Market Failures and Thermodynamics

Another word on Pareto efficiency A Pareto inefficient outcome is one that fails to make all trades that could benefit one person without leaving someone else worse off A reallocation or redistribution in which some people are made better off and others worse off is Pareto incomparable to the prior allocation. It is not Pareto inefficient.

Quick Review Excludability –Policy variable –Some resources are inherently non-excludable Rivalry –If a resource is rival and scarce, should ration access –Non-rival resources not depleted through use, should not be rationed Marginal cost of use = 0 Rationing creates artificial scarcity

Rivalness Anti rival (additive) –My use makes you better off –What's an example? Abundance, scarcity and rivalry –Rival and abundant: oxygen –Rival and borderline: Crowded beach –Rival and scarce: oil

So What? Rival Non-rival, Anti-rival ExcludableNon-Excludable Market Good: cars, houses, land, oil, timber, waste absorption capacity? Tragedy of the non- commons: property rights to genetic info., patented information, e.g. non- ozone dep. comp. Pure Public Good: Information, most ecosystem services, e.g. climate stability, coastline protection, life support functions, etc. Open Access Regime: Oceanic fisheries, timber etc. from unprotected forests, waste absorption capacity Congestible Toll Good, club good: Roads, parks, beaches. natural monopolies. Free Rider Problem

Open Access The “Tragedy of the commons” Common property vs. open access

Solutions to Open Access Rival and scarce resources must be rationed Rationing requires property rights –Public, private or common Private property allows markets and price rationing –Who gets ownership? Distribution matters!

Public Goods Free-riding No price signal as feed-back mechanism –Scarcity  price increase  innovation Lack of Incentives to produce or protect them Costs of degradation ignored Private profits, socialize costs Lack of incentives to create technologies that provide them

Public Goods (cont.) Free-market enthusiasts don’t deny public good problem, but claim they are relatively unimportant Increasing scale and public goods Are stable climate, ozone layer, disturbance regulation (e.g. storm protection) and other life support functions relatively unimportant?

Solutions for Public Goods Public goods created by rival, scarce resources –Ecosystem structure –Built infrastructure –Human capital Requires public investment in production and protection Public goods generate non-rival services –Rationing inefficient –Open access is efficient

Non-rival & Excludable: tragedy of the non-commons Why do we have patents? When did patents come about? –1790s in US –1947 international, rarely used before 1980s

Patents: efficiency and sustainability Create inadequate incentives for inventions that provide or preserve public goods Raise costs for research –Profit motive prevents sharing of knowledge Monopolies on non-rival resource –Expensive to enforce Prices ration use Examples: new technology for highly efficient solar energy; non-ozone depleting technologies; Indonesia’s avian flu

Patents and just distribution Samuel Slater, “Father of American Industry” Developed countries own 97% of all patents Raises costs for research that meets the needs of the poor –Golden corn “Standing on the shoulders of giants”

Solution to Tragedy of Non- commons Public investment, common ownership Land grant universities, e.g. UVM Rate of return on investments in public sector agriculture R&D 60-80% per year

Natural Monopolies Excludable High fixed costs, low marginal costs Rival goods (e.g. water, electricity, etc.) Non-rival goods (e.g. information)

Market goods: The theory of Externalities

Externalities Definition –“an activity by one agent causes a loss (gain) of welfare to another agent” –“The loss (gain) of welfare is uncompensated” Completely Internal to the Economic Process. Why? Externalities and profit maximization How are these related to public goods?

Example: Conversion of Mangrove Ecosystems to Shrimp Aquaculture

Structure, raw materials, stock-flow resources Building materials, charcoal, food Function, ecosystem services, fund- services Storm protection Habitat, nursery Waste absorption Climate stabilization Values of Natural Capital: Mangrove Ecosystems

Values of Conversion Shrimp Aquaculture High short term profits, heavily promoted by economistsHigh short term profits, heavily promoted by economists Shrimp and fish for 3-5 yearsShrimp and fish for 3-5 years Carnivorous, net reduction in food productionCarnivorous, net reduction in food production Less protein than intact ecosystemLess protein than intact ecosystem Massive waste outputMassive waste output Irreversible(?) destruction of ecosystemIrreversible(?) destruction of ecosystem Why convert?Why convert?

On natural capital:On natural capital: Loss of Ecosystem servicesLoss of Ecosystem services Loss of fish productionLoss of fish production On social capital?On social capital? On human capitalOn human capital Impact of Conversion

‘Optimal’ pollution/degradation

Solutions for Externalities: Regulations Best management practices Best available technologies Caps on resource extraction, waste emissions, e.g. no conversion of mangroves to shrimp aquaculture Non-market mechanism. Producers cannot adjust MC to equal MB –But costs and benefits may not be directly comparable

Market Solution: Property Rights Who owns the environment? polluter ‘rights’ sufferer rights What about future generations?

Market Option I: Property Rights Market Option I: Property Rights Shrimp aquaculture

Problems with property rights Transaction costs –in absence of transaction costs, no negative externalities –What are transaction costs likely to be for externalities affecting public goods? –How many Filipinos affected by typhoon? Wealth effect Intergenerational externalities

Market Solutions 2: Pigouvian Taxes Tax externalities –Ideal tax = marginal cost, e.g. gas tax $12.00 gallon –Can costs be measured in monetary terms? Basic idea –Set price, let this determine Q at which demand = price –Price determines scale

‘Market’ Option 2: Pigouvian tax: Getting prices right tax

Market Solutions 3: Cap and trade/ Cap and auction 3 steps –Sustainable scale: Set cap –Just distribution: determine property rights, e.g. do resources belong to those who exploit them, or to public? –Efficient allocation: Tradable quotas (Cap and Trade) or public auctions (cap and auction) Basic rule: scale is price determining

'Market' Option 3: Tradable Quotas: setting ecologically sustainable scale quota

What’s better, tax or quota? Prices adjust to ecological constraints faster then ecosystems adjust to economic impacts Distributional impacts –Taxes –Quotas

Ignorance and Uncertainty Perfect markets require perfect information Asymmetric information –Nobel Prize in 2000 –Theory of the Lemon Irreducible ignorance Time lags Ecosystem function Solution: better information flows, precautionary principle

Asymmetric Preference Formation What forms our preferences? In what direction are our preferences pushed, towards market or non-market goods? Solution: balanced information flows

Missing markets For a market to work, everyone must be able to participate Future generations can’t participate in today’s markets People without money cannot participate, e.g. many indigenous peoples How much would the Mona Lisa sell for if it were auctioned off in St. Albans? Solution: inalienable property rights for future generations