Market failure,
externalities and public goods.
Recall:
EPA (2010)
• Strictly speaking, the eq’m is not Pareto efficient.
• “NOT Pareto efficient”  “NOT KH efficient”
An externality results when the actions of an agent
(individual or firm) have an uncompensated effect on
the wellbeing of other agents.
• Unintentional
• Market participants (demanders and providers) do not
bear all of the costs or reap all of the rewards from the
transaction.
-K&O 2007
• Typical examples
– Positive externality (external benefit): beekeeper who places
bees in an area for honey  not paid for the pollination
services the bees provide for surrounding agricultural crops.
– Negative externality (external cost): power plant which does
not pay for its emissions of green house gases or particulate
matter and chemicals which affect human health.
To model externalities we will decompose
social impacts into private and external.
Total social costs = total private costs + total external costs
TSC =
TPC
+ TEC
Marginal case:
MSC = MPC + MEC
“private” costs or benefits: “felt” by the decision maker
“external” costs or benefits: not felt by the decision maker
Market equilibrium vs socially efficient outcome:
external costs (environmental damages)
What does the shape of this
curve imply about damages?
Is the additional damage from
each additional unit of
production constant?
B
A
Story: a pulp mill damaging a downwind
community with airborne emissions.
• We will frequently think of the external
costs specifically as the value of
environmental “damage”.
Classroom exercise. Identify:
• predicted market rate of output (based
on private incentives/payoffs)
• market equilibrium total amount of
external cost (env. damage)
• socially efficient rate of output (based on
social payoffs)
• socially efficient total amount of
external cost (env. damage)
One important source of externalities:
Open Access Resources (OAR)
• OAR: a common-pool resource or facility that is
1. non-excludable: open to uncontrolled access by users
•
Property rights regime: absence of property rights or lack of enforcement of
property rights
2. rival: one person’s consumption of a unit of the good diminishes the amount
of the good available for others to consume
–
Typical examples: fisheries, roadways,
air and water bodies as waste sinks
–
Problematic canonical example
• The Tragedy of the Commons, Hardin, 1968
– Grazing of cattle on a pasture “open to all”
•
But…common property is NOT open access (Ostrom, 1990)
Property Rights & the TOC
• Private property rights are exclusive rights to
use, profit from and distribute property.
• Idea: he who does not expect to reap will not
sow.
– Thus, property rights encourage investment. (Could
be investment in land, physical or human capital.)
• In contrast, goods which are owned communally
are sometimes subject to the TOC, the tendency
of any resource that is unowned--and hence
nonexcludable--to be overused and
undermaintained.
Cowen and Tabarrok 2010
Open access resources
Grazing story: the externality
• Note: this is an OAR example if we assume that there are no
restrictions on use of the grassland (not the same as common property).
• The externality:
– Suppose many individuals or firms each draw upon some resource (e.g.
harvesting fish, grazing cows, etc) such that total utilization is at or beyond
the “carrying capacity”. (For this example, need the use to be a such a level
that additional use involves a cost to all users.)
– If one individual increases their level of utilization (e.g. grazes an additional
cow) there are two effects:
1. The expanding individual receives the proceeds from increased utilization. (+)
2. The return to each individual for utilizing each unit will subsequently be
diminished. ( - )
– Each individual feels (internalizes) the diminished return (per unit of the
resource) to herself, but the diminished return imposed on all others is
considered external – it is ignored.
Central feature of an OAR problem is nonexcludability, i.e.
the lack of a (enforced) property right to the resource.
•
A rational sole owner sets use to maximize
profits (surplus). This will also be the socially
efficient level of use. (Why?)
•
With open access, typically use of the resource
keeps increasing and the surplus is (often
completely) dissipated. (diagram)
•
If the resource is environmental, then
increased use will likely result in a stressed
environment.
•
Connecting the framework of Hardin’s “The
tragedy of the commons” to our models for (1)
market equilibrium, (2) socially efficient outcome,
and (3) market failure/externality.
