1. Market Failures

2. The role of government and economics is to enhance public welfare Both seek to allocate scarce resources among alternative desirable ends Both seek to allocate scarce resources among alternative desirable ends When the market fails to allocate goods adequately, then the government should step in When the market fails to allocate goods adequately, then the government should step in

3. Three questions What are the desirable ends towards which society should allocate its scarce resources? What are the desirable ends towards which society should allocate its scarce resources? What are these scarce resources, and what are their characteristics relevant to allocation? What are these scarce resources, and what are their characteristics relevant to allocation? Based on the nature of the scarce resources and human nature, what allocative mechanisms is best for achieving these desired ends? Based on the nature of the scarce resources and human nature, what allocative mechanisms is best for achieving these desired ends? What allocative mechanisms are available? What allocative mechanisms are available?

4. The desirable ends: what improves social welfare? Is it ever greater consumption of market goods? Is it ever greater consumption of market goods? Can you buy and sell clean water, clean air, stable climate, biodiversity, ozone layer? Can you buy and sell clean water, clean air, stable climate, biodiversity, ozone layer? Why are we so obsessed with growth? Why are we so obsessed with growth? Does sustainability matter? Does sustainability matter? Does distribution matter? Does distribution matter? Who should own goods and services created by nature and by society? Who should own goods and services created by nature and by society? Is stability desirable? Is stability desirable?

5. What are the scarce resources? Economic goods and services Economic goods and services Ecosystem goods and services Ecosystem goods and services Laws of thermodynamics Laws of thermodynamics 1 st law: matter energy is constant 1 st law: matter energy is constant You can’t make something from nothing You can’t make something from nothing Economics is transformation, not waste Economics is transformation, not waste 2 nd law: entropy increases in an isolated system (supreme law of nature) 2 nd law: entropy increases in an isolated system (supreme law of nature) Economic activity results in waste Economic activity results in waste Economy can’t grow forever. We can’t grow our way out of poverty Economy can’t grow forever. We can’t grow our way out of poverty

6. From Empty World to Full World

7. What are the characteristics of the scarce resources?

8. Excludability Excludable resource regime Excludable resource regime One person can prevent another from using the resource One person can prevent another from using the resource Necessary for markets to exist Necessary for markets to exist Non-excludable Non-excludable No enforceable property rights due to technology or social institutions No enforceable property rights due to technology or social institutions Can’t charge for use Can’t charge for use Some resources non-excludable by nature. None are inherently excludable. Some resources non-excludable by nature. None are inherently excludable. Excludability is a product of institutions. Excludability is a product of institutions.

9. Rivalness Rival Goods Rival Goods My use leaves less for you to use My use leaves less for you to use All ecosystem goods are rival All ecosystem goods are rival Non-rival (or non-depletable) Non-rival (or non-depletable) My use does not leave less for you to use My use does not leave less for you to use Marginal cost for additional user = 0 Marginal cost for additional user = 0 Efficient allocation: Price = marginal cost of production Efficient allocation: Price = marginal cost of production All non-rival resources are services All non-rival resources are services Rival or non-rival is an innate characteristic of the good, not a result of institutions Rival or non-rival is an innate characteristic of the good, not a result of institutions

10. Rivalness (cont.) Non-rival but congestible Non-rival but congestible Non-rival as long as few people use it, becomes rival with excessive use (e.g. roads) Non-rival as long as few people use it, becomes rival with excessive use (e.g. roads) Empty planet vs. full planet Empty planet vs. full planet

11. So What? Rival Non-rival ExcludableNon-Excludable Market Good: cars, houses, land, oil, timber, waste absorption capacity? Potential market good but inefficient: patented information, e.g. energy efficiency, toll roads. Pure Public Good: Information, streetlights, public roads, defense, laws, public heal th, most ecosystem services Open Access Regime: Oceanic fisheries, undiscovered minerals, waste absorption capacity Non-rival, congestible MG when crowded: toll roads at rush hour, toll bridges, beaches, etc. OAR when crowded: e.g. public parks, beaches, roads, bridges, etc.

12. Open Access The “Tragedy of the commons” The “Tragedy of the commons” Common property vs. open access Common property vs. open access Individuals try to capture benefits for themselves, share costs with society Individuals try to capture benefits for themselves, share costs with society Market alone leads to over-exploitation Market alone leads to over-exploitation Threat of extinction Threat of extinction Loss of profit (to be explained later) Loss of profit (to be explained later) Role for government to step in Role for government to step in

13. Non-rival & Excludable Patents are protected by governments Patents are protected by governments Why do we have patents? Why do we have patents? Patents, profit motive and innovation Patents, profit motive and innovation When did patents come about? When did patents come about? 1790s in US 1790s in US 1947 international, rarely used before 1980s 1947 international, rarely used before 1980s

14. Non-rival & Excludable (cont.) Patents and the WTO Patents and the WTO 97% owned by developed nations 97% owned by developed nations Neem tree, steel drums, etc. Neem tree, steel drums, etc. Samuel Slater, “Father of American industry” Samuel Slater, “Father of American industry” Should government spend scarce resources to make these information excludable? Should government spend scarce resources to make these information excludable?

