Transcript ENVIRONMENTALITIES AND MARKET FAILURE

ENVIRONMENTALITIES AND
MARKET FAILURE
INTRODUCTION
• Markets allocate scarce resources with forces of
supply and demand
• Equilibrium of supply and demand is typically an
efficient allocation of resources
• Equilibrium market prices signal information and
allocate resources
• Markets sometimes fail to allocate resources
efficiently
• Examine in this chapter a type of market failure
called externalities
INTRODUCTION
• Market Failure and the Environment
 For environmental assets, markets can fail if prices do
not communicate society’s desires and constraints
accurately
 Prices often understate full range of services by
environmental assets or do not exist to signal the
value of the asset to the market
 Incomplete or absent markets for environmental assets
 Market failure occurs when private decisions based
on prices, or lack of them, do not generate Paretoefficient allocation of resources
INTRODUCTION
• Market Failure and the Environment
 Inefficiency (Pareto) implies that resources could be
reallocated to make at least one person better off
without anyone worse off
 Wedge is driven between what individuals want
privately and what society wants collectively
 Due to Market Failure:
 1. Inefficient resource allocation
 2. Leads to regulation or other public policies
 Divergence between interests of individual or group from
those of society at large
EXTERNALITIES
• Externalities are special case of market failure
• Externality
 The uncompensated impact of one person or firm’s
action on the well-being of a bystander
 Creates a cost or benefit
 Outcome is external to any market transaction (if any)
• Negative Externality or External Cost
 An adverse impact on bystander
 Imposes a cost on that bystander
• Positive Externality or External Benefit
 A beneficial impact on bystander
 Imposes a benefit on that bystander
EXTERNALITIES
• Technological vs. Pecuniary Externality
 Externalities can be either technological or
pecuniary
 Technological Externality
 External effect is not through market price, but
through its effect on consumption (utility) or
production (profit)
 Real effect: one person or firm’s gain/loss is not
another’s loss/gain
EXTERNALITIES
• Technological vs. Pecuniary Externality
 Pecuniary Externality
 External effect is through market price
 Leads to transfer or redistribution of income
 Gain or loss to one party is exactly offset by gain
or loss to another
 Pecuniary effects cancel out
EXTERNALITIES
• Types of Externalities
 Symmetric Externality
 Economic agents who generate externalities receive
reciprocal external effect
 Each consumer or firm imparts external effect to all other
consumers or producers, who in turn impart reciprocal
external effect on initial consumer or producer
 Asymmetric (Downstream) Externality
 Economic agents who generate externality are distinct from
those who experience them
 Production or consumption decisions of producers or
consumers enter production or utility functions of others, but
recipients of the externalithy do not cause any reciprocal
effect
EXTERNALITIES
• Types of Externalities
 Transferable Externality
 Individual or firm protects itself from external
damages by transferring an environmental risk
through space to another location or through time
to another generation
 Differs from traditional view of external cost in that
transferability motivated by intentional behavior,
not by unintentional behavior
 Example
 Example through space and time is dumping of
radioactive wastes at sea
EXTERNALITIES
• Types of Externalities
 Depletable Externality
 Also called rivalrous or private
 Experience of externality by one agent reduces the
amount experienced by other economic agents
 Share depletable charactistic of usual (private)
goods
 Example
 Dumping of oil to clean oil tankers’ tanks with seawater in
one area leaves that much less to be dumped in other
areas
EXTERNALITIES
• Types of Externalities
 Nondepletable Externality
• Also called nonrivalrous or public
• Experience of the externality by one agent does
not affect the amount experienced by other agents
• Have characteristics of gpublic goods or bads
• Example
• Amount of air pollution experienced by one agent does
not affect others’ experiencing it
EXTERNALITIES AND MARKET INEFFICIENCY
• Welfare Economics: A Recap
 Supply and demand curves contain important
information about costs and benefits
 Demand Curve
 Demand curve reflects value to consumer, as
measured by the prices they are willing to pay
 At any given quantity, height of demand curve
shows willingness to pay of marginal buyer
 It shows value to consumer of the last unit of the
good
EXTERNALITIES AND MARKET INEFFICIENCY
• Welfare Economics: A Recap
 Supply Curve
 Supply curve reflects costs of seller
 At any given quantity, height of supply curve shows
cost of the marginal seller
 It shows cost to seller of last unit of good sold
 In absence of externalities, price adjusts to
balance supply and demand
 Quantity produced and consumed in market
equilibrium is efficient in the sense that it
maximizes consumer and producer surplus
EXTERNALITIES AND MARKET INEFFICIENCY
• Welfare Economics: A Recap
Price
Supply curve reflects costs of
sellers
Supply
Equil.
Price
•Equilibrium quantity maximizes
total value to buyers minus the
total costs of sellers.
•In absence of externalities,
therefore, market equilibrium
is efficient and socially optimal.
