Market Failures
The role of government and economics
is to enhance public welfare
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Both seek to allocate scarce resources
among alternative desirable ends
When the market fails to allocate goods
adequately, then the government should
step in
Three questions
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What are the desirable ends towards which
society should allocate its scarce resources?
What are these scarce resources, and what are
their characteristics relevant to allocation?
Based on the nature of the scarce resources and
human nature, what allocative mechanisms is
best for achieving these desired ends?
What allocative mechanisms are available?
The desirable ends: what improves
social welfare?
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Is it ever greater consumption of market
goods?
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Does sustainability matter?
Does distribution matter?
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Can you buy and sell clean water, clean air,
stable climate, biodiversity, ozone layer?
Why are we so obsessed with growth?
Who should own goods and services created
by nature and by society?
Is stability desirable?
What are the scarce resources?
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Economic goods and services
Ecosystem goods and services
Laws of thermodynamics
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1st law: matter energy is constant
You can’t make something from nothing
 Economics is transformation, not waste
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2nd law: entropy increases in an isolated
system (supreme law of nature)
Economic activity results in waste
 Economy can’t grow forever. We can’t grow our
way out of poverty
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From Empty
World to Full
World
What are the characteristics of the
scarce resources?
Excludability
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Excludable resource regime
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Non-excludable
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One person can prevent another from using the
resource
Necessary for markets to exist
No enforceable property rights due to technology or
social institutions
Can’t charge for use
Some resources non-excludable by nature. None are
inherently excludable.
Excludability is a product of institutions.
Rivalness
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Rival Goods
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My use leaves less for you to use
All ecosystem goods are rival
Non-rival (or non-depletable)
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My use does not leave less for you to use
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Marginal cost for additional user = 0
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Efficient allocation: Price = marginal cost of production
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All non-rival resources are services
Rival or non-rival is an innate characteristic of the
good, not a result of institutions
Rivalness (cont.)
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Non-rival but congestible
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Non-rival as long as few people use it, becomes
rival with excessive use (e.g. roads)
Empty planet vs. full planet
So What?
Excludable
Rival
Non-rival
Non-rival,
congestible
Market Good: cars,
houses, land, oil,
timber, waste
absorption capacity?
Potential market
good but inefficient:
patented information,
e.g. energy efficiency,
toll roads.
MG when crowded:
toll roads at rush hour,
toll bridges, beaches,
etc.
Non-Excludable
Open Access Regime:
Oceanic fisheries,
undiscovered minerals,
waste absorption capacity
Pure Public Good:
Information, streetlights,
public roads, defense, laws,
public health, most ecosystem
services
OAR when crowded: e.g.
public parks, beaches,
roads, bridges, etc.
Open Access
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The “Tragedy of the commons”
Common property vs. open access
Individuals try to capture benefits for
themselves, share costs with society
Market alone leads to over-exploitation
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Threat of extinction
Loss of profit (to be explained later)
Role for government to step in
Non-rival & Excludable
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Patents are protected by governments
Why do we have patents?
Patents, profit motive and innovation
When did patents come about?
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1790s in US
1947 international, rarely used before 1980s
Non-rival & Excludable (cont.)
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Patents and the WTO
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97% owned by developed nations
Neem tree, steel drums, etc.
Samuel Slater, “Father of American
industry”
Should government spend scarce
resources to make these information
excludable?
Public Goods
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Free-riding
No price signal as feed-back mechanism
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Scarcity
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price increase
 innovation
•Lack of Incentives for market to produce
them
•Lack of incentives for markets to create
technologies that provide them
Public Goods (cont.)
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How important are public goods?
• Life support functions (Vermont’s forests)
• Flood protection (Winooski river)
• Water purification
• Lake Champlain
Infrastructure
Research and development
 if all the scientists are working for profit, none
are making PGs
Provision widely accepted as government duty
Is government provision efficient?
