Market Failure
All pollution should be eliminated.
Strongly Agree
Agree
Neutral
Disagree
Strongly Disagree
a)
b)
c)
d)
e)
1
2
3
4
5
0%
0%
0%
0%
0%
a)
b)
c)
d)
e)
Market Failure
When the market does not efficiently
allocate resources
 Either too much or too little is produced




Monopoly
Externalities
Public goods
Justification for
government intervention?
Externalities


Occur when decision makers do not consider
all costs (or benefits) of their actions
Two views
“Spillover effects”
A. C. Pigou
Ronald Coase
Pigouvian Approach
Social Cost = Private Cost + External Cost
Price of beer
Hangover
Damage to others
Boorish behavior
Drinking Alcohol
Cashmere Externalities
Pollution
Ssocial

Free Market: P1, Q1

Optimal Outcome: P2, Q2
$
Sprivate
P2
P1
External cost
Free market overproduces goods
that generate a negative externality
D1
How can society achieve social optimum?
 Impose tax = marginal external cost
Internalize the externality!
Q2 Q 1
“Pigou tax”
steel
The efficient output will be less than the free
market output when:
d)
a)
0%
1
2
3
4
5
0%
0%
0%
d)
c)
c)
b)
Marginal social cost and marginal
private cost are equal
Marginal social cost is greater
than marginal private cost
Marginal social benefit and
marginal private benefit are
equal
Marginal social benefit is greater
than marginal private benefit
b)
a)
Education

Free Market: P1, Q1

Optimal Outcome: P2, Q2
$
S1
P2
External benefit
P1
Free market underproduces goods
that generate a positive externality
Dsocial
Dprivate
How can society achieve social optimum?
 Provide subsidy = marginal external benefit
Q1
Q2
Years of
College
If there is a positive externality, the:
a)
social benefits will be greater
than the private benefits
external benefits will be
greater than the social benefits
social benefits will be equal to
the private benefits
private benefits will be greater
than the social benefits
b)
c)
d)
1
2
3
4
5
fit
s
w
i..
w
i..
ne
be
at
e
pr
iv
ci
al
be
ne
fit
s
ne
fit
...
be
so
te
rn
al
ex
so
ci
al
be
ne
fit
s
w
...
0% 0% 0% 0%
A consequence of a negative consumption externality is that social
benefits are ______ than private benefits, and the socially optimal
level of output is ______ than the private level of output.
a)
b)
c)
d)
greater; greater.
greater; less.
less; less.
less; greater.
1
2
3
4
5
;l
le
ss
te
r.
;g
ss
le
re
a
es
s.
ss
.
le
te
r;
gr
ea
gr
ea
te
r;
gr
ea
te
r
.
0% 0% 0% 0%
Pollution Worksheet


Optimal pollution for Marietta-Parkersburg
area is 60,000 units of emissions
Abatement Cost




Cars: $5
Utilities: $10
Factories: $20
Controlling pollution through:



Standards
Taxes
Tradable Permits
Standards

“Command-and-Control” approach


Emission standards
Technology standards
Set a maximum emissions of 20,000 units per source:
SOURCE
EMISSIONS
EMISSIONS
ABATED
ABATEMENT
COSTS
CARS
20,000
0
0
UTILITIES
20,000
10,000
$100,000
FACTORIES
20,000
20,000
$400,000
60,000
30,000
$500,000
TOTAL
Standards
Require each source to cut emissions by 10,000 units:
SOURCE
EMISSIONS
EMISSIONS
ABATED
ABATEMENT
COSTS
CARS
10,000
10,000
$50,000
UTILITIES
20,000
10,000
$100,000
FACTORIES
30,000
10,000
$200,000
60,000
30,000
$350,000
TOTAL
Standards
Require each source to cut emissions by 1/3:
SOURCE
EMISSIONS
EMISSIONS
ABATED
ABATEMENT
COSTS
CARS
13,333
6,667
$ 33,335
UTILITIES
20,000
10,000
$100,000
FACTORIES
26,667
13,333
$266,660
60,000
30,000
$399,995
TOTAL
Standards
Cost minimizing strategy of reducing emissions by 30,000 units.
SOURCE
EMISSIONS
EMISSIONS
ABATED
ABATEMENT
COSTS
0
20,000
$100,000
UTILITIES
20,000
10,000
$100,000
FACTORIES
40,000
0
0
60,000
30,000
$200,000
CARS
TOTAL
“$200,000 Solution”
Taxes
A tax of t = $6 per unit of pollution is imposed:
SOURCE
EMISSIONS
EMISSIONS
ABATED
ABATEMENT
COSTS
TAX COSTS
0
20,000
$100,000
0
UTILITIES
30,000
0
0
$180,000
FACTORIES
40,000
0
0
$240,000
70,000
20,000
$100,000
$420,000
CARS
TOTAL
Taxes
A tax of t = $11 per unit of pollution is imposed:
SOURCE
EMISSIONS
EMISSIONS
ABATED
ABATEMENT
COSTS
TAX COSTS
CARS
0
20,000
$100,000
0
UTILITIES
0
30,000
$300,000
0
40,000
0
0
$440,000
40,000
50,000
$400,000
$440,000
FACTORIES
TOTAL
Taxes
A tax of t = $10.05 per unit of pollution is imposed only on factories
for each unit of pollution over the 60,000 limit, regardless of the source.
SOURCE
EMISSIONS
EMISSIONS
ABATED
ABATEMENT
COSTS
TAX COSTS
CARS
20,000
0
0
0
UTILITIES
30,000
0
0
0
FACTORIES
40,000
0
0
$301,500
90,000
0
0
$301,500
TOTAL
If transactions costs low enough, then $200,000
solution can be achieved through private bargaining.
Cap and Trade Program
S
$
$20
F
Abatement Cost
P = $10
Q = 60,000
U
$10
C
$5
D
40
60
70
90
permits
2008 Spot Auction
2008 7-yr Advance Auction
“$200,000 Solution”
Coasian Approach

