Part I. Principles
A.
B.
C.
D.
E.
Markets
Market failure
Discounting & PV
Dynamic efficiency
Pollution solutions
B. Market failure
Chapter 2
From last time
• MSC – marginal cost incurred by entire
society, by the producer and by everyone
else on whom the cost falls = MC + MEC
• MSB – marginal benefit enjoyed by society,
by the consumers and by everyone else who
benefits from it = MB + MEB
Maximizing Social Benefits
• In order for social net benefits to be
maximized, it is necessary that:
MB = MSB
&
MC = MSC
$
MSB = MSC
S = MC = MSC
D = MB = MSB
Quantity
q*
Will MB = MSB, MC = MSC?
• For many goods (sushi, surfboards), YES
• For many environmental-related goods
(paper produced by water polluting paper
mill, snorkeling at Hanauma Bay), NO
• MB ≠ MSB and/or MC ≠ MSC
→ market failure
Market Failure
• Occurs when the market does not allocate
resources efficiently.
• 1 possible cause of market failure is a
divergence between private and social costs
(could also be between benefits).
• Consider a steel producer.
Production of steel
• MC reflects all the private costs of
production (labor, rent, materials) but does
not reflect all the social costs associated
with production (for example, air pollution).
• Steel producers respond to private MC, steel
consumers respond to private MB (here
same as MSB)
→ equilibrium at Q1
Figure 2.3.
Steel Production Example
Market Failure
• Market forces generate an equilibrium
production level and price associated with
private costs, at Q1.
• This output level is greater than the socially
optimal level of Q* (which considers
additional cost from pollution).
• The shaded area in Figure 2.3 represents the
costs to society of having this higher than
optimal level of output.
5 categories market failure
1.
2.
3.
4.
5.
Imperfect competition
Imperfect information
Public goods
Inappropriate government intervention
Externalities
1. Imperfect competition – monopoly
• Profit max: restrict output, raise price
• Electricity, natural gas companies
2. Imperfect information
• Consumers and/or producers do not know
true costs and/or benefits associated with
good or activity
• Radon leaks into homes – if people don’t
know health consequences, do not take
proper mitigation measures
• Deforestation – small farmers cutting and
burning (better techniques, but don’t know
them)
3. Public goods*
• 2 characteristics distinguish from private
goods:
1. Nonrival – 1 person’s consumption does
not diminish amount available for others to
consume
2. Nonexcludability – if 1 person can
consume it, others can’t be excluded from
consuming it
Pure public goods
• 100% nonrival, 100% nonexcludable
• Examples?
• Climate – my consumption doesn’t decrease
your consumption (nonrival); cannot
exclude me from enjoying benefits
(nonexcludable)
Pure or impure PG?
• Beaches – nonrival, nonexcludable?
• Rival – as more and more people use it,
quality diminishes (congestion,
environmental degradation)
• Excludable – can charge user fees (as in
NE, have to buy permits)
Pure or impure PG?
• Spectator sport (baseball) – nonrival,
nonexcludable?
• 90% Nonrival – if I am watching, you can
watch too, but congestion may diminish
quality
• Excludable – pay for admission, or pay for
cable to watch on TV
Pure or impure PG?
• Fish in a lake – nonrival, nonexcludable?
• Rival – if I catch more fish, less left for you
to catch
• 90% nonexcludable – if I am fishing, you
can fish too
Figure 2.5
Spectrum of public goods
Why market failure?
• Free rider – person who enjoys benefits of
good/service without paying for it
• Clean air is public good – do you pay for it?
• In general, public goods underprovided
(since free riders)
→ market failure
4. Inappropriate gov’t intervention
• Gov’t intervention is a potential source of
disparity between private and social values.
• Often gov’t action to address an alternative
issue creates this divergence.
• Gov’t policy regarding timber leases has
created a greater than socially optimal level
of timber harvest.
USFS policy
• Treats the forest as a private good – leases
right to harvest to timber companies,
ignoring other costs such as building roads,
loss of ecosystem services, etc.
• Harvester equates MC = MB
• But forest has public goods characteristics –
recreation, wildlife habitat, wilderness…
• Therefore, too many trees cut as opposed to
socially optimal level.
Inappropriate gov’t intervention
• USFS provides free roads to companies to
cut timber
5. Externalities*
• Externalities are best described as “spillover
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.
Negative Externalities
• Can be generated by both producer and
consumer side
• Production – air pollution, noise
• Consumption – smoking, traffic congestion
Negative production externality,
e.g., pollution
Negative consumption externality,
e.g., smoking
Positive Externalities
• Can also be generated by both producer and
consumer sides
• Production – apples and honey, R&D
• Consumption – gardens, education,
vaccines
Pecuniary vs. technological
• Pecuniary – price effect – unintended price
change NOT an externality (demand for jeans ↑,
price of cotton ↑, price of t-shirts ↑). Nothing has
happened to ability to produce jeans/shirts, just
price has changed.
• Technological – air pollution – cannot grow as
much cotton – price cotton ↑ – price of t-shirts ↑
– this is an EXTERNALITY
Figure 2.8Production Possibilities Frontier
Pecuniary vs. technological
• Notice the lower curve in Figure 2.8.
• This represents a situation where the
production of steel generates pollution (an
externality).
• Pollution reduces the yield per acre of
cotton with the existing resource base.
Pecuniary vs. technological
• A new lower PPF results from this
externality.
• Pecuniary externality would cause
movement along same PPF, not shift of PPF.
• Technical externality – reduces welfare.
• Pecuniary shifts preferences.
Property Rights
• Important reason market failure exists
• Property rights for many environmental
goods not well defined (clean air, water,
etc.)
• Suffer from air pollution – who pays?
Open access externality
• Lack of or inability to enforce property
rights
• E.g., fisheries, grazing
• Leads to overfishing, overgrazing
• Even if rights exist, hard to enforce
Does efficiency = 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 – return to
this in Part II of class (criteria for environ.
decision making)
Conclusion
• This section focused on markets and how
markets efficiently allocate goods and
services.
• When market failure occurs, MB  MSB
and/or MC  MSC
• Market failure can result from externalities,
public goods, imperfect information,
imperfect competition, and inappropriate
government intervention.