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

2 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

3 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

4 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

5 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

6 Modeling a Public Goods Market for Environmental Quality Figure 3.1 Combined Demand of Two Consumers for Air Quality (SO 2 Abatement)

7 Modeling a Public Goods Market for Environmental Quality Figure 3.2 Market Supply and Market Demand for Air Quality (SO 2 Abatement)

8 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

9 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

10 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

11 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

12 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

13 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

14 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

15 Modeling Environmental Damage As a Negative Externality Figure 3.3 Competitive Equilibrium in the Market for Refined Petroleum

16 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

17 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

18 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).

19 Modeling Environmental Damage As a Negative Externality Figure 3.4 Comparing Competitive and Efficient Equilibria Using Marginal Benefit and Marginal Cost: Refined Petroleum Market in the Presence of Negative Externality

20 Modeling Environmental Damage As a Negative Externality Figure 3.5 Comparing Competitive and Efficient Equilibria Using Marginal Profit and Marginal External Cost: Refined Petroleum Market in the Presence of Negative Externality

21 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

22 Modeling Environmental Damage As a Negative Externality Figure 3.6 Assessing the Net Gain to Society of Restoring Efficiency in the Refined Petroleum Market

23 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

24 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

25 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

26 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

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

28 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

29 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

30 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

31 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