•
Quotes from TTOTC:
“In economic affairs, The Wealth of Nations (1776)
popularized the "invisible hand," the idea that an
individual who "intends only his own gain," is, as
it were, "led by an invisible hand to promote ...
the public interest".
Adam Smith … contributed to a dominant tendency
of thought that has ever since interfered with
positive action based on rational analysis,
namely, the tendency to assume that decisions
reached individually will, in fact, be the best
decisions for an entire society.
If this assumption is correct it justifies the
continuance of our present policy of laissez-faire
in reproduction.” (p. 1224)
Market
forces/
incentives
FTWE
[comment: yes but
only if certain
conditions are met
which preclude
market failure.]
Institutions and common property
Elinor Ostrom
• Only woman to win the Nobel Memorial
Prize in Economic Sciences (2009). Not
an economist.
• “…challenged the conventional wisdom
that common property is poorly managed
and should be completely privatized or
regulated by central authorities.”
• Studied: user-managed fish stocks,
pastures, woods, lakes, and groundwater
basins
(Source: Economic Sciences Prize Committee of the
Royal Swedish Academy of Sciences)
Institutions & common property: a critique
of conventional economic advice
• When markets fail, economist advocate for
State intervention “without asking how
incentives are generated within State
bureaucracies to improve performance.”
– The (mistaken) conventional
wisdom/accepted theory: “voluntary selforganization to provide public goods or
manage common-pool resources is highly
unlikely”
Ostrom and Ostrom 2003
Do common-pool resources always result
in the TOC?
• Results from a wide selection of field studies:
• Common-pool resource users have developed a
variety of institutional structures for cooperation, with
and without the help of outsiders.
Ostrom and Ostrom 2003
• Also, there are many cases in which this fails to occur.
• “Although tragedies have undoubtedly occurred, it is also
obvious that for thousands of years people have
– self-organized to manage common-pool resources, and
– users often do devise long-term, sustainable institutions for
governing these resources” (Ostrom et al. Science, 1999)
• Central empirical and theoretical question: Why in some
instances and not others?
Institutions and common property
• “Any single, comprehensive set of formal laws intended
to govern a large expanse of territory containing diverse
ecological niches is bound to fail in many of the areas
where it is applied.” (p. 10) shorthand no panacea
• Policy recommendation: as opposed to imposing uniform
management rules from above, focus on building the
capacity of resource users to self-organize.
– Courts (efficient, fair and honest), effective property rights, and
infrastructure (e.g. highways).
– Develop policy that works in concert with the ways in which local
collective efforts evolve and operate.
Ostrom and Ostrom 2003
“8 Keys to a Successful Commons”
(Ostrom, 2010)
1.
2.
3.
4.
5.
6.
7.
Define clear group boundaries.
{Common prop. degree of excl.}
Match rules governing use of common goods to local needs and
conditions.
{Advantage of common prop mgt  customization.}
Ensure that those affected by the rules can participate in modifying
the rules.
Make sure the rulemaking rights of community members are
respected by outside authorities.
Develop a system, carried out by community members, for
monitoring members’ behavior.
Use graduated sanctions for rule violators.
Provide accessible, low-cost means for dispute resolution. {Possible
role for government  invest in institutions.}
8.
Build responsibility for governing the common resource in nested
tiers from the lowest level up to the entire interconnected system.
Source: Ostrom (Feb. 2010): http://www.yesmagazine.org/issues/america-the-remix/8-keys-to-a-successful-commons
Recall:
• OAR: a common-pool resource or facility
that is
1. non-excludable: open to uncontrolled access by
users
• Property rights regime: absence of property rights or lack of
enforcement of property rights
2. rival: one person’s consumption of a unit of the good
diminishes the amount of the good available for others to
consume
Continuum of private to public goods
Rival
Nonrival
Nonexcludable
Excludable
Rival
Nonrival
Source: Fig. 5.2, Keohane and Olmstead (2007)
Public goods
•
“Pure PGs” are characterized by two features**
1.
2.
