Modeling Market Failure Chapter 3 © 2004 Thomson Learning/South-Western.

Modeling Market Failure

Chapter 3

© 2004 Thomson Learning/South-Western

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Environmental Problems: A Market Failure Market failure – the result of an inefficient market

condition Environmental problems are modeled as market

failures using either the theory of public goods or the theory of externalities If the market is defined as “environmental quality,” then

the source of the market failure is that environmental quality is a public good

If the market is defined as the good whose production or consumption generates environmental damage, then the market failure is due to an externality

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Environmental Problems: A Public Good Public good – a commodity that is nonrival in

consumption and yields benefits that are nonexcludable

Characteristics of public goods Nonrivalness – the characteristic of indivisible benefits

of consumption such that one person’s consumption does not preclude that of another

Nonexcludability – the characteristic that makes it impossible to prevent others from sharing in the benefits of consumption

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Modeling a Public Goods Market for Environmental Quality Public goods generate a market failure because the

nonrivalness and nonexcludability characteristics prevent natural market incentives from achieving an allocatively efficient outcome

Allocative Efficiency in the Market for a Public Good Achieving an allocatively efficient equilibrium in a public

goods market depends on the existence of well-defined supply and demand functions

Market demand for a public good – the aggregate demand of all consumers in the market, derived by vertically summing their individual demands

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Modeling a Public Goods Market for Environmental Quality Assessing the Implications

Abating at the 100 percent level to reduce pollution to zero involves prohibitive opportunity costs

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Modeling a Public Goods Market for Environmental QualityFigure 3.1 Combined Demand of Two Consumers for Air

Quality (SO2 Abatement)

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Modeling a Public Goods Market for Environmental QualityFigure 3.2 Market Supply and Market Demand for Air Quality

(SO2 Abatement)

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Modeling a Public Goods Market for Environmental Quality Understanding the Market Failure of Public Goods

Market Nonrevelation of preferences – an outcome that arises

when a rational consumer does not volunteer a willingness to pay because of the lack of a market incentive to do so

Free-ridership – recognition by a rational consumer that the benefits of consumption are accessible without paying for them

Imperfect information Market forces alone cannot provide an allocatively

efficient level of a public good

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Modeling a Public Goods Market for Environmental Quality The Solution: Government Intervention

A common means by which government responds to the dilemma of free-ridership and nonrevelation of preferences is through direct provision of public goods

An alternative government response is the use of political procedures and voting rules aimed at identifying society’s preferences about public goods

Government response to imperfect information includes education and public information

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Environmental Problems: Externalities Externality theory specifies the relevant market as

environmental as the good whose production or consumption generates environmental damage outside the market transaction Externality – a spillover effect associated with

production or consumption that extends to a third party outside the market

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Environmental Problems: Externalities Basics of Externality Theory

Negative externality – an external effect that generates costs to a third party

Positive externality – an external effect that generates benefits to a third party

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Environmental Problems: Externalities Environmental Externalities

Environmental economists are interested in externalities that damage the atmosphere, water supply, natural resources, and the overall quality of life

Environmental externalities can occur in relation to both production and consumption

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Environmental Problems: Externalities Relationship Between Public Goods and

Externalities Although public goods and externalities are not the

same concept, they are closely related If the externality affects a broad segment of society and

if its effects are nonrival and nonexcludable, the externality is itself a public good

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Modeling Environmental Damage As a Negative Externality Developing a formal model of a negative

environmental externality Defining the Relevant Market

The market is defined as refined petroleum products Modeling the Private Market for Refined Petroleum

Assume the private market for refined petroleum is competitive

Supply function is the marginal private cost Demand relationship is the marginal private benefit

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Modeling Environmental Damage As a Negative ExternalityFigure 3.3 Competitive Equilibrium in the Market for Refined

Petroleum

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Modeling Environmental Damage As a Negative Externality Inefficiency of the Competitive Equilibrium

