Chapter 3
Modeling Market Failure
Environmental Pollution
• Market failure is the result of an inefficient market
condition
• Environmental problems are modeled as market failures
using either the theory of public goods or the theory of
externalities
– If the market is defined as “environmental quality,”
then the source of the market failure is that
environmental quality is a public good
– If the market is defined as the good whose production
or consumption generates environmental damage,
then the market failure is due to an externality
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Environmental Quality
A Public Good
• A public good is a commodity that is
nonrival in consumption and yields
nonexcludable benefits
– Nonrivalness – the characteristic of indivisible benefits of
consumption such that one person’s consumption does not
preclude that of another
– Nonexcludability – the characteristic that makes it
impossible to prevent others from sharing in the benefits of
consumption
• Clean air, clean drinking water, clean waste
treatment…
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A Public Goods Market for Environmental
Quality
• Market failure because the nonrivalness and
nonexcludability characteristics prevent market
incentives from achieving allocative efficiency
• Cannot specify / identify / operationalize demand
• Consumers are unwilling to reveal their demand because
they can share in consuming the public good even when
purchased by someone else
• This problem is called nonrevelation of preferences,
which arises due to free-ridership
• In addition, lack of awareness of environmental problems
exacerbates the problem
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Solution to Public Goods Dilemma
• 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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Environmental Problems
A Negative Externality
• An externality is a spillover 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
• Examples: dumping toxic waste in ocean, emitting
gases into local air space
• EPA Toxic Release Inventory
• Externalities caused by doing something we want to
do: produce or consume
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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 external 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
Marginal Private Cost
S:
P = 10.0 + 0.075Q
Marginal Private Benefit
D:
P = 42.0 − 0.125Q, where
Q is thousands of barrels per day
Find the competitive solution
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Competitive Solution
Set
MPB = MPC
42.0 − 0.125Q = 10.0 + 0.075Q
Solve:
QC = 160,000
PC = $22
Analysis:
– This ignores external costs from contamination
– Efficiency requires all costs to be counted in MPC
function
– MPC undervalues (assumes at zero) pollution costs
– QC is too high; PC is too low
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Examples of costs from
pollution
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April 20, 2010: Deepwater Horizon
Explosion
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Finding a Socially Efficient Solution
• Include the external pollution effects, as Marginal External
Costs or Marginal External Benefits (MEC, MEB)
• Use Marginal Social Cost and Marginal Social Benefit (MSC,
MSB)
• Instead of just MPC, use MSC=MPC+MEC
• Instead of just MPB, use MSB=MPB+MEB
• Assume Marginal External Cost (MEC) = 0.05Q
MSC = 10.0 + 0.075Q + 0.05Q
= 10.0 + 0.125Q
• Assume no external benefits, MEB = 0, so MSB = MPB
• Find the new efficient (for real) solution
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Efficient Solution
• Set MSC = MSB
• 10.0 + 0.125Q = 42.0 - 0.125Q
QE = 128,000 PE = $26
• In the presence of an externality, market forces cannot
determine an efficient outcome
• If externality is negative, market Q is too low, market P is
too high
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P per barrel
42
MSC = MPC + MEC
S =MPC
PE = 26
PC = 22
10
D = MPB = MSB
0
128
QE
160
QC
Q (thousands)
Measuring Society’s Net Gain
From Social Efficiency
• As Q falls from 160 to 128:
 Refineries lose p (MPB over MPC) for each unit
of Q reduced [area WYZ]
 Society gains accumulated reduction in MEC for
each unit of Q reduced [area WXYZ]
 Net gain = Area WXYZ - Area WYZ = Area WXY
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Measuring Society’s Net Gain
P per barrel
Refined Petroleum Market
42
PE = 26
Society gains WXYZ; refineries
lose WYZ; net gain is WXY
W
X
MSC = MPC + MEC
S = MPC
Y
PC = 22
Z
10
D = MPB = MSB
0
QE = 128 QC = 160
Q (thousands)
• Both externality and public goods models
show inefficiency of private market
solution, i.e., market failure
• Pigou’s solution for externalities:
– Make sure consumers and producers work off
MSB and MSC curves
– Make sure consumers and producers do not
work of MPB and MPC curves
• Another solution: by Coase
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Ronald Coase
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Property Rights
• Property rights are “valid claims to a good
or resource that permit use and transfer of
ownership”
• For environmental goods, it’s often unclear
who has property 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 will allow
bargaining between parties such that efficient
solution results, regardless of who holds rights
– Assumes costless transactions
– Assumes damages are accessible and
measurable
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Building the Model
Refined Petroleum Market
• Refineries use the river to release chemicals as
an unintended by-product of production
– Objective: to maximize p
• Recreational users use the river for swimming
and boating
– Objective: to maximize utility
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Bargaining When Rights Belong to
Refineries
• Recreational users are willing to pay refineries
for each unit of Q not produced
• Will pay up to the negative effect on utility (MEC)
• Refineries are willing to accept payment not to
produce
• Will accept payment greater than their loss in
profit from reducing production (Mp)
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Bargaining When Rights
Belong to Refineries
• Initial point is Qc, since the refineries, who own
the rights, would choose this point
• Recreational users:
Willing to offer a payment r
r < (MSC - MPC), or r < MEC
• Refineries:
Willing to accept payment r
r > (MPB - MPC), or r > Mp
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P per barrel
Bargaining
Process
Between Q and Q , MEC >
C
E
Mp, so bargaining proceeds
42
MSC = MPC + MEC
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W
22
Z
X
Y
S =MPC
MEC at Qc is XY
Mp at Qc is 0
Bargaining begins
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At QE, MEC = Mp, so
bargaining ends
0
D = MPB = MSB
128
QE
160
QC
Q (thousands)
Bargaining Process
• Bargaining should continue as long as:
(MSC - MPC) > r > (MPB - MPC) or
MEC
>r >
Mp
• At QC: Refineries’ Mp = 0, but MEC > 0, (distance XY)
– Since MEC > Mp, bargaining begins
• Between QC and QE, same condition holds
• At QE: MEC = Mp, (distance WZ); output reductions
beyond this point are infeasible, since Mp > MEC
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Bargaining When Rights Belong to
Recreational Users
• Bargaining will proceed analogously
• An efficient outcome can be realized
without government intervention
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Limitations of the Coase Theorem
• Bargaining is too difficult
• Transactions costs are too high
• Transactions costs:
–
–
–
–
Costs of identifying damage
Costs of agreeing on damage
Costs of negotiating settlement
Costs of enforcing payment
• Negative incentive (repeat offender)
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Coase Theorem
①Problem; negative externalities
②Really a problem of property rights
③Assign property rights
④Bargain to get to socially efficient solution
⑤Cannot bargain because of transactions
costs
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Solutions
One solution:
• Internalize externality by assigning property rights
• Make sure bargaining can happen
Or:
• Set policy prescription (standards, taxes…)
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Very big issues here
• Public goods – address with government
provision
• Externalities – address with property rights
or other policies
• Key theory: MSC not MPC / MSB not MPB
• MSC = MPC+MEC MSB = MPB+MEB
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