Market Failures and
Thermodynamics
Another word on Pareto
efficiency
• A Pareto inefficient outcome is one that
fails to make all trades that could benefit
one person without leaving someone else
worse off
• A reallocation or redistribution in which
some people are made better off and
others worse off is Pareto incomparable to
the prior allocation. It is not Pareto
inefficient.
Quick Review
• Excludability
– Policy variable
– Some resources are inherently non-excludable
• Rivalry
– If a resource is rival and scarce, should ration
access
– Non-rival resources not depleted through use,
should not be rationed
• Marginal cost of use = 0
• Rationing creates artificial scarcity
Rivalness
• Anti rival (additive)
– My use makes you better off
– What's an example?
• Abundance, scarcity and rivalry
– Rival and abundant: oxygen
– Rival and borderline: Crowded beach
– Rival and scarce: oil
So What?
Excludable
Rival
Non-rival,
Anti-rival
Market Good: cars,
houses, land, oil,
timber, waste
absorption capacity?
Tragedy of the noncommons:
property rights to
genetic info., patented
information, e.g. nonozone dep. comp.
Toll Good, club good:
Congestible Roads, parks, beaches.
natural monopolies.
Non-Excludable
Open Access Regime:
Oceanic fisheries, timber
etc. from unprotected
forests, waste absorption
capacity
Pure Public Good:
Information, most ecosystem
services, e.g. climate
stability, coastline protection,
life support functions, etc.
Free Rider Problem
Open Access
• The “Tragedy of the commons”
• Common property vs. open access
Solutions to Open Access
• Rival and scarce resources must be
rationed
• Rationing requires property rights
– Public, private or common
• Private property allows markets and price
rationing
– Who gets ownership? Distribution matters!
Public Goods
• Free-riding
• No price signal as feed-back mechanism
– Scarcity

price increase
 innovation
•Lack of Incentives to produce or protect
them
•Costs of degradation ignored
• Private profits, socialize costs
•Lack of incentives to create technologies
that provide them
Public Goods (cont.)
• Free-market enthusiasts don’t deny public
good problem, but claim they are relatively
unimportant
• Increasing scale and public goods
• Are stable climate, ozone layer, disturbance
regulation (e.g. storm protection) and other life
support functions relatively unimportant?
Solutions for Public Goods
• Public goods created by rival, scarce
resources
– Ecosystem structure
– Built infrastructure
– Human capital
• Requires public investment in production
and protection
• Public goods generate non-rival services
– Rationing inefficient
– Open access is efficient
Non-rival & Excludable: tragedy of
the non-commons
• Why do we have patents?
• When did patents come about?
– 1790s in US
– 1947 international, rarely used before 1980s
Patents: efficiency and
sustainability
• Create inadequate incentives for inventions that
provide or preserve public goods
• Raise costs for research
– Profit motive prevents sharing of knowledge
• Monopolies on non-rival resource
– Expensive to enforce
• Prices ration use
• Examples: new technology for highly efficient
solar energy; non-ozone depleting technologies;
Indonesia’s avian flu
Patents and just distribution
• Samuel Slater,
“Father of American
Industry”
• Developed countries
own 97% of all
patents
• Raises costs for
research that meets
the needs of the poor
– Golden corn
• “Standing on the
shoulders of giants”
Solution to Tragedy of Noncommons
• Public investment, common ownership
• Land grant universities, e.g. UVM
• Rate of return on investments in public
sector agriculture R&D 60-80% per year
Natural Monopolies
•
•
•
•
Excludable
High fixed costs, low marginal costs
Rival goods (e.g. water, electricity, etc.)
Non-rival goods (e.g. information)
Market goods: The theory of
Externalities
Externalities
• Definition
– “an activity by one agent causes a loss (gain)
of welfare to another agent”
– “The loss (gain) of welfare is
uncompensated”
• Completely Internal to the Economic
Process. Why?
• Externalities and profit maximization
• How are these related to public goods?
Example: Conversion of Mangrove
Ecosystems to Shrimp Aquaculture
Values of Natural Capital:
Mangrove Ecosystems
•Structure, raw materials, stock-flow
resources
•Building materials, charcoal, food
•Function, ecosystem services, fundservices
•Storm protection
•Habitat, nursery
•Waste absorption
•Climate stabilization
Values of Conversion
Shrimp Aquaculture
•High short term profits, heavily promoted by economists
•Shrimp and fish for 3-5 years
•Carnivorous, net reduction in food production
•Less protein than intact ecosystem
•Massive waste output
•Irreversible(?) destruction of ecosystem
•Why convert?
Impact of Conversion
•On natural capital:
•Loss of Ecosystem services
•Loss of fish production
•On social capital?
•On human capital
‘Optimal’ pollution/degradation
Solutions for Externalities:
Regulations
• Best management practices
• Best available technologies
• Caps on resource extraction, waste
emissions, e.g. no conversion of
mangroves to shrimp aquaculture
• Non-market mechanism. Producers
cannot adjust MC to equal MB
– But costs and benefits may not be directly
comparable
Market Solution: Property Rights
• Who owns the environment?
• polluter ‘rights’
• sufferer rights
• What about future generations?
Market Option I: Property Rights
Shrimp aquaculture
Problems with property rights
• Transaction costs
– in absence of transaction costs, no negative
externalities
– What are transaction costs likely to be for externalities
affecting public goods?
– How many Filipinos affected by typhoon?
• Wealth effect
• Intergenerational externalities
Market Solutions 2: Pigouvian
Taxes
• Tax externalities
– Ideal tax = marginal cost, e.g. gas tax $12.00
gallon
– Can costs be measured in monetary terms?
• Basic idea
– Set price, let this determine Q at which
demand = price
– Price determines scale
‘Market’ Option 2: Pigouvian
tax: Getting prices right
tax
Market Solutions 3: Cap and
trade/ Cap and auction
• 3 steps
– Sustainable scale: Set cap
– Just distribution: determine property rights,
e.g. do resources belong to those who exploit
them, or to public?
– Efficient allocation: Tradable quotas (Cap and
Trade) or public auctions (cap and auction)
• Basic rule: scale is price determining
'Market' Option 3: Tradable Quotas:
setting ecologically sustainable scale
quota
What’s better, tax or quota?
• Prices adjust to ecological constraints
faster then ecosystems adjust to economic
impacts
• Distributional impacts
– Taxes
– Quotas
Ignorance and Uncertainty
• Perfect markets require perfect information
• Asymmetric information
– Nobel Prize in 2000
– Theory of the Lemon
•
•
•
•
Irreducible ignorance
Time lags
Ecosystem function
Solution: better information flows, precautionary
principle
Asymmetric Preference Formation
• What forms our preferences?
• In what direction are our preferences
pushed, towards market or non-market
goods?
• Solution: balanced information flows
Missing markets
• For a market to work, everyone must be
able to participate
• Future generations can’t participate in
today’s markets
• People without money cannot participate,
e.g. many indigenous peoples
• How much would the Mona Lisa sell for if it
were auctioned off in St. Albans?
• Solution: inalienable property rights for
future generations