Chapter 3
Modeling Market Failure
1. Environmental Pollution:
A Market Failure
• Market failure is the result of an __________
market condition
• Environmental problems are modeled as
market failures using either the theory of
public goods (the market is defined as
“environmental quality”) or the theory of
externalities (the market is defined as the good
whose production or consumption generates
environmental damage)
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2. Environmental Quality:
A Public Good
• A public good is a commodity that is _________
______________ and yields _____________
benefits
• An example: environmental quality
Two classic examples of public goods are
a lighthouse and national defense.
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Important Characteristics of Goods
• A good is excludable if a person can be
prevented from using it if he does not pay for it.
– excludable: fish tacos
– not excludable: national defense
• A good is rival in consumption if one person’s
use/consumption of it diminishes others’
use/consumption.
– rival: fish tacos
– not rival: national defense
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Classic division of
goods in economy
Excludable
(have to pay)
Not excludable
Rival in consumption
(consumption
diminishes its value)
Not rival
private goods:
food
clothing
natural monopolies
(club goods):
cable TV
common resources:
fish in the sea
environmental quality?
public goods:
national defense
tornado siren
environmental quality
(our book)?
Public access without any
control leads to
depletion/overuse/exploitation
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3. A Public Goods Market for
Environmental Quality
• Air quality (measured by reductions in SO2)
market
• Market supply:
Some number of hypothetical producers are
willing and able to supply various reductions in
SO2 at different price levels
Market supply: P = 4 + 0.75QS
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• Market demand:
In theory, market demand for a public good is
found by vertically summing individual demands
– Vertical sum because we must ask consumers “What
price would you be willing to pay for each quantity of
the public good?”
For a private good, the market demand is
found by horizontally summing individuals’
demands.
“What quantity of this good would you
consume at each price?”
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Demand for consumer 1:
p1 = 10 – 0.12QD
+ Demand for consumer 2:
p2 = 15 – 0.18QD
Demand for consumers 1 & 2: p1 + p2 = 25 – 0.3QD
Market demand: P = 25 – 0.3QD
Check page 57: Figure 3.1
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Market supply: P = 4 + 0.75QS
Market demand: P = 25 – 0.3QD
– Equilibrium found where
4 + 0.75QS = 25 – 0.3QD, or
where QE = ___ percent
and
PE = $___ million
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Page 59: Figure 3.2
P
($ millions)
S
25
PE = 19
4
0
D
QE = 20
Q (% of SO2 abatement)
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Comment 1:
• QE (=20%):
--efficient or optimal level of abatement
--not necessarily 100% (which means zero
pollution)
1. Efficient level is at MB =MC
2. Zero pollution: forgone production and
consumption of any good generating
even the smallest amount of pollution
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Comment 2:
• Consumers are unwilling to reveal their WTP because
they can share in consuming the public good even
when purchased by someone else
--This problem arises due to free-ridership
--Result is that market demand is undefined
--Consequently, allocative efficiency cannot be
achieved without third-party intervention
--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
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Public Goods
• Public goods are difficult for private markets to
provide because of the free-rider problem.
• ________: a person who receives the benefit of
a good but avoids paying for it
– If good is not excludable, people have incentive to
be free riders, because firms cannot prevent nonpayers from consuming the good.
• Result: The good is not produced, even if buyers
collectively value the good higher than the cost
of providing it.
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Example:
Imagine a city in which 60,000 people are living.
There is a chance to install a tornado warning
system at the cost of $60,000. Each person may be
prepared to pay $1. However, it is quite possible
that some people will refuse to pay, and instead
hope that others will pay for the system anyway,
and they receive the benefit for no personal
expense. The result is that it is possible no system
will be installed.
a tornado warning system--______________
some people--______________
the result--________________
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4. Environmental Problems:
Externalities
• An externality is a ____________ 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
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Pollution: A Negative Externality
• Example of negative externality:
Air pollution from a factory.
– The firm does not bear the
full cost of its production,
and so will produce
more than the
socially efficient quantity.