Externalities are due to incomplete
property rights assignment
“It takes two to tango”
Aunt Linda and the Nudist
Rifle River
Aunt Linda
$1500
Nudist
$1200
$1000
Judge rules in favor of Aunt Linda
Fence comes down
Judge rules in favor of Nudist
Fence comes down
2
rulings
(Linda pays Nudist)
Coasian Approach

Externalities are due to incomplete
assignment of property rights
Coase Theorem
If property rights are well-defined and transactions costs
are low enough, then private bargaining can result in an
efficient allocation of resources.
Corollary
Allocation of resources does not depend on initial
assignment of property rights.
Pollution Revisited
Cheshire, Ohio v. AEP

AEP paid $20 million to buy the 221-resident town
in 2002
A factory's production process creates sludge that pours into
a river. This sludge makes it difficult to fish in the river,
increasing the costs of the local fishermen by $5000. The
factory can install a water filter system for $4100, and the
fishermen can utilize a weighted fishing net system (to get
under the sludge) for $3250. Both systems would remedy the
sludge damage to the fishermen.
Nets: $3250
Factory
Damage: $5000
a) Transactions costs low and factory is not liable for damage?
b) Transactions costs low and factory is liable for damage?
c) Transactions costs high and factory is liable for damage?
Filter: $4100
Characteristics of Goods

Excludability: can you be excluded from consuming the good?

Rivalry: does my consumption hinder your consumption?
Excludable
NonExcludable
Rival
Non-rival
Private Goods
Artificially Scarce
Goods
Common
Resources
Public Goods
Government Provided Goods and Services









Schools
Roads
Police
Courts
Fire Department
Water
Library
Health Care
Transportation





National Defense
Social Security
Medicare
Postal Service
FBI, CIA, SEC, FTC,
FCC, NSF, FDA, ARC,
FDIC, NLRB, HUD
National Defense

Federal Government spent $670 billion in 2007
Per capita
expenditure
$670,000,000,000

 $2,233
300,000,000
How do we pay for this?
National Defense Telethon?
 Taxes!
Public Goods

Problems



“free-rider” problem
Under-provision by free market
Social Optimum requires:

MSB = MSC
Must find some way to aggregate individual marginal
benefits
Fireworks in Marietta
Quantity
Julia’s
MB
Seita’s
MB
Leah’s
MB
ΣMB
MC
Total
Benefit
Total
Cost
Net
Benefits
10
$8
$5
$9
$22
$10
$22
$10
$12
20
$7
$4
$8
$19
$10
$41
$20
$21
30
$6
$3
$6
$15
$10
$56
$30
$26
40
$5
$2
$4
$11
$10
$67
$40
$27
50
$4
$1
$2
$7
$10
$74
$50
$24
60
$3
$0
$1
$4
$10
$78
$60
$18
The table below shows the marginal benefit from submarines for the
only two citizens of a country. Submarines are a public good. If
submarines cost $175 a piece to produce, what is the efficient quantity
of submarines?
f)
1
2
3
4
1
150
75
2
100
50
3
50
25
4
10
0
5
0
5
0%
0%
0%
0%
0%
0%
5
e)
100
4
d)
Marginal benefit
(dollars per sub)
3
c)
Quantity
2
b)
0
1
2
3
4
5
Marginal benefit
(dollars per sub)
1
a)
Bobby
0
Kathy
Common Resources
Non-excludable
 Rival in consumption
* overuse
* congestion

“Tragedy of the commons”

Examples



Elephants in Africa
Fish in the sea
Bison in America
CITES
Campfire
Artificially Scarce Goods
Excludable
 Non-Rival

Marginal Cost of
provision is zero
$

Examples



Software
Pay-per-view movies
pharmaceuticals
P1
MR
Q1
D
Q0
MC
Drugs