1. Market Failure (?): Externalities
Dr. D. Foster
Microeconomics

2. Economics Scarcity Choices (Opportunity) Costs
A framework for understanding. . .
Scarcity
Choices
(Opportunity) Costs
Limited Resources
Unlimited Wants
Premise: Rational self-interest
i.e., human action is not random; it is purposeful.

3. First choice – markets …
Choices must be made
What will be produced?
How will it be produced?
Who will get what is produced?
Productive efficiency
Allocative efficiency
Distributive efficiency
Efficiency -
“measure” of how well we answer these questions.
First choice – markets …

4. Putting Supply & Demand Together
At P2 the market is in equilibrium.
Price
Supply
At P1 a surplus will drive down prices. P1 Q1 Q3 P2 P3
At P3 a shortage will drive up prices.
Demand
Quantity Q2

5. What is “market failure”?
When markets fail to achieve allocative and productive efficiency.
When do markets fail?
Asymmetric information
Public goods
Common property
Positive externalities
Negative externalities

6. Positive Externalities
Some “consumers” benefit w/out paying. -- concert -- flower garden -- flu shot
What to do? -- Nothing. -- Subsidize producer/consumer - there is a cost to this!

7. Positive Externalities
Quantity
Price
Supply
D = MPB P1
MSB Q2
$30 $5 Q1

8. Negative Externalities
Third parties bear part of the cost without receiving any of the benefit. -- Pollution: the firm treats waste disposal as free.
How do we deal with this problem? -- Tax the producer/consumer. -- Set standards/quotas for pollution. -- Allow parties to negotiate. -- Sell pollution rights.

9. Pollution - Tax & Standard
MSC Q2
Tax raises costs;  production.
Quota on production would (might?) serve the same purpose.
Standards for pollution would also raise costs and  production.
Quantity
Price
S = MPC
D = MPB P1
$25
$15 Q1

10. Pollution & The Coase Theorem
Assign property rights to the resource (!)
And, it doesn’t matter who gets the rights!

11. Is zero the “right” level of pollution?$ MC
NO !!! MB
Quantity of pollution
Qmin Q*
Qmax
Problems: Holdouts and Free Riders

12. The firm owns the rights
The Free Rider Problem
Quantity of pollution MC MB $ Q* Qm
$1000
$400
The firm owns the rights

13. The downstream users own the rights
The Holdout Problem
Quantity of pollution MC MB $ Q* Qm
$20,000
$2000
The downstream users own the rights

14. Selling Pollution Rights (!) Reduce Pollution by 3 Units
Cost to reduce by:
Firm X
Firm Y
Firm Z
1st unit
$50
$70
$800
2nd unit
$75
$130
$1000
3rd unit
$100
$200
$2000
How? Cost? Price of permits? Issue 2 each.

15. Reduce Pollution by 3 Units
Cut back equally (by 1 unit each):
Cost = $50 + $70 + $800 = $920
Cut back most cheaply (by 3 units total):
Cost = $50 (X) + $70 (Y) + $75 (X) = $195
Charge a price of . . .
$90 per permit.
Give out 2 each . . .
Firm Z will buy 1 from X.

16. Limitations Transactions costs must be low.
Assignment of rights will be contentious.
What is optimal level of pollution?
It is not a scientific question!!
Who will set the tax? Who will be exempt?
Coal & the Clean Air Act (1970, 1977, 1990)
Choices: scrubbers, washing, use low-SO2 coal.
Mandate on scrubbers benefits . . .

19. Buying & Selling the right to pollute.
Class Exercise
Buying & Selling the right to pollute.

20. Market Failure (?): Externalities
Dr. D. Foster
Microeconomics