• How govt may improve
the market outcome:
– Impose a tax on the firm equal to the
external cost of the pollution it generates
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5. Environmental Damage:
A Negative Externality
• Environmental economists are interested in
externalities that damage the atmosphere,
water supply, natural resources, and overall
quality of life
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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 _________ cost (MEC)
• Problem: Producers (refineries) have no
incentive to consider the externality
• Result: Competitive solution is inefficient
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Finding a Competitive Solution
Refined Petroleum Market
• S:
• D:
P = 10.0 + 0.075Q
P = 42.0 - 0.125Q, where
Q is in thousands of barrels per day
• Since S is MPC and D is MPB, rewrite as
MPC = 10.0 + 0.075Q
MPB = 42.0 - 0.125Q
(P means private)
• Find the competitive solution and analyze
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Competitive Solution
• Set MPB = MPC
42.0 - 0.125Q = 10.0 + 0.075Q
• Solve:
QC = _____ thousand; PC = $___ per barrel
(C means competitive)
• Analysis:
– This ignores external costs from contamination
– QC is too high; PC is too low
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Finding a Socially Efficient Solution
Refined Petroleum Market
• Let Marginal External Cost (MEC) = 0.05Q
• Marginal Social Cost (MSC) = MPC + MEC
– MSC = 10.0 + 0.075Q + 0.05Q
=
_______________
• Marginal Social Benefit (MSB) = MPB + MEB
– Assuming no external benefits, MEB= 0, so MSB =
MPB
• Find the efficient solution; show graphically
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Socially Efficient Solution
• Set MSC = MSB
--10.0 + 0.125Q = 42.0 - 0.125Q
--Solving: QE = ___ thousand; PE = $___/barrel
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MSC, MPC, MPB Graph
P ($ per barrel)
42
Page 67
MSC = MPC + MEC
S =MPC
PE = 26
PC = 22
10
D = MPB = MSB
0
128 160
QE QC
Q (thousands)
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• Results of negative externality
--QC (160) is higher than QE (128), since the firm
does not bear the full cost of its production,
and so will produce more than the socially
efficient quantity (overallocation of resources)
--PC (22) is lower than PE (26), since MEC is not
captured by market transaction
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Important Observations
• Both externality and public goods models
show inefficiency of private market solution,
i.e., market failure
• Underlying source of failure is absence of
property rights
– Recall Boston Harbor application
Because no one owns the atmosphere or the
earth’s rivers, there is no market incentive to
prevent or correct contamination of these
resources. Government is needed.
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6. Absence of Property Rights
The Coase Theorem
Ronald Coase, Nobel Laureate, 1991
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Property Rights
• Valid claims to a good or resource that permit
the use and transfer of ownership through sale
• For environmental goods, it’s unclear who
“owns” rights
• Economics says it’s the absence of rights that
matters, not who possesses them
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Coase Theorem
• Proper assignment of property rights, even if
externalities are present, will allow bargaining
between parties such that efficient solution
results, regardless of who holds rights
– Assumes costless transactions
– Assumes damages are accessible and measurable
In economics, a transaction cost is a cost
incurred in making an economic exchange. It
includes: search and information cost,
bargaining cost, and enforcement cost.
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The Coase Theorem: An Example
Dick owns a dog named Spot.
_____________ externality:
Spot’s barking disturbs Jane,
Dick’s neighbor.
The socially efficient outcome
maximizes Dick’s + Jane’s well-being.
– If Dick values having Spot more
See Spot bark.
than Jane values peace & quiet,
the dog should stay. Otherwise, the dog should go.
Coase theorem: The private market will reach the
efficient outcome on its own…
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The Coase Theorem: An Example
• CASE 1:
Dick has the right to keep Spot (Jane needs to
pay Dick to get rid of Spot).
Benefit to Dick of having Spot = $500
Cost to Jane of Spot’s barking = $800
• Socially efficient outcome:
Spot goes bye-bye.
• Private outcome:
Jane pays Dick $600 to get rid of Spot,
both Jane and Dick are better off.
• Private outcome = efficient outcome
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The Coase Theorem: An Example
• CASE 2:
Dick has the right to keep Spot (Jane needs to
pay Dick to get rid of Spot).
Benefit to Dick of having Spot = $1000
Cost to Jane of Spot’s barking = $800
• Socially efficient outcome:
See Spot stay.
• Private outcome:
Jane not willing to pay more than $800,
Dick not willing to accept less than $1000,
so Spot stays.
• Private outcome = efficient outcome
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The Coase Theorem: An Example
• CASE 3:
Jane has the legal right to peace & quiet (Dick
needs to pay Jane to keep Spot).
Benefit to Dick of having Spot = $500
Cost to Jane of Spot’s barking = $800
• Socially efficient outcome: Spot goes bye-bye.
• Private outcome:
Dick not willing to pay more than $500,
Jane not willing to accept less than $800,
so Spot goes bye-bye.
• Private outcome = efficient outcome
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The Coase Theorem: An Example
• CASE 4:
Jane has the legal right to peace & quiet (Dick
needs to pay Jane to keep Spot).
Benefit to Dick of having Spot = $1000
Cost to Jane of Spot’s barking = $800
• Socially efficient outcome: Spot stays.
• Private outcome:
Dick pays Jane $900 to keep Spot,
both Jane and Dick are better off.
• Private outcome = efficient outcome
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The private market achieves the efficient
outcome regardless of the initial
distribution of rights.
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Solution to Externalities
Government Intervention
a private solution
• Internalize externality by:
– Assigning property rights, OR public solutions
– Setting policy prescription, such as:
• Set standards on pollution allowed Ch4
• Tax polluter (= MEC at QE)
Ch5
• Establish a market and price for pollution Ch5
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Consumption externalities
Production externalities
Positive
Negative
Positive
Negative
The benefits to
the rest of
society of
people being
vaccinated
before traveling
abroad
Noise
pollution
from using
car stereos
The benefits to
the environment
that arise from
the planting of
woodland by a
forestry company
Wastes
being
dumped
into a
river by a
company
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