Chapter 3

Modeling Market Failure

1. Environmental Pollution:A Market Failure

• Market failure is the result of an __________ market condition

• Environmental problems are modeled as market failures using either the theory of public goods (the market is defined as “environmental quality”) or the theory of externalities (the market is defined as the good whose production or consumption generates environmental damage)

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2. Environmental Quality:A Public Good

• A public good is a commodity that is _________ ______________ and yields _____________ benefits

• An example: environmental quality

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Important Characteristics of Goods

• A good is excludable if a person can be prevented from using it if he does not pay for it. – excludable: fish tacos– not excludable: national defense

• A good is rival in consumption if one person’s use/consumption of it diminishes others’ use/consumption. – rival: fish tacos– not rival: national defense

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Classic division of goods in economy

Rival in consumption(consumption diminishes its value)

Not rival

Excludable(have to pay)

private goods: food clothing

natural monopolies (club goods): cable TV

Not excludablecommon resources: fish in the seaenvironmental quality?

public goods: national defensetornado sirenenvironmental quality (our book)?

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3. A Public Goods Market for Environmental Quality

• Air quality (measured by reductions in SO2) market

• Market supply: Some number of hypothetical producers are

willing and able to supply various reductions in SO2 at different price levels

Market supply: P = 4 + 0.75QS

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• Market demand: In theory, market demand for a public good is

found by vertically summing individual demands– Vertical sum because we must ask consumers “What price would you be willing to pay for each quantity of the public good?”

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Demand for consumer 1: p1 = 10 – 0.12QD

+ Demand for consumer 2: p2 = 15 – 0.18QD

Demand for consumers 1 & 2: p1 + p2 = 25 – 0.3QD

Market demand: P = 25 – 0.3QD

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Market supply: P = 4 + 0.75QS

Market demand: P = 25 – 0.3QD

– Equilibrium found where

4 + 0.75QS = 25 – 0.3QD, or

where QE = ___ percent

and PE = $___ million

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10

S

D

Comment 1:

• QE (=20%):

--efficient or optimal level of abatement --not necessarily 100% (which means zero

pollution)

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Comment 2: • Consumers are unwilling to reveal their WTP because they can

share in consuming the public good even when purchased by someone else

--This problem arises due to free-ridership --Result is that market demand is undefined --Consequently, allocative efficiency cannot be achieved without

third-party intervention --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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Public Goods• Public goods are difficult for private markets to

provide because of the free-rider problem. • ________: a person who receives the benefit of

a good but avoids paying for it – If good is not excludable, people have incentive to

be free riders, because firms cannot prevent non-payers from consuming the good.

• Result: The good is not produced, even if buyers collectively value the good higher than the cost of providing it.

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Example:Imagine a city in which 60,000 people are living.

There is a chance to install a tornado warning system at the cost of $60,000. Each person may be prepared to pay $1. However, it is quite possible that some people will refuse to pay, and instead hope that others will pay for the system anyway, and they receive the benefit for no personal expense. The result is that it is possible no system will be installed.

a tornado warning system--______________some people--______________the result--________________ 14

4. Environmental Problems: Externalities

• An externality is a ____________ 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

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Pollution: A Negative Externality• Example of negative externality:

Air pollution from a factory. – The firm does not bear the

full cost of its production, and so will produce more than the socially efficient quantity.

• How govt may improve the market outcome:– Impose a tax on the firm equal to the

external cost of the pollution it generates16

5. Environmental Damage:A Negative Externality

• Environmental economists are interested in externalities that damage the atmosphere, water supply, natural resources, and overall quality of life

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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 _________ cost (MEC)

• Problem: Producers (refineries) have no incentive to consider the externality

• Result: Competitive solution is inefficient18

Finding a Competitive SolutionRefined Petroleum Market

• S: P = 10.0 + 0.075Q• D: P = 42.0 - 0.125Q, where

Q is in thousands of barrels per day• Since S is MPC and D is MPB, rewrite as MPC = 10.0 + 0.075Q MPB = 42.0 - 0.125Q

(P means private)• Find the competitive solution and analyze

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Competitive Solution

• Set MPB = MPC42.0 - 0.125Q = 10.0 + 0.075Q

• Solve:QC = _____ thousand; PC = $___ per barrel

(C means competitive)• Analysis:

– This ignores external costs from contamination– QC is too high; PC is too low

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Finding a Socially Efficient SolutionRefined Petroleum Market

