Chapter 3 Modeling Market Failure

Environmental Pollution

• Market failure condition is the result of an inefficient market • Environmental problems are modeled as market failures using either the theory of public goods or the theory of externalities – If the market is defined as “environmental quality,” then the source of the market failure is that environmental quality is a public good – If the market is defined as the good whose production or consumption generates environmental damage, then the market failure is due to an externality 2

Environmental Quality

A Public Good • A public good is a commodity that is nonrival in consumption and yields nonexcludable benefits – Nonrivalness – the characteristic of indivisible benefits of consumption such that one person’s consumption does not preclude that of another – Nonexcludability impossible to prevent others from sharing in the benefits of consumption – the characteristic that makes it • Clean air, clean drinking water, clean waste treatment… 3

A Public Goods Market for Environmental Quality • Market failure because the nonrivalness and nonexcludability characteristics prevent market incentives from achieving allocative efficiency • Cannot specify / identify / operationalize demand • Consumers are unwilling to reveal their demand because they can share in consuming the public good even when purchased by someone else • This problem is called nonrevelation of preferences, which arises due to free-ridership • In addition, lack of awareness of environmental problems exacerbates the problem 4

Solution to Public Goods Dilemma

• 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 5

Environmental Problems

A Negative Externality • An externality is a spillover effect associated with production or consumption that extends to a third party outside the market – Negative externality costs to a third party – an external effect that generates – Positive externality – an external effect that generates benefits to a third party • Examples: dumping toxic waste in ocean, emitting gases into local air space • EPA Toxic Release Inventory • Externalities caused by doing something we want to do: produce or consume 6

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

external

cost (MEC)

Problem

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

Result

: Competitive solution is inefficient 7

Finding a Competitive Solution

Refined Petroleum Market Marginal Private Cost S: P = 10.0 + 0.075Q

Marginal Private Benefit D: P = 42.0 − 0.125Q, where Q is thousands of barrels per day Find the competitive solution 8

Competitive Solution

Set MPB = MPC 42.0 − 0.125Q = 10.0 + 0.075Q

Solve: Q C = 160,000 P C = $22 Analysis: – This ignores external costs from contamination – Efficiency requires all costs to be counted in MPC function – MPC undervalues (assumes at zero) pollution costs – Q C is too high; P C is too low 9

Examples of costs from pollution

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April 20, 2010: Deepwater Horizon Explosion

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Finding a Socially Efficient Solution

• Include the external pollution effects, as Marginal External Costs or Marginal External Benefits (MEC, MEB) • Use Marginal Social Cost and Marginal Social Benefit (MSC, MSB) • Instead of just MPC, use MSC=MPC+MEC • Instead of just MPB, use MSB=MPB+MEB • Assume Marginal External Cost (MEC) = 0.05Q

MSC = 10.0 + 0.075Q + 0.05Q = 10.0 + 0.125Q

• Assume no external benefits, MEB = 0, so MSB = MPB • Find the new efficient (for real) solution 17

Efficient Solution

• Set MSC = MSB • 10.0 + 0.125Q = 42.0 - 0.125Q

Q E = 128,000 P E = $26 • In the presence of an externality, market forces

cannot

determine an efficient outcome • If externality is negative, market Q is too low, market P is too high 18

42 P E = 26 P C = 22 10 0 MSC = MPC + MEC S =MPC 128 Q E 160 Q C D = MPB = MSB Q (thousands)

Measuring Society’s Net Gain From Social Efficiency • As Q falls from 160 to 128:  Refineries lose p ( MPB over MPC) for each unit of Q reduced [area WYZ]  Society gains accumulated reduction in MEC for each unit of Q reduced [area WXYZ]  Net gain = Area WXYZ - Area WYZ = Area WXY 20

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Measuring Society’s Net Gain

Refined Petroleum Market Society gains WXYZ; refineries lose WYZ; net gain is WXY MSC = MPC + MEC P E = 26 P C = 22 W X Y Z S = MPC 10 0 Q E = 128 Q C = 160 D = MPB = MSB Q (thousands)

• Both externality and public goods models show inefficiency of private market solution, i.e., market failure • Pigou’s solution for externalities: – Make sure consumers and producers work off MSB and MSC curves – Make sure consumers and producers do not work of MPB and MPC curves • Another solution: by Coase 22

Ronald Coase

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Property Rights

• Property rights are “valid claims to a good or resource that permit use and transfer of ownership” • For environmental goods, it’s often unclear who has property rights • Economics says it’s the

absence

of rights that matters, not who possesses them 24

Coase Theorem

• Proper assignment of property rights will allow bargaining between parties such that efficient solution results, regardless of who holds rights – Assumes costless transactions – Assumes damages are accessible and measurable 25

Building the Model

Refined Petroleum Market • Refineries use the river to release chemicals as an unintended by-product of production – Objective: to maximize p • Recreational users use the river for swimming and boating – Objective: to maximize utility 26

Bargaining When Rights Belong to Refineries

• Recreational users are willing to pay refineries for each unit of Q not produced • Will pay

up to

the negative effect on utility (MEC) • Refineries are willing to accept payment not to produce • Will accept payment

greater than

their loss in profit from reducing production (M p ) 27

Bargaining When Rights Belong to Refineries

• Initial point is Qc, since the refineries, who own the rights, would choose this point • Recreational users: Willing to offer a payment r r < (MSC - MPC), or r < MEC • Refineries: Willing to accept payment r r > (MPB - MPC), or r > M p 28

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Bargaining Process

Between Q C and Q E , MEC > M p , so bargaining proceeds MSC = MPC + MEC W X S =MPC Y 10 At Q E , MEC = M p , so bargaining ends 0 Z 128 Q E 160 Q C MEC at Qc is XY M p at Qc is 0 Bargaining begins D = MPB = MSB Q (thousands)

Bargaining Process

• Bargaining should continue as long as: (MSC - MPC) > r > (MPB - MPC) or MEC > r > M p • At Q C : Refineries’ M p = 0, but MEC > 0, (distance XY) – Since MEC > M p, bargaining begins • Between Q C and Q E , same condition holds • At Q E : MEC = M p, (distance WZ); output reductions beyond this point are infeasible, since M p > MEC 30

Bargaining When Rights Belong to Recreational Users • Bargaining will proceed analogously • An efficient outcome can be realized without government intervention 31

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Limitations of the Coase Theorem

• Bargaining is too difficult • Transactions costs are too high • Transactions costs: – Costs of identifying damage – Costs of agreeing on damage – Costs of negotiating settlement – Costs of enforcing payment • Negative incentive (repeat offender) 33

Coase Theorem

① Problem; negative externalities ② Really a problem of property rights ③ Assign property rights ④ Bargain to get to socially efficient solution ⑤ Cannot bargain because of transactions costs 34

Solutions

One solution: • Internalize externality by assigning property rights • Make sure bargaining can happen Or: • Set policy prescription (standards, taxes…) 35

Very big issues here

• Public goods – address with government provision • Externalities – address with property rights or other policies • Key theory: MSC not MPC / MSB not MPB • MSC = MPC+MEC MSB = MPB+MEB 36