15. Public Goods Free-riding Free-riding No price signal as feed-back mechanism No price signal as feed-back mechanism Scarcity  price increase  innovation Scarcity  price increase  innovation Lack of Incentives for market to produce them Lack of incentives for markets to create technologies that provide them

16. Public Goods (cont.) How important are public goods? How important are public goods? Life support functions (Vermont’s forests) Life support functions (Vermont’s forests) Flood protection (Winooski river) Flood protection (Winooski river) Water purification Water purification Lake Champlain Lake Champlain Infrastructure Infrastructure Research and development Research and development if all the scientists are working for profit, none are making PGs if all the scientists are working for profit, none are making PGs Provision widely accepted as government duty

17. Is government provision efficient? Privatization debate Privatization debate Read chapter on political economy Read chapter on political economy

18. Market goods: The theory of Externalities

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

20. Examples Individual consumption Individual consumption Waste outputs Waste outputs Status effect Status effect Industry Industry Pollution Pollution Brownfields Brownfields Agriculture Agriculture Ecosystem conversion- loss of riparian zones Ecosystem conversion- loss of riparian zones Phosphorous emissions Phosphorous emissions Siltation Siltation Factory farming Factory farming

21. Examples (cont.) Natural resource harvest Natural resource harvest Depletion of ecosystem services Depletion of ecosystem services Waste emissions Waste emissions Community issues Community issues Crime reduction Crime reduction Economic stability Economic stability Education Education Health Health

22. ‘Optimal’ externalities for society ‘Optimal’ externalities for society Agricultural production

23. Property Rights Who owns the environment? Who owns the environment? polluter rights (privilege, no rights) polluter rights (privilege, no rights) sufferer rights (rights, duties) sufferer rights (rights, duties) What about future generations? What about future generations?

24. Obstacles to Optimal Transaction costs Transaction costs in absence of transaction costs, no negative externalities in absence of transaction costs, no negative externalities What are transaction costs likely to be for externalities affecting public goods? What are transaction costs likely to be for externalities affecting public goods? Wealth effect Wealth effect Intergenerational externalities Intergenerational externalities

25. Government role What can the government do about externalities, and how does it relate to finance? What can the government do about externalities, and how does it relate to finance? Regulations Regulations Cost money to enforce Cost money to enforce

28. Government role What can the government do about externalities, and how does it relate to finance? What can the government do about externalities, and how does it relate to finance? Regulations Regulations Cost money to enforce Cost money to enforce Economically inefficient Economically inefficient No incentives to go beyond compliance No incentives to go beyond compliance Taxes Taxes Auctioned quotas Auctioned quotas

29. Controlling price or quantity

30. Marginal pollution abatement costs for three firms emitting 5000 tons of pollution each.

31. Pigouvian taxes and subsidies Tax (subsidy) equal to value of negative (positive) externality theoretically leads to efficient outcome Tax (subsidy) equal to value of negative (positive) externality theoretically leads to efficient outcome What is value of externality? What is value of externality? Incentives Incentives

32. Tradable quotas Example of sulfur dioxide Example of sulfur dioxide First determine scale First determine scale Next decide on distribution Next decide on distribution Justice vs. feasibility Justice vs. feasibility Allow market to allocate Allow market to allocate

33. Tax or quota? With a tax, you can theoretically get right amount, but amount will change with economic change. Better to let prices vary (economic) than amount of resource to be used (ecological) With a tax, you can theoretically get right amount, but amount will change with economic change. Better to let prices vary (economic) than amount of resource to be used (ecological) tax or quota on single resource leads to substitution, on all resources will not tax or quota on single resource leads to substitution, on all resources will not

34. Tax or quota Uncertainty Uncertainty We don’t know marginal abatement cost curves, nor marginal benefit curves We don’t know marginal abatement cost curves, nor marginal benefit curves not only do we not know where we are on the curve, we don’t know the slope of the curve not only do we not know where we are on the curve, we don’t know the slope of the curve Slope of curve very important Slope of curve very important In full world, lower risks from quotas, in empty world, lower risks from tax In full world, lower risks from quotas, in empty world, lower risks from tax

35. Ignorance and Uncertainty Perfect markets require perfect information Perfect markets require perfect information Asymmetric information Asymmetric information Nobel Prize in 2000 Nobel Prize in 2000 Poverty insurance Poverty insurance Irreducible ignorance Irreducible ignorance Time lags Time lags Ecosystem function Ecosystem function

36. How do ignorance and uncertainty relate to budgeting and finance? Who pays clean up costs when unexpected negative impacts occur? Who pays clean up costs when unexpected negative impacts occur? Health impacts Health impacts Superfund sites Superfund sites Role of government in providing social security (poverty insurance) Role of government in providing social security (poverty insurance)

37. Natural Monopoly High fixed cost, low marginal cost High fixed cost, low marginal cost Roads Roads How should hey be regulated? How should hey be regulated?

38. Conclusions Many market economists and politicians argue that there is little role for government, market is best allocative mechanism Many market economists and politicians argue that there is little role for government, market is best allocative mechanism Market systematically fails to provide many goods Market systematically fails to provide many goods Government is essential Government is essential Future lectures will examine just and efficient mechanisms for coping with these market failures Future lectures will examine just and efficient mechanisms for coping with these market failures

39. Naural Monopolies,

40. PG: the Privatization debate

41. Private Provision Examples Examples 3 private police for every public officer in US 3 private police for every public officer in US 2/3 of homes in Denmark with private fire service 2/3 of homes in Denmark with private fire service SUVs or plowed roads? SUVs or plowed roads? Relative costs Relative costs Administrative costs Administrative costs Diversity of tastes Diversity of tastes Distributional issues Distributional issues Skimming Skimming

42. Private Production: examples Skating rink in Central park Skating rink in Central park Trains in WWI Trains in WWI Military personnel in Iraq Military personnel in Iraq Airport security Airport security Municipal water supply Municipal water supply Education Education

43. Private Production : issues Examples Examples Skating rink in Central park Skating rink in Central park Trains in WWI Trains in WWI Military personnel in Iraq Military personnel in Iraq Airport security Airport security Municipal water supply Municipal water supply Education Education