AGEC 640 – Nov. 6, 2018 Policy: How well can market failures be remedied?

Part B Policy options: How can society move towards Q*? A quick history of thought: Plato (400 BC): a “benevolent dictator” who knows the level of Q* can impose it through direct regulation. Pigou (1920s): a government which knows the marginal external cost or benefit can impose it as a marginal tax or subsidy, and let producers/consumers find Q*. Coase (1960s): a government that can allocate property rights and enforce contracts over the externality can help people make Coasian transactions to find Q*. The “Coase Theorem”: if transaction costs are zero, then the market equilibrium will be Q* for any initial allocation of property rights, which affect only the distribution of output. ==> it is transaction costs (or entry barriers) that prevent free exchange and create market failure in the first place.

Policy option #1: Welfare-maximizing regulation sets a quota at Q* S′ = MC + MD MD = marginal external damage to others G S = MC (marginal cost to producers) D E F D = WTP (willingness to pay by consumers) A B C Q* Qfree quota Effects of Optimal Quota Change in producer surplus -ABC Change in consumer surplus -DEF net gain Change in external costs +C FG +AB DE Change in quota rents

Policy option #2: An optimal Pigovian tax equals the MEC at Q* S′ = MC + MD MD = marginal external damage to others G S = MC (marginal cost to producers) D E F t D = WTP (willingness to pay by consumers) A B C Q* Qfree Effects of Optimal Pigovian Tax Change in producer surplus -ABC Change in consumer surplus -DEF net gain Change in external costs +C FG +AB DE Change in government revenue

In ideal “Coasian” transactions, people trade Policy option #3: In ideal “Coasian” transactions, people trade the externality itself, until MD = WTP-MC S′ = MC + MD MD = marginal external damage to others G′ S = MC (marginal cost to producers) H D E F Pc D = WTP (willingness to pay by consumers) A B C I J For example, if victims of the externality paid for reduced production… Q* Qfree Effects of Coasian Bargain paid cut Change in producer surplus +DE –C +FCHI Change in consumer surplus -DEF Change in ext. victims’ surplus +CFG′H -FCHI net gain

Part C: From ideal governments to reality what would be second-best optimal policy? Even well-intentioned government leaders often cannot achieve optimal policies Often can’t observe Q* or MD (marginal damage) can’t enforce property rights and regulations can’t tax or spend without changing incentives Second-best policy takes account of limitations constrained second-best policy involves less intervention than unconstrained, ideal policy clearest example concerns use of trade policy to achieve domestic policy goals

Part D: What determines real-life policies Part D: What determines real-life policies? Collective action and the political economy Clearest example is from Garrett Hardin (1968): “The Tragedy of the Commons” (aka “open access”) Property rights over common pool resources may be ill-defined, leading to over-exploitation and degradation over time …but studies of common property management find many nonmarket institutions arise to govern their use: grazing rules over pasture use in “traditional” societies, agreed upon hunting/fishing “rules” that govern use of wildlife, etc. social norms and conventions in general (pizza party etiquette)

Part D: What determines real-life policies Part D: What determines real-life policies? Collective action and the political economy It’s rarely clear how far from Q* we really are! to tell, we would need careful measurement of the externality… and also careful assessment of enforcement options; “better” institutions can help societies get closer to Q*… but institutions are notoriously slow in responding to technological change! Shively (1997) “Poverty, Technology, and Wildlife Hunting in Palawan.” Environmental Conservation, 24(1):57-63.

Collective action as a Prisoner’s Dilemma In Hillman’s example, two shepherds share a meadow. Their payoffs are mutually dependent: The payoff matrix Shepherd #2’s choices Restrict Don’t restrict Shepherd #1’s choices 14,14 1,20 20,1 3,3 What will each shepherd do? Tragedy of the Commons (TOTC)! Von Neumann-Morgenstern (1944): cooperative equilibrium …something else is needed to sustain cooperation Nash (1950, 1951): “best response” equilibrium we can predict based only on idea that both optimize.

