1. Chapter 3 Modeling Market Failure1

2. Environmental Pollution
Market failure is 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 Quality A Public Good
A public good is a commodity that is nonrival in consumption and yields nonexcludable benefits
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
Clean air, clean drinking water, clean waste treatment…

4. A Public Goods Market for Environmental Quality
Market failure because the nonrivalness and nonexcludability characteristics prevent market incentives from achieving allocative efficiency
Cannot specify / identify / operationalize demand
Consumers are unwilling to reveal their demand because they can share in consuming the public good even when purchased by someone else
This problem is called nonrevelation of preferences, which arises due to free-ridership
In addition, lack of awareness of environmental problems exacerbates the problem

5. Solution to Public Goods Dilemma
Government might respond through direct provision of public goods
Government might use political procedures and voting rules to identifying society’s preferences about public goods

6. Environmental Problems A Negative Externality
An externality is a spillover effect associated with production or consumption that extends to a third party outside the market
Negative externality – an external effect that generates costs to a third party
Positive externality – an external effect that generates benefits to a third party
Examples: dumping toxic waste in ocean, emitting gases into local air space
EPA Toxic Release Inventory
Externalities caused by doing something we want to do: produce or consume

7. Modeling a Negative Environmental Externality
Define the market as refined petroleum
Assume the market is competitive
Supply is the marginal private cost (MPC)
Demand is the marginal private benefit (MPB)
Production generates pollution, modeled as a marginal external cost (MEC)
Problem: Producers (refineries) have no incentive to consider the externality
Result: Competitive solution is inefficient

8. Finding a Competitive Solution Refined Petroleum Market
Marginal Private Cost S: P = Q Marginal Private Benefit D: P = 42.0 − 0.125Q, where Q is thousands of barrels per day Find the competitive solution

9. Competitive Solution Set MPB = MPC 42.0 − 0.125Q = 10.0 + 0.075Q
Solve:
QC = 160,000 PC = $22
Analysis:
This ignores external costs from contamination
Efficiency requires all costs to be counted in MPC function
MPC undervalues (assumes at zero) pollution costs
QC is too high; PC is too low

10. Examples of costs from pollution

14. April 20, 2010: Deepwater Horizon Explosion

17. Finding a Socially Efficient Solution
Include the external pollution effects, as Marginal External Costs or Marginal External Benefits (MEC, MEB)
Use Marginal Social Cost and Marginal Social Benefit (MSC, MSB)
Instead of just MPC, use MSC=MPC+MEC
Instead of just MPB, use MSB=MPB+MEB
Assume Marginal External Cost (MEC) = 0.05Q
MSC = Q Q
= Q
Assume no external benefits, MEB = 0, so MSB = MPB
Find the new efficient (for real) solution

18. Efficient Solution Set MSC = MSB 10.0 + 0.125Q = 42.0 - 0.125Q
QE = 128,000 PE = $26
In the presence of an externality, market forces cannot determine an efficient outcome
If externality is negative, market Q is too low, market P is too high

19. 42
MSC = MPC + MEC
P per barrel
S =MPC
PE = 26
PC = 22 10
D = MPB = MSB
128
160
Q (thousands) QE QC

20. Measuring Society’s Net Gain From Social Efficiency
As Q falls from 160 to 128:
Refineries lose p (MPB over MPC) for each unit of Q reduced [area WYZ]
Society gains accumulated reduction in MEC for each unit of Q reduced [area WXYZ]
Net gain = Area WXYZ - Area WYZ = Area WXY

21. Measuring Society’s Net Gain Refined Petroleum Market
Society gains WXYZ; refineries lose WYZ; net gain is WXY 42
P per barrel
MSC = MPC + MEC X
S = MPC W
PE = 26 Y
PC = 22 Z 10
D = MPB = MSB
QE = 128
QC = 160
Q (thousands)

22. Pigou’s solution for externalities:
Both externality and public goods models show inefficiency of private market solution, i.e., market failure
Pigou’s solution for externalities:
Make sure consumers and producers work off MSB and MSC curves
Make sure consumers and producers do not work of MPB and MPC curves
Another solution: by Coase

23. Ronald Coase

24. Property Rights
Property rights are “valid claims to a good or resource that permit use and transfer of ownership”
For environmental goods, it’s often unclear who has property rights
Economics says it’s the absence of rights that matters, not who possesses them

25. Coase Theorem
Proper assignment of property rights will allow bargaining between parties such that efficient solution results, regardless of who holds rights
Assumes costless transactions
Assumes damages are accessible and measurable

26. Building the Model Refined Petroleum Market
Refineries use the river to release chemicals as an unintended by-product of production
Objective: to maximize p
Recreational users use the river for swimming and boating
Objective: to maximize utility

27. Bargaining When Rights Belong to Refineries
Recreational users are willing to pay refineries for each unit of Q not produced
Will pay up to the negative effect on utility (MEC)
Refineries are willing to accept payment not to produce
Will accept payment greater than their loss in profit from reducing production (Mp)

28. Bargaining When Rights Belong to Refineries
Initial point is Qc, since the refineries, who own the rights, would choose this point
Recreational users:
Willing to offer a payment r
r < (MSC - MPC), or r < MEC
Refineries:
Willing to accept payment r
r > (MPB - MPC), or r > Mp

29. Bargaining Process X W Y Z MSC = MPC + MEC S =MPC D = MPB = MSB 42
Between QC and QE, MEC > M, so bargaining proceeds 42
P per barrel
MSC = MPC + MEC X
S =MPC W 26 22 Y Z
MEC at Qc is XY
M at Qc is 0
Bargaining begins 10
At QE, MEC = M, so bargaining ends
D = MPB = MSB
128
160
Q (thousands) QE QC

30. Bargaining Process Bargaining should continue as long as:
(MSC - MPC) > r > (MPB - MPC) or
MEC > r > Mp
At QC: Refineries’ Mp = 0, but MEC > 0, (distance XY)
Since MEC > Mp, bargaining begins
Between QC and QE, same condition holds
At QE: MEC = Mp, (distance WZ); output reductions beyond this point are infeasible, since Mp > MEC

31. Bargaining When Rights Belong to Recreational Users
Bargaining will proceed analogously
An efficient outcome can be realized without government intervention

33. Limitations of the Coase Theorem
Bargaining is too difficult
Transactions costs are too high
Transactions costs:
Costs of identifying damage
Costs of agreeing on damage
Costs of negotiating settlement
Costs of enforcing payment
Negative incentive (repeat offender)

34. Coase Theorem Problem; negative externalities
Really a problem of property rights
Assign property rights
Bargain to get to socially efficient solution
Cannot bargain because of transactions costs

35. Solutions One solution:
Internalize externality by assigning property rights
Make sure bargaining can happen
Or:
Set policy prescription (standards, taxes…)

36. Very big issues here Public goods – address with government provision
Externalities – address with property rights or other policies
Key theory: MSC not MPC / MSB not MPB
MSC = MPC+MEC MSB = MPB+MEB