Environmental Economics Market & Policy Failures Harvard Summer School June 29, 2011

Market Failure results: Whenever externalities are present In the provision of public goods When a resource is common property When special interests form a coalition “Collective Action” Imperfect markets (Monopoly power) Divergent Discount rates Unpriced Resources: Valuable resources are free or undervalued.

Policy Failures Distortion of otherwise well functioning markets Failure to consider & internalize side effects of otherwise warranted policy interventions. Government intervention to correct a market failure but makes things worse. Lack of intervention in failing markets.

External Costs Costs imposed upon 3 rd parties or society at large (not borne by producer or consumer). External costs can be pollution. When external costs are present the cost to society is high. Social costs > Private costs The free market will never result in an optimal level of production or consumption of negative or positive externalities.

Goal: Internalize the External costs Even when the costs from pollution are substantial they can be free to the polluter and imposed upon society at large. Society has to either live with the pollution (borne out by health costs, aesthetic costs, and lower quality of life) or pay through taxes for clean up. Rather, these costs should be borne by those who create them. Economists call this “internalizing the external costs”

Profit Maximizing Output Private producers will consider only private costs. Profit maximizing rate of Q: MC = MR MR is represented by the D curve because TR = P x Q MR = the addition to total revenue from the last unit sold Profit maximizing producer will produce output where MC = D

Problem is that s/he is looking only at private costs. The real cost of production is the Social cost of production, represented by MC social

External Costs MC Social MC private Demand Quantity Price External Costs P Social P private Q Social Q private

Presence of External Costs Equilibrium price will be too low because it will not reflect the true costs of production to society. Output will be higher than socially desirable.

Must internalize these external costs: this is the challenge. Government can accomplish through taxes, subsidies. Tax can be on consumer or producer. If on the producer, the tax will shift the private MC curve up (will increase prices – how much depends on elasticities)

If tax is on the consumer this will shift the demand curve in (how much depends on elasticity of demand).

Getting Prices Right Prices of goods should reflect their true costs to society. Getting prices right is one of the most important challenges facing environmental economists & policy makers. At the core of many of our worst environmental problems.

Higher prices are not bad when the costs were there anyway – just imposed on others. When price is too low people over- consume, further exacerbating the externality situation.

Environmental Resources are generally of a Common Property, Public Good Nature Non-exclusionary Characterized by Open-Access Results in “Market Failure”

Public Goods Goods or Services that are Non- exclusionary & Non-rivalrous in nature. Non-exclusionary: once provided / produced it can be freely enjoyed by all. Non-rivalrous: can be enjoyed equally by all. Free market (private sector) will Not (usually) provide these goods or services.

Common Property Situation in which property rights are either not well defined or the resource is the joint property of many people. The resource is characterized by open access. If left to the free market this will result in market failure because individuals will be motivated to overexploit the resource.

Tragedy of the Commons Resources are exploited on a 1 st come, 1 st served basis. Garrett Hardin –Population –Pasture for grazing cattle

Privately Owned Resource Owner of the resource maximizes profits by producing Q where MP = MC (or MR = MC) MP = MB = MR Profit maximizing rate of output : MR = MC

Common Property Resource No incentive to conserve the resource. Producers maximize profits by equating MC with Average Product With property rights production / harvest will be where MP = MC Q private preserves the scarcity rent (long run producer surplus). Q private is the efficient level because MP (MB) = MC means that net benefits are maximized (this is the efficiency criterion)

Collective Action Common in the U.S., or any stable democracy, for special interest groups to proliferate. A small, special interest group with vested economic interests is able to form a coalition & by acting collectively further their own interests at the expense of the greater population or society at large.

Mancur Olson Theory explains the ability of small special interest groups to prevail politically even at the expense of millions. Special interest groups most successful when: –Benefits are concentrated –Costs are diffuse