•
Nonrivalry: one person’s consumption of a unit of the good
does not diminish the amount of the good available for others to
consume (e.g. my consumption of a public street light doesn’t
diminish yours)
Nonexcludability: it is not feasible or practical to selectively
allow access for users to consume the resource (e.g. all have
access to public street lights; quite difficult to charge an
individual based on their specific use of it.)
PGs are a common source of external
benefits/costs (and hence of potential market
failure).
*NOTE: in reality nonrivalry and nonexcludability will usually not be
absolute
**Adapted from Kolstad, 2000 (Environmental Economics)
In cases of external benefits the market left to itself
will normally undersupply the good in question.
• Why?
– First: recall what we mean by undersupply
• Less than the socially efficient level
– Because: an individual or firm which bears the cost of
supply will enjoy only some fraction of the total social
benefit.
– Individuals then have an incentive to “free ride” :
contribute less than their true WTP.
Private provision of a public good
Setting: housemates Alice and Bob
must individually decide on what
level of contribution to make to the
public good of household
cleanliness. MC is the same for
both. MB curves are given below.
Note that in this simple example,
“society” and “the public” is
comprised of just Alice and Bob.
MC
• Who values
cleanliness more?
• What level of
cleanliness would
each desire on their
own?
• Who would we
predict to “free ride”
• What is the
aggregate MWTP
(aka SMB here) for
the public good?
QB
• What is the socially
optimal level of
cleanliness?
***MC curve detail: MC increasing because of increasing effort needed for
each additional unit (NOT due to increasing opportunity cost of time).
Source: Keohane
and Olmstead (2007)
Aggregate WTP for a public good
• Example: Lake pollution. Currently pollution
concentration is at 5 ppm.
• Identify (graphically and in the table)
“Agg. WTP” or “Agg. demand”, D
– Aggregate demand for water quality (vertical
sum in graph):
AMWTP(q) = MWTPA(q) + MWTPB(q) +
MWTPC(q)
• Note this is different than for a private good
since for a public good we are valuing the
same unit across each individual since the
good is nonrival
Efficient provision of a public good
Exercise:
Aggreg. WTP
– What is the socially efficient level of
pollution?
– What level of contaminant would be
reached if only Homeowner A paid for
cleanup? (consider only discrete levels
{4, 3, etc} (hint: look at table)
• Would B or C voluntarily contribute to
further cleanup?
• Connect this to the idea of “free-riding”
The “Tragedy” as collection action problem
First, a diversion: “Adam Smith was wrong.”
Game theory
Saturday Morning
Breakfast Cereal
by Zach Weinersmith
http://www.smbccomics.com/comics/20100605.gif
Game theory &
international environmental agreements (IEAs)
Game theory: the study of multi-agent decision problems where the payoffs to
actions depend on the actions of others.
A simplified story of the transboundary/international pollution problem:
•
•
•
•
•
•
•
Two countries, A & B, contribute to emissions of a transboundary pollutant.
– Currently, neither A nor B is addressing the pollution issue but both are
considering doing so
Discrete strategies: each country will choose either to contribute or shirk (not
contribute)
Non-cooperative game theory: A & B will not negotiate but rather simply choose
(irreversibly) a strategy.
Each behaves individually rationally
Information is complete: payoffs are fixed and common knowledge
Static, one-shot game: the actions of A & B are selected once, simultaneously, and
are permanent.
Any “agreement” to take action must be self-enforcing—there is no higher authority
to impose constraints.
Finus, M. (2001)
The cost/benefit structure
Assumptions:
• Costs:
• effective action: 4 total
• If one country takes effective action (“contributes”) its
costs are 4.
• If both “contribute” then each faces a cost of 2.
• no action: zero cost
• Benefits
• effective action: 3 each
• Both countries receive benefits of 3 regardless of
whether the effective action is due to the efforts of one or
both countries
• no effective action by either: 0 each
**This example based on Keohane and Olmstead (2007, p. 79)
Assumptions:
• Costs:
• effective action: 4 total
• If one country takes
effective action
(“contributes”) its costs
are 4.
• If both “contribute” then
each faces a cost of 2.
