1. Dr. D. Foster Microeconomics Market Failure (?): Public Goods, Common Property & Externalities

2. When do markets fail? When will even perfectly competitive markets fail to produce the allocatively efficient level of output? Public goods Common property Positive externalities Negative externalities

3. Public Goods Non-rival in consumption One person doesn’t use it up. Non-excludable Non-payers can’t be (easily) excluded. For example: National defense Legal system Lighthouses TV and radio Roads

4. Public Goods Not all “publicly-provided” goods meet the test of being public goods. For example: Education Trash collection Social security National parks... Roads & lighthouses ! The legal system ?!

5. Public Goods Non-excludability problem leads to free riders. How do markets deal with this problem? “Charge” differently “Charge” differently - TV & radio ads Find way to exclude Find way to exclude - TV & cable/satellite Tie-in sales Tie-in sales - lighthouses - shopping malls - gated communities

6. Graphical Analysis For private goods, the market demand is the horizontal summation of individual demands. Everyone pays the same price, consumes differing amounts $10 $5 MC Tom Sally The Market 15 25 40 $3 Price Quantity

7. Graphical Analysis Everyone consumes the same amount, pays differing prices. $11 $10 $5 $15 MC Tom Sally The Market 20 public goods vertical summation For public goods, the market demand is the vertical summation of individual demands. $8 $3 $ $ $ Q Q Q

8. Caveats Government provision may not be desirable: --The free rider problem is replaced with the forced rider. --Government may be inefficient, imposing higher costs such that we would be better off without this good/service!

9. Common Property Weak incentive to preserve/protect. Weak incentive to preserve/protect. Weak incentive to maximize value. Weak incentive to maximize value. Who owns common property? Who owns common property? Fish in the ocean Fish in the ocean This is another free rider problem.

10. Common Property P1P1 Q* Q2Q2 D2D2 Q - Fish P Supply D1D1 Q1Q1 Q mx

11. Common Property What to do? -- Assign private property rights. -- Regulate use... -standards, -limits, -prohibit. What to do? -- Assign private property rights. -- Regulate use... -standards, -limits, -prohibit.

12. Some observations Elephants in Africa 1970s - 1.2 million 1980s - 600,000 Elephants in Africa 1970s - 1.2 million 1980s - 600,000 150,000 2007

13. Can markets really work? What about non-renewable resources? Hotelling Principle: People treat exhaustible resources like any asset and want to max. value over time. Hotelling Principle: People treat exhaustible resources like any asset and want to max. value over time. The Simple Version - We can’t run out of... D S P Q S’ S”

14. Hotelling Principle The more complicated story: The more complicated story: Asset value must grow at the market rate of interest to find equilibrium extraction. Asset value must grow at the market rate of interest to find equilibrium extraction. If asset value grows more slowly,  extraction. If asset value grows more slowly,  extraction. If asset value grows faster,  extraction. If asset value grows faster,  extraction. i = market return r = asset return r i % Q Q* If we start “running out?” r' Q’

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

16. Positive Externalities To promote allocatively efficient level of output, subsidize by the vertical distance. Q P S D = MPB Q1Q1 MSB Q2Q2 P1P1

17. Negative Externalities Third parties bear part of the cost without receiving any of the benefit. -- In the case of pollution: the firm is facing zero-priced waste disposal. Third parties bear part of the cost without receiving any of the benefit. -- In the case of pollution: the firm is facing zero-priced waste disposal. How do we deal with this problem? -- Tax the producer/consumer. -- Set standards/quotas for pollution. -- Allow parties to negotiate. -- Sell pollution rights. How do we deal with this problem? -- Tax the producer/consumer. -- Set standards/quotas for pollution. -- Allow parties to negotiate. -- Sell pollution rights.

18. Pollution - Tax & Standard Tax raises costs;  production. Quota on production would (might?) serve the same purpose. Standards for pollution would also raise costs and  production. Q P S = MPC D = MPB Q1Q1 MSC Q2Q2 P1P1

19. Pollution & The Coase Theorem Assign property rights to the resource (!) Assign property rights to the resource (!) It doesn’t matter who gets the right... It doesn’t matter who gets the right...

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

21. $400 The Free Rider Problem $1000 The firm owns the rights... The firm owns the rights... Quantity of pollution MC MB $ Q* QmQm 0

22. The Holdout Problem The downstream users own the rights... The downstream users own the rights... Quantity of pollution MC MB $ Q* QmQm 0 $2000 $20,000

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

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

25. Dr. D. Foster Microeconomics Market Failure (?): Public Goods, Common Property & Externalities