• Let Marginal External Cost (MEC) = 0.05Q• Marginal Social Cost (MSC) = MPC + MEC

– MSC = 10.0 + 0.075Q + 0.05Q

= _______________• Marginal Social Benefit (MSB) = MPB + MEB

– Assuming no external benefits, MEB= 0, so MSB = MPB

• Find the efficient solution; show graphically

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Socially Efficient Solution

• Set MSC = MSB--10.0 + 0.125Q = 42.0 - 0.125Q--Solving: QE = ___ thousand; PE = $___/barrel

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MSC, MPC, MPB Graph

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P ($ per barrel)

Q (thousands)

D = MPB = MSB

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S =MPC

MSC = MPC + MEC

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160

PC = 22

128

PE = 26

0QE QC

• Results of negative externality

--QC (160) is higher than QE (128), since the firm does not bear the full cost of its production, and so will produce more than the socially efficient quantity (overallocation of resources)

--PC (22) is lower than PE (26), since MEC is not captured by market transaction

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Important Observations

• Both externality and public goods models show inefficiency of private market solution, i.e., market failure

• Underlying source of failure is absence of property rights– Recall Boston Harbor application

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6. Absence of Property Rights

The Coase TheoremRonald Coase, Nobel Laureate, 1991

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Property Rights

• Valid claims to a good or resource that permit the use and transfer of ownership through sale

• For environmental goods, it’s unclear who “owns” 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, even if externalities are present, 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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The Coase Theorem: An ExampleDick owns a dog named Spot.

_____________ externality: Spot’s barking disturbs Jane, Dick’s neighbor.

The socially efficient outcome maximizes Dick’s + Jane’s well-being. – If Dick values having Spot more

than Jane values peace & quiet, the dog should stay. Otherwise, the dog should go.

Coase theorem: The private market will reach the efficient outcome on its own…

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See Spot bark.

The Coase Theorem: An Example

• CASE 1: Dick has the right to keep Spot (Jane needs to pay Dick to get rid of Spot). Benefit to Dick of having Spot = $500Cost to Jane of Spot’s barking = $800

• Socially efficient outcome: Spot goes bye-bye.

• Private outcome: Jane pays Dick $600 to get rid of Spot, both Jane and Dick are better off.

• Private outcome = efficient outcome30

The Coase Theorem: An Example• CASE 2:

Dick has the right to keep Spot (Jane needs to pay Dick to get rid of Spot). Benefit to Dick of having Spot = $1000Cost to Jane of Spot’s barking = $800

• Socially efficient outcome: See Spot stay.

• Private outcome: Jane not willing to pay more than $800, Dick not willing to accept less than $1000, so Spot stays.

• Private outcome = efficient outcome31

The Coase Theorem: An Example• CASE 3:

Jane has the legal right to peace & quiet (Dick needs to pay Jane to keep Spot).

Benefit to Dick of having Spot = $500Cost to Jane of Spot’s barking = $800

• Socially efficient outcome: Spot goes bye-bye.

• Private outcome: Dick not willing to pay more than $500, Jane not willing to accept less than $800, so Spot goes bye-bye.

• Private outcome = efficient outcome32

The Coase Theorem: An Example• CASE 4:

Jane has the legal right to peace & quiet (Dick needs to pay Jane to keep Spot).

Benefit to Dick of having Spot = $1000Cost to Jane of Spot’s barking = $800

• Socially efficient outcome: Spot stays.

• Private outcome: Dick pays Jane $900 to keep Spot, both Jane and Dick are better off.

• Private outcome = efficient outcome33

The private market achieves the efficient The private market achieves the efficient outcome regardless of the initial outcome regardless of the initial distribution of rights.distribution of rights.

The private market achieves the efficient The private market achieves the efficient outcome regardless of the initial outcome regardless of the initial distribution of rights.distribution of rights.

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Solution to ExternalitiesGovernment Intervention

• Internalize externality by:– Assigning property rights, OR– Setting policy prescription, such as:

• Set standards on pollution allowed

• Tax polluter (= MEC at QE)

• Establish a market and price for pollution

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Consumption externalities Production externalities

Positive Negative Positive Negative

The benefits to the rest of society of people being vaccinated before traveling abroad

Noise pollution from using car stereos

The benefits to the environment that arise from the planting of woodland by a forestry company

Wastes being dumped into a river by a company

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