Market Failure and Public Policy February 7, 2005

An efficient market allocation: Maximizes net benefits MB = MC MNB 0 =PV MNB 1 =PV MNB 2 =…=PV MNB n Cannot make anyone better off without making someone else worse off

Market Failure: External costs (S=MPC only)

Tons of coal mined $ D S=MPC only S=MPC + MSC qmqm pmpm q* P*

Market Failure: External costs (S=MPC only) External benefits (D=MPB only)

Acres of farmland $ MC qmqm pmpm q* P* MPB MSB + MPB

External costs (S=MPC only) External benefits (D=MPB only) High exclusion costs High exclusion costs limit incentive for private production of good or service Market Failure:

External costs (S=MPC only) External benefits (D=MPB only) High exclusion costs Non-rival goods (MC for additional user is 0)

Market Failure: External costs (S=MPC only) External benefits (D=MPB only) High exclusion costs Non-rival goods (MC for additional user is 0) Open access Individual users benefit but do not bear all costs of their use

Case 1 - Privately owned land Commodity produced with labor: Q = 12n – 2n 2 Input is labor (n): n = number of laborers MB = 12 – 4n MC = wage rate = 8 P = $1 so TB = $1*Q so TB = 12n – 2n 2 MB = MC 12 – 4n = 8 n = 1, TB = 10 Rent = TB – TC = 10 – 8 = 2

Number of laborers $ — MC Rent = ½(4)(1) = 2

Case 2 – Open access land Commodity produced with labor: Q = 12n – 2n 2 n = number of laborers Labor is added until all potential gains are exhausted (on average, all costs are covered) P = $1 so Q = TB AB = TB/n = (12n – 2n 2 )/n = 12 – 2n First laborer earns rent. Second laborer observes this “surplus” and sees an opportunity to benefit.

Number of laborers $ — MC

AB = 12 – 2n MC = wage rate = 8 AB = MC 8 = 12 – 2n n = 2, TB = 16 Rent = 16 – 16 = 0 Case 2 (cont.) Rent is exhausted, or dissipated.

Number of laborers $ — MFC Rent dissipated

Market Failure: External costs (S=MPC only) External benefits (D=MPB only) High exclusion costs Non-rival goods Open access Planning horizon Private vs. social discount rate

Reasons for public policy: Correct market failure Internalize externalities Provide public goods Change/create property rights Change outcome if we don’t like the efficient market outcome Change/create property rights Correct government failure

Incentive-based policies: Property rights changes Market failure: Open access shellfish flats on Cape Cod resulted in decreased quantity and quality of shellfish Property rights change: Shellfish flats divided into individual parcels, sold or leased, and owners or lessees manage for the long run

Incentive-based policies: Property rights changes Public (government) incentives Taxes (increase cost of undesired activity) Subsidies (increase benefits of desired activity) These imply underlying property rights preferences

Tons of coal mined $ D S=MPC only S=MPC + severance tax qmqm pmpm q* P* tax rate = p* - p m Example: Severance tax $t per ton of coal mined

Example: Subsidy payment for land retained in farming Acres of farmland $ MC qmqm pmpm q* P* MPB MSB + MPB Total subsidy paid

Direct public action: Command and control Direct regulations or controls

Example: Zoning regulations limit development options Acres of farmland $ MC qmqm pmpm q* P* MPB MSB MC with regulation

Direct public action: Command and control Direct regulations or controls Public goods production Where no private incentive for production exists High exclusion costs Non-rival goods

Why attributes of things matter: Consider the following communication between Canadian authorities and the commander of a U.S. Navy ship off the coast of Newfoundland in October, 1995: Americans: Please divert your course 15 degrees to the North to avoid a collision. Canadians: Recommend you divert your course 15 degrees to the South to avoid a collision. Americans: This is the Captain of a U.S. Navy ship. I say again, divert your course. Canadians: No. I say again, you divert your course. Americans: This is the aircraft carrier U.S.S. Lincoln, the second-largest ship in the United States’ Atlantic Fleet. We are accompanied by three destroyers, three cruisers, and numerous support vessels. I demand that you change your course 15 degrees North, That’s one-five degrees North, or counter measures will be undertaken to ensure the safety of this ship. Canadians: This is a lighthouse. Your call.