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Privatization debate
Read chapter on political economy
Market goods: The theory of
Externalities
Externalities
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Definition
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“an activity by one agent causes a loss (gain)
of welfare to another agent”
“The loss (gain) of welfare is uncompensated”
Completely Internal to the Economic
Process. Why?
How are these related to public goods?
Examples
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Individual consumption
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Industry
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Waste outputs
Status effect
Pollution
Brownfields
Agriculture
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Ecosystem conversion- loss of riparian
zones
Phosphorous emissions
Siltation
Factory farming
Examples (cont.)
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Natural resource harvest
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Depletion of ecosystem services
Waste emissions
Community issues
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Crime reduction
Economic stability
Education
Health
‘Optimal’ externalities for society
Agricultural production
Property Rights
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Who owns the environment?
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polluter rights (privilege, no rights)
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sufferer rights (rights, duties)
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What about future generations?
Obstacles to Optimal
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Transaction costs
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in absence of transaction costs, no negative
externalities
What are transaction costs likely to be for
externalities affecting public goods?
Wealth effect
Intergenerational externalities
Government role
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What can the government do about
externalities, and how does it relate to
finance?
Regulations
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Cost money to enforce
Government role
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What can the government do about
externalities, and how does it relate to
finance?
Regulations
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Cost money to enforce
Economically inefficient
No incentives to go beyond compliance
Taxes
Auctioned quotas
Controlling price or quantity
Marginal
abatement
costs
First 20%
Firm 1
Firm 2
Firm 3
$50,000
$10,000
$25,000
2nd 20%
$200,000
$25,000
$50,000
3rd 20%
$400,000
$50,000
$100,000
4th 20%
$800,000
$100,000
$175,000
Final 20%
$1600,000
$500,000
$200,000
Marginal pollution abatement costs for three firms emitting 5000 tons of pollution each.
Pigouvian taxes and subsidies
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Tax (subsidy) equal to value of negative
(positive) externality theoretically leads to
efficient outcome
What is value of externality?
Incentives
Tradable quotas
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Example of sulfur dioxide
First determine scale
Next decide on distribution
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Justice vs. feasibility
Allow market to allocate
Tax or quota?
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With a tax, you can theoretically get right
amount, but amount will change with
economic change. Better to let prices vary
(economic) than amount of resource to be
used (ecological)
tax or quota on single resource leads to
substitution, on all resources will not
Tax or quota
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Uncertainty
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We don’t know marginal abatement cost curves,
nor marginal benefit curves
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not only do we not know where we are on the curve,
we don’t know the slope of the curve
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Slope of curve very important
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In full world, lower risks from quotas, in
empty world, lower risks from tax
Ignorance and Uncertainty
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Perfect markets require perfect information
Asymmetric information
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Nobel Prize in 2000
Poverty insurance
Irreducible ignorance
Time lags
Ecosystem function
How do ignorance and uncertainty relate to
budgeting and finance?
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Who pays clean up costs when
unexpected negative impacts occur?
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Health impacts
Superfund sites
Role of government in providing social
security (poverty insurance)
Natural Monopoly
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High fixed cost, low marginal cost
Roads
How should hey be regulated?
Conclusions
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Many market economists and politicians
argue that there is little role for
government, market is best allocative
mechanism
Market systematically fails to provide
many goods
Government is essential
Future lectures will examine just and
efficient mechanisms for coping with these
market failures
Naural Monopolies,
PG: the Privatization debate
Private Provision
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Examples
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3 private police for every public officer in US
2/3 of homes in Denmark with private fire service
SUVs or plowed roads?
Relative costs
Administrative costs
Diversity of tastes
Distributional issues
Skimming
Private Production: examples
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Skating rink in Central park
Trains in WWI
Military personnel in Iraq
Airport security
Municipal water supply
Education
Private Production : issues
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Examples
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Skating rink in Central park
Trains in WWI
Military personnel in Iraq
Airport security
Municipal water supply
Education