutral third party creates legal bargaining framework by assigning property rights for clean water to B

MC curve in figure represents B’s supply of clean water and MB represents A’s demand for clean water

Given B has property rights, A would compensate B by amount MC* for each unit of pollution


• Coase Theorem: Illustration Coast Theorem works as follows 2. Suppose neutral third party assigns

property rights to pollute to A MC curve now represents B’s demand for

pollution control and MB curve now represents A’s supply of pollution control

Given A has property right to pollute, B can offer bribe to A of amount MB* for each unit of pollution control


• Coase Theorem: Illustration Theoretically, Coase Theorem works

regardless of initial assignment of property rights Optimal per unit bribe MB* equals optimal per unit

compensation MC*, i.e. MB* = MC*, at socially optimal level of pollution Q*

Depending on relative magnitude of MB and MC curves, optimal level of pollution could be zero (high MC) or private optimum where MB is zero (low MC)


• Coase Theorem: Illustration1. Optimal Level of Pollution = 0: High MC

Price


MC

MB

MC = MB

Q*

0


• Coase Theorem: Illustration2. Optimal Level of Pollution = Private Optimum (Low MC)

Price


MC

MB

Q*


• Why Private Solutions Do Not Always Work Coase theorem applies only when the interested

parties have no trouble reaching and enforcing an agreement

Transactions costs can prevent parties from agreeing to and following through on an agreement Transactions Costs: the costs that parties incur in the

process of agreeing and following through on an agreement

Reaching an efficient agreement is especially difficult when number of interested parties is large because coordinating everyone is costly

PUBLIC POLICIES TOWARD EXTERNALITIES

• Introduction When an externality causes a market to reach

an inefficient allocation of resources, government can respond in one of two ways: 1. Command-and-control policies

Regulate behavior directly

2. Market-based policies Provide incentives so that private decision-makers will

choose to solve the problems on their own


• Regulation Government remedies an externality by

making certain behaviors either required or forbidden

In this case, external costs to society far exceed benefits to polluter

Government institutes command-and-control policy that prohibits this act altogether

In most cases, situation is not this simple


• Regulation Technology Standards

Government sets standards for type of technology to be used

Examples: catalytic converter for smog, mileage standards for automobiles

Example: circle hooks and mackerel-type bait for longliners to lower turtle interactions and mortality

Production Standards Quotas


• Pigovian Taxes and Subsidies Instead of regulating behavior in response to

an externality, government can use market-based policies to align private incentives with social efficiency

Government can internalize externality by taxing activities that have negative externalities and subsidizing activities that have positive externalities


• Pigouvian Taxes and Subsidies Pigovian Tax

A tax enacted to correct the effects of a negative externality.

Pigovian taxes raise cost of generating negative externality

Pigovian tax effectively places a price on right to generate negative externality Just as markets allocated goods to those buyers who value

them most highly, a Pigovian tax allocates negative externality to polluters that face highest cost of reduction


• Pigovian Taxes and Subsidies Pigovian taxes generally preferred to

regulation Regulation (command-and-control production

standard) dictates a level of pollution Tax gives polluter an economic incentive to reduce

pollution Tax reduces pollution more efficiently

Regulation requires same level of reduction for all polluters

But equal reduction not necessarily least expensive way


• Pigovian Taxes and Subsidies Difficulty in setting right level of tax to

generate socially optimal level of negative externality


• Pigovian Taxes and Subsidies Pigovian taxes differ from most other taxes

Most taxes distort incentives and move allocation of resources away from social optimum.

Reduction in economic well-being (consumer and producer surplus) exceeds revenue government raises, resulting in deadweight loss

In contrast, when externalities are present, Pigovian taxes correct incentives for presence of externalities and thereby move allocation of resources closer to social optimum.


• Pigovian Taxes and Subsidies Pigovian taxes differ from most other taxes

Pigovian taxes generate a double dividend: Raise revenue for public purposes and enhance

economic efficiency


• Transferable Property Rights Establish a property right for negative

externality and let polluters voluntarily exchange these pollution permits through a market that develops

This market is governed by the forces of supply and demand

New market efficiently allocates right to generate negative externalities -- pollute

Transferable Property Rights

Price of pollution


Supply of TransferableProperty Right: Pollution Permits

Demand for TransferableProperty Right: PollutionPermits

P

Q2….which, together with the demand curve, determines the price of pollution.

1. Pollution permits set the quantity of pollution….

• Supply is perfectly inelastic• Quantity of pollution set by number of permits or total cap on pollution


• Transferable Property Rights Firms that can reduce pollution only at high cost will

be willing to pay the most for pollution permits. Firms that can reduce pollution at low cost will prefer

to sell whatever permits they have. Initial allocation of property right among firms does

not affect economic efficiency, but affects distribution of wealth Can initially allocate transferable property right -- pollution

permits -- to polluters or to society Initial allocation of transferable property rights among

polluters affects their distribution of wealth


• Transferable Property Rights Both transferable property rights and Pigovian

taxes internalize externality by making it costly to pollute With Pigovian taxes, polluting firms must pay tax to

government With transferable property rights, polluting firms

pay when buy and sell permits


• Transferable Property Rights Government fixes total quantity of pollution Position of demand curve for pollution permits

determines the price of pollution Government often knows overall level of

pollution (which sets supply of permits) but not individual firm’s cost structure or demand curve for pollution

Hence difficult to set correct size of tax to achieve that goal but easier and more accurate to use transferable property rights

Equivalence of Pigovian Taxes and Transferable Property Rights

Pigovian Tax Transferable Right

Price of Pollution Price of Pollution

Quantity ofpollution

Quantity ofpollution

PP

QQ

Demand forpollution rights

Demand forpollution rights

Pigoviantax

Supply ofpollution permits

1. A Pigoviantax sets theprice ofpollution…

2…which together withthe demand curve, determinesthe quantity of pollution.

1. Pollution permits set the quantity of pollution…

2…which together with the demand curve, determines

the price of pollution


• Equivalence of Pigovian Taxes and Transferable Property Rights Demand curve for right to pollute differs With Pigovian tax

Government uses tax to set a price for pollution Supply curve for pollution rights is perfectly elastic, because

firms can pollute as much as they want by paying the tax Position of demand curve determines the price of pollution


• Equivalence of Pigovian Taxes and Transferable Property Rights With transferable property right (pollution permits)

Government sets quantity of pollution by issuing pollution permits

Supply curve for pollution rights is perfectly inelastic, because the quantity of pollution is fixed by the number of permits

Position of demand curve determines the price of pollution Hence, with any demand curve for negative

externality or pollution, government can achieve any point on the demand curve either by setting a price with a Pigovian tax or by setting a quantity with pollution permits or overall quantity of pollution

ENVIRONMENTALITIES AND MARKET FAILURE. INTRODUCTION Markets allocate scarce resources with forces of supply and demand Equilibrium of supply and demand.

Documents

externalities externalities

market failure slide

externalities technological

introduction market

bystander slide

reciprocal external

type of market failure

reciprocal effect slide