Solving for a Nash Equilibrium The payoff matrix Shepherd #2’s choices Restrict Don’t restrict Shepherd #1’s choices 14,14 1,20 20,1 3,3 The Nash Program asks what is each one’s best response? If #1 restricts, then #2’s best response is to not restrict (gets 20 instead of 14) If #1 does not restrict, then #2’s best response is to not restrict (gets 3 instead of 1) so Nash predicts #2 will not restrict and by symmetry, the unique “Nash equilibrium” is neither restricts …unless something else comes along!

Avoiding the TOTC Elinor Ostrom Political Scientist at IU-Bloomington Conducted research worldwide on common pool resources (CPRs). Conducted field research in a Swiss village. Classic set up for a TOTC, but… No overgrazing! Poetic Justice!!! She was rejected as an applicant to the PhD program in Economics at UCLA, but went on to win the Nobel Prize in Economics in 2009 for her work on CPRs.

Ostrom’s 8 Principles for Managing a CPR 1. Define clear group boundaries. 2. Match rules governing use of common goods to local needs and conditions. 3. Ensure that those affected by the rules can participate in modifying the rules. 4. Make sure the rule-making rights of community members are respected by outside authorities. 5. Develop a system, carried out by community members, for monitoring members’ behavior. 6. Use graduated sanctions for rule violators. 7. Provide accessible, low-cost means for dispute resolution. 8. Build responsibility for governing the common resource in nested tiers from the lowest level up to the entire interconnected system.

A resource arrangement that works in practice can work in theory. Ostrom’s Law A resource arrangement that works in practice can work in theory.

Can property rights help avoid the prisoner’s dilemma? Ronald Coase (1960) "The Problem of Social Cost" Journal of Law and Economics. 3(1):1-44. society can do better than the Nash equilibrium by defining property rights Awarded the 1991 Nobel Prize in Economics (died in 2013 at the age of 102!)

Can property rights help avoid the prisoner’s dilemma? Coase’s Theorem: society can do better than the Nash equilibrium, by assigning and enforcing property rights. if property rights were assigned over everything, there would be no more externalities! so all market failures can be seen as absence of well-defined property rights, as well as the presence of significant transaction costs (Coase, 1937)… does it matter how the rights are assigned? does the benefit of enforcement exceed the cost?

Any allocation of property rights leads to the The Coase Theorem Value per cigarette Any allocation of property rights leads to the same Qe Marginal cost of smoking to non-smokers equilibrium payment “collective action” zone marginal damage Marginal benefit of smoking to smokers foregone benefit Number of cigarettes smoked Qn Qe Qs No smoking Coasian equilibrium Free smoking

Under what conditions does the “Coase Theorem” hold? Any allocation of property rights leads to Qe, if: There are no transaction costs full information costless enforcement There are no income effects no change in marginal costs/benefits These are extremely STRONG assumptions! “Coasian” transactions are widespread towards the predictions of the “Coase theorem” but initial allocations determine how close to the competitive equilibrium the market can reach. Why?

Some applications of Coasian logic Coasian logic says assigning property rights to minimize transaction costs can improve outcomes e.g. what’s easiest way to pay for a harbor’s lighthouse? with few ships but many merchants, make the ships pay with many ships, easier to make the merchants on shore pay In some cases, we can assign property rights to gain other benefits, e.g. for pollution policy: can choose the “polluter pays” principle gives a double dividend when payments finance clean-up or, alternatively, a “cap-and-trade” system gives polluters Pareto compensation through permit values

Some conclusions about collective action Market outcomes depend on market structure the easier it is for people to communicate and transact, the closer they can move to the surplus maximizing Q* Market structure involves non-market institutions: taxes or subsidies quantity regulations inintial allocations of property rights legal recourse and the performance of the court system