• no action: zero cost
for each possible outcome, the
net benefits to each country are
give by: (NBA, NBB)
Country B
Contribute
Shirk
Country A
• Benefits
• effective action: 3 each
• Both countries receive
benefits of 3 regardless
of whether the effective
action is due to the
efforts of one or both
countries
• no effective action by either:
0 each
The payoff matrix:
Contr.
(1,1)
(-1,3)
Shirk
(3,-1)
(0,0)
Note: payoffs to A depend on
the choice of B and vice versa.
Prediction of the equilibrium
• Any “agreement” to take action must be self-enforcing
• Each player’s predicted strategy must be that player’s
best response to the anticipated strategy of the other
player.
C: contribute
S: shirk
• The strategy of player i, given by si, is chosen from the
set {C,S}
• The strategies {s*A, s*B} are a “Nash equilibrium” (NE) if,
for each player, s*i is player i‘s best response to the
strategy specified for the other player. (There is no incentive to
deviate.)
Gibbons (1992)
Nash equilibrium
Solution process: check whether each possible outcome satisfies the
NE condition:
1. For each player and for each strategy, determine the other player’s best
response (and underline that payoff)
2. The pair of strategies {s*A, s*B} is a
NE if each players’ strategy is a best
response to the other’s (i.e. if both
payoffs are underlined).
Country B
Contribute
Shirk
Country A
Shirk
Contr.
• Consider B’s best response:
If A contr.  should B shirk or contr.?
If A shirks  should B shirk or contr.?
• Consider A’s best response:
If B contr.  should A shirk or contr.?
If B shirks  should A shirk or contr.?
(1,1)
(-1,3)
(3,-1)
(0,0)
Is the predicted outcome Pareto inferior (i.e. can one agent be made better off
without making any other agent worse off)?
Prisoner’s Dilemna in Action
Golden Balls - £100,000 Split Or Steal? 3/14/08
Model extensions:
• To capture the wide variety of IEAs
requires model extensions:
– N>2 countries
– Coordination
– Dynamic/repeated games (finite, infinite)
– Continuous strategy space
– Negotiation models
– Coalition models
See Finus (2001)
Optional additional slides
Common property is not open access
(Ostrom et al. Science, 1999)
OPEN ACCESS
no owner
COMMON/GROUP
PROPERTY
INDIVIDUAL PROPERTY
single owner
Property held by a group or in common may be
governed by formal or informal institutions
• From explicit rules to informal social norms
Example: common/group vs. government property (mgmt)
Ostrom et al. Science, 1999, pp. 280
Institutions & common property
• Ostrom findings: resource users can create
sytems of governance to manage a shared
resource by generating explicit rules about
• what people can use
• what their responsibilities are
• how they will be punished if they break the rules
• Key departure from the idea of the TOC:
– When resource users interact repeatedly over time
“clever punishments for wrongdoing (are) feasible”.
• Credible threats  enable cooperation.
The Economist (2009)
Ostrom v. Hardin
•
•
Fran: So, are you saying that Hardin is sometimes right?
Elinor: Yes. People say I disproved him, and I come back and say “No, that’s not
right. I’ve not disproved him. I’ve shown that his assertion that common property will
always be degraded is wrong.” But he was addressing a problem of considerable
significance that we need to take seriously. It’s just that he went too far. He said
people could never manage the commons well.
•
Elinor: No panaceas! We tend to want simple formulas. We have two main
prescriptions: privatize the resource or make it state property with uniform rules. But
sometimes the people who are living on the resource are in the best position to figure
out how to manage it as a commons.
Fran: Is there a role for government in those situations?
Elinor: We need institutions that enable people to carry out their management roles.
For example, if there’s conflict, you need an open, fair court system at a higher level
than the people’s resource management unit. You also need institutions that provide
accurate knowledge. The United States Geological Survey is one that I point to
repeatedly. They don’t come in and try to make proposals as to what you should do.
They just do a really good job of providing accurate scientific knowledge, particularly
for groundwater basins such as where I did my Ph.D. research years ago. I’m not
against government. I’m just against the idea that it’s got to be some bureaucracy
that figures everything out for people.
•
•
Korten and Ostrom (2010)