ENV 536: Environmental
Economics and Policy
(Lecture 4)
Modeling Market Failure
Asst.Prof. Dr. Sasitorn Suwannathep
School of Liberal Arts
King Mongkut’s University of Technology
Thonburi
1
Market Failure
Based on the materials balance model, we
know that economic activities generate
residuals that can damage natural
resources.
 Why dose pollution persist.
 Why is the market unable to respond to
environmental pollution, or can it?
 The answer is due to market failure.
 Market failure occurs because the
assumption of perfect competition failed to
fully function.

2
Analytical Tools to Understand
Market Failure
 Environmental
quality as a public
good
the theory of public good
 Environmental damage as a
externality
the theory of
externality
3
Environmental Quality: A Public Good
A
public good: a commodity that is
nonrival in consumption and yields
benefit that are nonexcludable.
– Nonrivalness: the characteristic of
indivisible benefits of consumption: one
person consumption does not preclude
another.
– Nonexcludability: the characteristic of
impossibility to prevent other from
sharing the benefits of consumption.
4
Environmental Quality: A Public Good
(con’t)
 the
nonrivalness and nonexcludability
characteristics of public goods prevent
natural market incentives from
achieving an allocative efficient
outcome.
5
A Case Study of Public Good:
Air Quality *
 Air
quality can be defined as “an
acceptable level of pollution
abatement” some percentage
reduction in sulfur dioxide (SO2)
emission.
* For details see Callan and Thomas Ch. 4 p. 58-64
6
A Case Study of Public Good:
Air Quality (con’t)
Market Supply for Air Quality
 The producers are willing and able to
supply various reductions in SO2 at
different price level.
 the aggregation of these production
decisions gives rise to market supply.
Market supply: P = 4 + 0.75 Qs
Qs: a percentage of SO2 abatement
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A Case Study of Public Good:
Air Quality (con’t)
Market Demand for Air Quality
 Market demand for a public good is
different from a private good.
 Once
the public good is provided, it is
available at the same quantity to all
consumers (nonrivalness
characteristic).
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A Case Study of Public Good:
Air Quality (con’t)

Private good
– What quantity of
this good would you
consume at each of
following prices?
– Horizontally
summing
– At given price level,
sum quantities of
each consumer

Public good
– What price would
you be willing to
pay for each
quantity?
– Vertically summing
– At given quantity
level, sum prices of
each consumer
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A Case Study of Public Good:
Air Quality (con’t)
 In
the public good theory, each
consumer should express a unique
“willingness to pay (WTP)” for the
public good based on the benefits
each expects to derive consumption
Demand for consumer 1: p1 = 10 – 0.12 QD
Demand for consumer 2: p2 = 10 – 0.18 QD
Market demand: p1 + p2
= 25 – 0.3 QD
A critical assumption is that consumers would reveal their willingness to
10
pay for SO2 abatement.
Source: Callan, S. J. and Thomas, J. M. 2007. Environmental Economics and Management:
Theory, Policy, and Applications.
11
Equilibrium in the Air Quality
Market
 Equilibrium
in the air quality market
comes from the combination of
market demand and market supply.
At equilibrium: Market Supply = Market Demand
4 + 0.75 Qs
= 25 – 0.3 QD
Since Qs = QD, 1.05Q = 21 , then Q = 20 percent
At Q = 20, P = 4 + 0.75 (20) or 25 – 0.3 (20) then P = 19
Source: Callan, S. J. and Thomas, J. M. 2007. Environmental Economics and Management:
Theory, Policy, and Applications.
12
QE represents the efficient
or optimal level of abatement
measure from left to right and
implicitly the optimal level of
pollution measured from right to
left.
Source: Callan, S. J. and Thomas, J. M. 2007. Environmental Economics and Management:
Theory, Policy, and Applications.
13
Assessing the Implication
 Regarding
the air quality market, the
optimal level is not necessarily zero.
 Abating at the 100 percent level to
reduce pollution to zero involves
prohibitive opportunity costs.
14
Market Failure of Public Good Market
An allocatively efficient outcome in a public
good depends on the identification of welldefined demand and supply functions.
 In a public good market, there is no
incentive for a rational consumer to
volunteer a WTP for the good that she can
consume without paying for it.

– Nonrevelation of preferences
– Free-ridership

Even if consumers could be induced to
express their WTP for a public good, it is
highly likely that the resulting demand
price would underestimate the true
benefits.
15
Market Failure of Public Good
Market (con’t)
 In
many public goods markets,
consumer are not fully aware of the
benefits associated with consumption.
 Market
forces alone cannot provide an
allocatively efficient level of a public
good, then intervention by third party
(the government) is required.
– A direct provision of public goods
– Political procedures and voting rules.
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Environmental Problems:
Externalities

This approach specifies the relevant market
as the good whose production or
consumption generates environmental
damage outside the market transaction.
Price fails to capture all the benefits and
costs of a market transaction.
Market
fail.
 A third party is affected by the production or
consumption of commodity.
Externality

