Externalities as a Source of Market Failure

Property Rights, Externalities and Environmental Problems

Introduction

Property Rights: refers to a bundle of entitlement de�ning theowner�s rights,privileges, and limitations for use of the resource.

An owner of a resource with a well-de�ned property right has apowerful incentive to use that resource e¢ ciently. WHY?An e¢ cient structure of property rights has 3 main characteristics:

1 Exclusivity: all bene�ts and costs should accrue to the owner2 Transferability: PR should be transferable from one owner toanother

3 Enforceability: PR should be secure from involuntary seizureby others

When well-de�ned property rights are exchanged, as inmarket economy, this exchange facilitates e¢ ciency.

Property Rights, Externalities and Environmental Problems

Consumer and Producer Surplus

Consumer Surplus

The incentives consumers and producers face when a well-de�nedsystem of property rights is in place.

P*

Q*

Price

Quantity

Demand

Consumer Surplus

Property Rights, Externalities and Environmental Problems

Consumer and Producer Surplus

Producer Surplus

The incentives consumers and producers face when a well-de�nedsystem of property rights is in place.

P*

Q*

Price

Quantity

Supply

Producer Surplus

Property Rights, Externalities and Environmental Problems

Externalities as a Source of Market Failure

Introduction

Externality:

1 An activity by one agent causes a loss of welfare to anotheragent

2 The loss of welfare is uncompensated

Property Rights, Externalities and Environmental Problems

Externalities as a Source of Market Failure

We can draw a number of conclusions about marketallocations of commodities causing pollution externalities:

1 The output of the commodity is too large2 Too much pollution is produced3 The prices of products responsible for pollution are too low4 As long as the costs are external, no incentives to search waysto yield less pollution per unit of output are introduced by themarket

5 Recycling and reuse of the polluting substances arediscouraged since release into the environment is soine¢ ciently cheap

The e¤ects of a market imperfection for one commodity endup a¤ecting the demands for raw materials, labor and so on.

Property Rights, Externalities and Environmental Problems

Types of Externalities

Positive Externality (external economy)

Negative Externality (external diseconomy)

Pecuniary Externality

Property Rights, Externalities and Environmental Problems

Externalities as a Source of Market Failure

An externality exists whenever the welfare of some agent,either a �rm or household, depends not only on his or heractivities, but also on activities under the control of someother agent.

Simple Externality Examples

The Rat Race Problem

Simple Externality Examples

The Rat Race Problem

It is a contest for relative position. It helps explain:Why students work too hard when �nal marking takes the form of aranking.The intense competition for a promotion in the workplace whencandidates compete with each other and only the best is promotedAssume that performance is judge not in absolute terms butin relative terms

Player 2

Low effort High effort

Player 1 Low effort (1/2,1/2) (0,1­c)

High effort (1­c,0) (1/2­c,1/2­c)

Note that 0 < c < 1/2

Simple Externality Examples

RIVER POLLUTION

River Pollution

Simple Externality Examples

RIVER POLLUTION

River Pollution

Assume:

1 Two �rms are located along the same river2 The upstream �rm u pollutes the river3 The production of the downstream �rm,d , is a¤ected4 P = 15 Both �rms produce the same output6 Labor and Water are used as inputs7 Water is free, labor receives w8 F u(Lu) and F d (Ld , Lu) with ∂F d

∂Lu < 09 Each Firm acts independently and seeks to maximize its ownpro�t: πi = F i (�)� wLi

Simple Externality Examples

RIVER POLLUTION

Equilibrium with river pollution

Revenue

Revenue

Cost

Cost

Downstream

Upstream

Ou Od

L*u,L*d

πu

πd

Simple Externality Examples

Improperly Designed Property Rights Systems

Other Property Rights Regimes:

1 State Property Regimes: The government owns and controlthe property

2 Common-property Regimes: The property is jointly owned andmanaged by a speci�c group of co-owners

3 Open-access Regimes: no one owns or exercise control overthe resources

1 Tragedy of the Commons: Nobody is willing to conserve thenatural resource

Simple Externality Examples

Improperly Designed Property Rights Systems

Example of Open-access Regimes