Market failure, externalities and public goods.

Gwen Arnold

Recall:

• Strictly speaking, the eq’m is not Pareto efficient. • “NOT Pareto efficient” “NOT KH efficient”

EPA (2010)

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.

• 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.

-K&O 2007

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)

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)

What does the shape of this curve imply about damages? Is the additional damage from each additional unit of production constant?

AB

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 resourcesGrazing 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 self-organization 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.

• 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?

Ostrom and Ostrom 2003

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. Define clear group boundaries. {Common prop. degree of excl.}

2. Match rules governing use of common goods to local needs and conditions. {Advantage of common prop mgt customization.}

3. Ensure that those affected by the rules can participate in modifying the rules.

4. Make sure the rulemaking rights of community members are respected by outside authorities.

5. Develop a system, carried out by community members, for monitoring members’ behavior.

6. Use graduated sanctions for rule violators.7. 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

Source: Fig. 5.2, Keohane and Olmstead (2007)

Rival Nonrival

Excludable

Nonexcludable

Rival Nonrival

Public goods • “Pure PGs” are characterized by two features**

1. 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)

2. 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 itselfwill 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

Source: Keohane and Olmstead (2007)

• 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?

• What is the socially optimal level of cleanliness?

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

QB

***MC curve detail: MC increasing because of increasing effort needed for each additional unit (NOT due to increasing opportunity cost of time).

Aggregate WTP for a public good

• Example: Lake pollution. Currently pollution concentration is at 5 ppm.

• Identify (graphically and in the table)– 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

“Agg. WTP” or “Agg. demand”, D

Efficient provision of a public good

Exercise:– What is the socially efficient level of

pollution?– What level of contaminant would be

reached if only Homeowner A paid for cleanup? Hint: superimpose MC curve on Homeowner A’s figure.

– Would B or C voluntarily contribute to further cleanup?

– Connect this to the idea of “free-riding”

Aggreg. WTP

MC

The “Tragedy” as collection action problem. First, a diversion: “Adam Smith was wrong.”

http://www.smbc-comics.com/comics/20100605.gif

Game theory

Saturday Morning Breakfast Cerealby Zach Weinersmith

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)

(1,1) (-1,3)

(3,-1) (0,0)

Contribute

Contr.

Shirk

Shirk

Country B

Cou

ntry

A

The payoff matrix: for each possible outcome, the net benefits to each country are give by: (NBA, NBB)

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

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 equilibriumSolution 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)• 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)

Contribute

Con

tr.

Shirk

Shi

rk

Country B

Cou

ntry

A

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).

Is the predicted outcome Pareto inferior (i.e. can one agent be made better off without making any other agent worse off)?

Prisoner’s Dilemma 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

Property held by a group or in common may be governed by formal or informal institutions

• From explicit rules to informal social norms

(Ostrom et al. Science, 1999)

single ownerno ownerOPEN ACCESS INDIVIDUAL PROPERTYCOMMON/GROUP

PROPERTY

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)