Resource Use and Economic Inefficiency
Dr. A K M Nazrul Islam
Associate Professor
Dhaka School of Economics
September 7, 2022
The Working of the Invisible Hand

Adam Smith’s The Wealth of Nations argues that
markets lead to socially efficient allocation of
resources. People acting in their own best interests
tend to promote the social interest.

Anti-globalization protestors counter
markets are the root of all social evils.

The truth probably lies somewhere in between.
that
free
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Market Fundamentals

Begin by looking at an every day private good.

The goal is to understand the differing
components of a market.

After we understand how a market works, we
can add the complexity associated with the
impact of market activity on the environment,
and the impact of the environment on market
activity and society in general.
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Market Failure: When the Invisible Hand
Doesn’t Work

Market Failure occurs when the market does not allocate
resources efficiently.

There are 5 categories of market failure:

Imperfect competition/ Monopoly market

Imperfect information/ Asymmetric information

Public goods

Inappropriate government intervention

Externalities.
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Imperfect Competition

Imperfect competition occurs when the individual
actions of particular buyers or sellers have an impact
on market price.

Monopoly = a single seller

Examples of monopoly: railways, electricity (regulated),
etc.

Market failure due to imperfect competition has an
impact on the study of environmental and natural
resources because of the monopoly power in
extractive industries such as oil and coal.
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Monopoly – 1: Seller who controls the
market
$
Marginal Cost
P1
Marginal
Revenue
Demand
Q1
Q*
Quantity
6
Figure: Imperfect Competition
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Monopoly (imperfect competition)

Creates market failure

In imperfectly competitive markets, marginal
revenue diverges from price and marginal social
cost is not equal to marginal social benefit at
equilibrium.

Monopoly is inefficient

Why else don’t we like monopoly?
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Imperfect Information

Imperfect information means that some segment of the
market (either consumers, producers, or both) does not
know the true costs or benefits associated with the good
or activity.

For example:



High risk occupations where workers do not have
complete information about risks.
Hazards of using chemicals in your home where you may
not be fully aware of dangers and potential side-effects.
Potential that farmers in developing countries are not
aware of environment-friendly alternatives to clear cutting.
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Public Goods

Public goods are distinguished from private goods by
two primary characteristics: non-rivalry and nonexcludability.

Non-rivalry means that one individual’s consumption
does not diminish the amount of the public good
available for other’s to consume.

Non-excludability means that if one person has the
ability to consume the public good, then others can’t
be excluded from consuming it.
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Public Goods

National defense is an example of a pure public
good.

Non-excludability holds because in protecting
one citizen in a region from missile attack, every
citizen is protected.

Non-rivalry holds because one citizen’s
consumption of protection does not reduce the
level of protection available to other citizens.
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Public Goods

Not all public goods are pure public goods.

It is possible to build a long fence around the
Sundarbans to exclude people.

It is also true that beyond some point, more
people at the Sundarbans reduces the quality of
the experience for everyone.
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Figure: Spectrum of public goods
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Public goods: Demand
Market Demand = VERTICAL sum of demands
$
DA
DB
Marginal Cost
QB
QA
Q*
Quantity
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Public Goods, inefficient outcome of
free market

Generally, too few public goods provided by free
market

Free riding = get enjoyment out of public good
provided by others without paying for it

Does this happen?

Government provision of public goods with taxation
to pay for them is often justified based on these
inefficiency arguments
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Inappropriate Government Intervention

Government intervention is a potential source of
disparity between private and social values.

Government action to address an alternative
issue may create a divergence.

Government policy regarding leasing of
timbering has created a greater than socially
optimal level of timber harvest.
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Figure: Inappropriate Government
Intervention
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Externalities

A common cause of market failure is the
divergence externalities create between private
and social costs.

Consider a production process which reflects
all the private costs of production but does not
reflect all the social costs associated with
production (for example, if the process
generates air pollution).

Now, marginal social cost is different from
marginal private cost
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Externality: Pollution from a factory
$
Marginal
Damage from
pollution
Quantity of Steel Output
19
Figure: Steel Production Example
MSC = MPC + Marginal Damage from pollution
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Market Failure

Market forces generate an equilibrium production level
and price associated with private costs (Q1 and P1).

This output level is greater than the socially optimal
level of Q* (which considers additional cost from
pollution).

The shaded area in the previous figure represents the
costs to society of having this higher than optimal level
of output. Too much output is generated by the free
market.

Shaded area = “deadweight loss” or lost social “net
benefits” from too much production
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Externalities

Externalities are best described as “spill-over
costs or benefits”, unintended consequences or
side
effects,
associated
with
market
transactions.

These unintended costs or benefits will result in
a divergence between private and social
benefits and costs.

Externalities are perhaps the most important
class of market failures for the field of
environmental and resource economics.
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Externalities

A more complete definition is provided by
Baumol and Oates (1988, p.17):

“An externality is present whenever some
individual’s (say A’s) utility or production
relationships
include
real
(that
is
nonmonetary) variables, whose values are
chosen by others (persons, corporations,
governments) without particular attention to
the effects on A’s welfare.”
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Production and Utility Relationships

Air pollution has the potential to impact both
production and utility relationships.

Air pollution may create a less ideal growing
condition and impact yields.

Air pollution may also make outdoor activities
less enjoyable (reduce utility).

These
are
externalities.
examples
of
technological
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Technological vs. Pecuniary Externalities

Consider the next figure which represents a production
possibilities frontier for two goods: cotton and steel

The production possibilities frontier shows all feasible
production points.

Consumer
preferences
determine
the
combination of cotton and steel produced.

A change in consumer preferences will result in a
change in demand, which changes prices and profit
potential, which, in turn, will cause a change in
production levels of both goods (along the same
production possibilities frontier). This is a pecuniary
externality.
actual
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Figure: Production Possibilities Frontier
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Technological vs. Pecuniary Externalities

What happens if cotton production
damaged by steel generation?
was

Suppose, pollution reduces the yield per acre of
cotton with the existing resource base.

A new lower production possibilities curve
results from this externality.

This
is
a
technological
externality.
Technological externalities can be a cause for
government intervention- market failure
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Externalities as Public Goods

Referred to as non-depletable externalities,
these are characterized by the public good
property of non-rivalry.

Air pollution that obscures a beautiful view is a
good example where one person’s consumption
of the externality (seeing the pollution) does not
reduce the amount of pollution to which others
are exposed (next guy that drives by still see
cruddy view).
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Market Failure and Property Rights:
Open-access problems



A special class of externality that is generated
by the lack of property rights (or the inability to
enforce property rights) is the open-access
externality.
In this case property rights are insufficient to
prevent general use of a resource and
uncontrolled use leads to destruction or damage
of the resource.
We will discuss this type of externality in detail
later when we discuss renewable resource
problems, fisheries and wildlife very susceptible
to open-access problems
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The Invisible Hand and Equity





Market allocation of resources, absent of market
failure, is efficient.
An efficient allocation maximizes the difference
between social benefits and social costs.
An efficient allocation, however, does not imply
equitable allocation.
The “best” distribution depends on what view of equity
or fairness is held.
Some (many?) arguments for government intervention
relate to equity, what we have studied here are
arguments based on efficiency, getting the most value
for the most people.
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Conclusion

Much of this analysis focuses on markets and
how markets efficiently allocate goods and
services.

When market failure occurs, marginal private
benefits diverge from marginal social benefits
and marginal private costs diverge from
marginal social costs.

Market failure results from externalities, public
goods,
imperfect
information,
imperfect
competition and inappropriate government
intervention.
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