The problem with this equilibrium is that it ignores the external costs to society of contaminated water supplies caused by refined petroleum production

Costs of water production are external to market exchange and not factored into private market decisions

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Modeling Environmental Damage As a Negative Externality Modeling the External Costs

Model the hypothetical marginal external cost as MEC = 0.05Q

Modeling the Marginal Social Costs and Marginal Social Benefits Marginal social cost – the sum of the marginal private

cost (MPC) and the marginal external cost (MEC) Marginal social benefit – the sum of marginal private

benefit (MPB) and marginal external benefit

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Modeling Environmental Damage As a Negative Externality Efficient Equilibrium

Competitive equilibrium – the point where marginal private benefit (MPB) equals marginal private cost (MPC), or where marginal profit (M∏)= 0

Efficient equilibrium – the point where marginal social benefit (MSP) equals marginal social cost (MSC), or where marginal profit (M∏) = marginal external cost (MEC).

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Modeling Environmental Damage As a Negative ExternalityFigure 3.4 Comparing Competitive and Efficient Equilibria Using

Marginal Benefit and Marginal Cost: Refined Petroleum Market in the Presence of Negative Externality

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Modeling Environmental Damage As a Negative ExternalityFigure 3.5 Comparing Competitive and Efficient Equilibria Using

Marginal Profit and Marginal External Cost: Refined Petroleum Market in the Presence of Negative Externality

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Modeling Environmental Damage As a Negative Externality Measuring the Welfare Gain to Society

If production of a commodity generates a negative externality, the market will yield an inefficient solution with too many resources allocated to production

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Modeling Environmental Damage As a Negative ExternalityFigure 3.6 Assessing the Net Gain to Society of Restoring

Efficiency in the Refined Petroleum Market

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Modeling Environmental Damage As a Negative Externality Market Failure Analysis

There is no market incentive for a rational firm to incur higher costs than it has to, even if it is for the good of society

Market failure models give us a better understanding of why we observe increasing damage to the physical environment as industrial production has intensified throughout the world

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The Absence of Property Rights

Property rights – the set of valid claims to a good or resource that permits its use and the transfer of its ownership through sale

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The Absence of Property Rights

The Coase Theorem – assignment of property rights, even in the presence of externalities, will allow bargaining such that an efficient solution can be obtained Two important underlying assumptions of this theory:

Transactions are costless Damages are accessible and measurable

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The Absence of Property Rights

Bargaining When Property Rights Belong to the Refineries Assigning rights to refineries should have no effect on

the outcome at all

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The Absence of Property Rights

Figure 3.7 Bargaining in the Refined Petroleum Market with the Assignment of Property Rights

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The Absence of Property Rights

Bargaining When Property Rights Belong to the Recreational Users According to Coase Theorem, an efficient outcome can

be achieved regardless of which of the affected parties controls the property rights

There is an opportunity for bargaining to proceed so long as the following condition holds:

M∏ > ρ > MEC The assignment of property rights leads to an efficient

outcome without any government intervention

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The Absence of Property Rights

Limitations of the Coase Theorem Coase’s model underscores the importance of property

rights to market process, regardless of who is assigned those rights

For this theory to hold in practice, at minimum it must be the case that very few individuals are involved on each side of the market

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The Absence of Property Rights

Common Property Resources – those resources for which property rights are shared If property rights exist in some form but are ill defined,

the outcome will be an inefficient one Because property rights extend to more than one

individual, they are not as clearly defined as for pure private goods

With common property resources, the problem is that public access without any control leads to exploitation, which in turn generates a negative externality

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The Absence of Property Rights

The Solution: Government Intervention The general solution to externalities, including those

affecting the environment, is to internalize the externality, that is, to force the market participants to absorb the external costs or benefits

Other approaches to internalizing environmental externalities are policies that change the effective price of a product by the amount of the associated external cost or benefit