A
negative externality: generates cost to a third party
 A positive externality: generates benefit to a third party
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Environmental Problems:
Externalities (con’t)
 If
the consumption generates
external benefits, the market price
undervalues the good, too little of
production.
 If there is a negative externality, the
market does not reflect the external
costs, and too much of the
commodity is produced.
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Negative Externality: A Case of
Refined Petroleum Products
 Assume
the private market for
refined petroleum is competitive and
no external benefits.
Supply:
P = 10.0 + 0.75 Q
Demand:
P = 42.0 - 0.125 Q
Where Q: thousands of barrels per day
P: the price per barrel
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Negative Externality: A Case of
Refined Petroleum Products
 Supply
represents the marginal cost
of production (or marginal private
cost: MPC) and demand represents
the marginal benefit of consumption
(or marginal private benefit: MPB).
MPC
= 10.0 + 0.075 Q
MPB
= 42.0
- 0.125 Q
20
Source: Callan, S. J. and Thomas, J. M. 2007. Environmental Economics and Management:
Theory, Policy, and Applications.
21
Inefficiency of the Competitive
Equilibrium
At the equilibrium, we ignore the external
costs to society of contaminated water
supplies caused by the refined petroleum
production.
 The costs of water pollution are external to
the market exchange and consequently are
not factored into private market decisions.
 The MPC undervalues the opportunity costs
of production, and resulting output level is
too high.
 The economists have identified and
monetized external costs and applied in the
analysis.
Marginal external cost (MEC)

22
Marginal Social Costs (MSC)
Marginal Social Costs (MSC) = MPC + MEC
Where, MPC
MEC
= 10.0 + 0.075 Q
= 0.05 Q
Then MSC = 10.0 + 0.125 Q
 The
marginal social cost (MSC)
captures all costs of producing
refined petroleum.
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Marginal Social Benefit (MSB)
 The
marginal social benefit (MSB) is
the sum of the MPB and any marginal
external benefit (MEB).
MSB =
MPB + MEB
 If
there is no the MEB, then the MPB
equals the MSB.
 Efficient equilibrium
MSB
=
MSC
MPB + MEB = MPS + MEC
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Efficient Equilibrium
P
Competitive equilibrium with
a negative externality, overallocation
of resource
No MEB, then MSB = MPB
Q
Source: Callan, S. J. and Thomas, J. M. 2007. Environmental Economics and Management:
Theory, Policy, and Applications.
25
Welfare Gain to Society
 Based
on the refined petroleum
production, if the output were
reduced from Qc to QE (32,000
barrels a day), the social’s welfare is
higher.
 From the firm perspective, the
reduction in output causes profit loss
(at QE, MPB > MPC).
26
Profit loss of firm: area WYZ
Society gain: area WXYZ
Area under MEC curve above MPC
But the net gain area WXY
Source: Callan, S. J. and Thomas, J. M. 2007. Environmental Economics and Management:
Theory, Policy, and Applications.
27
Implication on the Refined
Petroleum Production
 Petroleum
refineries are motivated
by private gain, not by social gain.
 The
firms may be aware of the
environmental damage associated
with their production, there is no
incentive for them to absorb these
costs due to negative affect to their
profits even it is good for the society
as a whole.
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The Absence of Property Rights
 The
externality is a public good if it
affected a broad segment of society.
 The environmental good is no
property right, the market dose not
exist.
 Property rights are the set of valid
claims to a good or resource that
permits its use and the transfer of its
ownership through sale.
29
The Coase Theorem

Nobel laureate, Ronald Coase, proposed
that the assignment of property rights
alone can provide for an efficient solution
even in the presence of an externality.
Coase Theorem with two assumptions
– Transaction costs are costless
– Damages are accessible and measurable.

The assignment of property rights to any
good will allow bargaining between the
affected parties such that an efficient
solution can be obtained, no matter which
part holds the rights.
30
Property Rights Belong to the
Refineries
 Refineries
have the right to pollute
the river as part of their production
processes.
 They
prefer to produce up to the
level that maximizes profit, which
will cause negative impact to the
recreational users. The negotiation
between these two parties will be
occurred.
31
Property Rights Belong to the
Refineries (con’t)
Recreational users:
Willing to offer a payment () such that  < (MSC-MPC)
Refineries:
Willing to accept a payment () such that  > (MPB-MPC)
Note: (MSC – MPC) is MEC
(MPB – MPC) is M
The bargaining between two groups should continue as long as
the payment is greater than refineries’ loss in profit but less than
the recreational users’ damage.
(MSC – MPC) >  > (MPB-MPC) or equivalently,
MEC >  > M
32
Recreational users
Bargaining will start
at Q0 until (MPB – MPC) = (MSC – MPC)
If the refineries hold the right, the bargaining
will start at Qc to reduce output
until (MSC – MPC) = (MPB – MPC)
Source: Callan, S. J. and Thomas, J. M. 2007. Environmental Economics and Management:
Theory, Policy, and Applications.
33
Property Rights Belong to the
Recreational Users
Refineries:
Willing to offer a payment () such that  < (MPB-MPC)
Recreational users:
Willing to accept a payment () such that  <(MSC-MPC)
(MPB-MPC) >  > (MSC – MPC) or equivalently,
M >  > MEC
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Limitations of the Coase Theorem
 The
application of the Coase Theorem
depends on two assumptions.
– Transaction costs are costless
– Damages are accessible and measurable
 It
will be practical if there is a case
which few individuals are involved on
each side of the market.
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Common Property Resource

The resources that property rights are
shared by some group of individual.
– Common property resources are not accessible to
everyone, some excludability.
– The rights extend to more than one individual
(co-owner makes decision about using resources
based only on private costs and benefits ignoring
the impact of other owners).

The solution: The government would have to
make this determination as well as enforce
limitations on the rights for the good of
society.
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