Demand curve reflects value
to consumer by willingness to pay
Demand
Equilibrium
Quantity
Quantity
EXTERNALITIES AND MARKET INEFFICIENCY
• Negative Externalities or External Cost
 A cost of an activity that falls on people or
firms other than those who pursue the activity
 Private Cost
 Cost faced by the economic agent pursuing the
activity
 Social Cost
 Total cost to society of pursuing the activity
 Private cost + external cost
EXTERNALITIES AND MARKET INEFFICIENCY
• Negative Externalities or External Costs
Price
Social
Optimum
POPTIMUM
PMARKET
External
Cost
Social cost =
Private +
external cost
•Social cost of good
exceeds private cost
•Socially optimum
Supply
quantity exceeds
(private
marginal cost) privately optimum
quantity
Market Equilibrium
•Socially optimum price
exceeds privately
optimum price
Demand
QOPTIMUM
QMARKET
Quantity
EXTERNALITIES AND MARKET INEFFICIENCY
Social cost =
Private +
external cost
• External Cost
Price
POPTIMUM
External
Cost
PMARKET
Supply
(private
marginal cost)
Demand
Quantity
QOPTIMUM QMARKET
Figure 11.1
EXTERNALITIES AND MARKET INEFFICIENCY
EXTERNALITIES AND MARKET INEFFICIENCY
• Positive Externalities or External Benefits
Price
External
Benefit
Supply
(private
marginal cost)
•Social value exceeds private
value.
•Socially optimal quantity exceeds
private market equilibrium.
MBSOCIAL
= POPTIMUM
MBPRIVATE
= PMARKET
Social demand =
Private demand + external benefit
Demand
(private value)
QMARKET
QOPTIMUM
Quantity
Figure 11.2
A Good Whose Production Generates a
Positive Externality for Consumers
EXTERNALITIES AND MARKET INEFFICIENCY
• Internalizing the Externality
 Altering incentives so that people and firms take
account of the external effects of their actions
THE OPTIMAL AMOUNT OF
EXTERNALITIES IS NOT ZERO
• Optimal amount of negative externalities is
not zero
 Socially optimal policy is to curtail negative
externality until the cost of further abatement
just equals the marginal benefit
 Clean up pollution to but only up to a certain
point
 Beyond this socially optimal level, costs more
to society than it will benefit
 Marginal cost > marginal benefit
THE OPTIMAL AMOUNT OF
EXTERNALITIES IS NOT ZERO
• Optimal amount of positive externalities is
not zero
 Socially optimal quantity to expand positive
externality until the benefit of further increase
just equals the marginal cost
 Expand but only up to a certain point
 Beyond this socially optimal level, costs more
to society than it will benefit
 Marginal cost > marginal benefit
PRIVATE SOLUTONS TO
EXTERNALITIES
• Introduction
 Externalities lead markets to allocate
resources inefficiently
 Both private actors and public policymakers
respond to externalities in various ways
 All remedies share goal of moving allocation
of resources to social optimum
PRIVATE SOLUTONS TO
EXTERNALITIES
• The Types of Private Solutions
 Government action not always needed
 People and firms sometimes develop private solutions
 Sometimes solved with moral codes and social
sanctions
 Example: littering
 Charities
 Example: Sierra Club to protect environment due to negative
externalities
 Example: Universities receive gifts from alumni, etc. in part
because education has positive externalities for society
PRIVATE SOLUTONS TO
EXTERNALITIES
• The Types of Private Solutions
 Private market solutions can rely on selfinterest of relevant parties
 Sometimes can integrate different types of
business
 Example of bee keeper and orchard owner who integrate
into single firm
 Sometimes inerested parties enter into a contract
 Example of bee keeper and orchard owner
 Contract specifies number of trees, number of bees, and
perhaps payments
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem
 The proposition that if private parties can
bargain without cost over the allocation of
resources, they can solve the problem of
externalities on their own.
 Coase theorem says that private economic
actors can voluntarily solve the problem of
externalities among themselves.
 Whatever the initial distribution of rights, the
interested parties can always reach a bargain
in which everyone is better off and the
outcome is efficient.
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem
 If private parties can bargain without cost over
the allocation of resources (i.e. no
transactions costs), then the private market
will always solve the problem of externalities
and allocate resources efficiently.
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem
 Real question is should A be allowed to harm
B or should B be allowed to harm A?
 For example, if by polluter’s activities, a polluter
imposes an externality on someone, by asking
polluter to reduce emission of pollutants, pollutee
also causes a damage to the polluter.
 To whom should the property right be assigned?
 There are distributive effectives of private
bargaining.
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem
 Voluntary negotiation will lead to a fully efficiency
outcome provided that:
 1. rights are well defined
 2. transactions are costless
 3. there are no income effects.
 When income effects are taken into account, the assignment
of property rights will affect resource use.
 When damaged party is a consumer, willingness to pay may
differ from required compensation, because the former is
constrained by the consumer’s income.
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem
 Implications of Coase Theorem:
 1. If markets are incomplete, people will
negotiate and the efficient outcome will result;
 2. there is no need for government
intervention;
 3. the outcome is independent of the intial
assignment of rights.
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Advanced Discussion
 Inability or unwillingness to assign property
rights such that a complete set of markets can
be generated provides rationale for
government intervention
 But Coase observed that if there are zero
transactions costs, the set of markets can be
expanded beyond normal private goods to
include many non-market environmental
assets
 As long as institutional constraints to assigning
well-defined property rights are removed
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Advanced Discussion
 Coase Theorem posits that disputing parties
will work out Pareto-efficiency private
agreement
 Regardless of intial assignment of property righths
to non-market (environmental) asset
 As long as these legal entitlements can be
freely exchanged, government intervention is
relegated to designating and enforcing welldefined property rights
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Illustration
 Suppose two firms, A and B, who disagree
about optimal level of pollution in bay
 A produces pulp and paper and discharges
waste water back into bay
 B owns a boat marina
 A’s emissions reduce profitability of B’s
marina
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Illustration
 Following figure illustrates socially optimal level of
pollution Q*
Price
Marginal Cost
MB* = MC*
• MC = marginal cost to
B from pollution
• MB = marginal benefit to
A from pollution
• Q* = socially optimal level
of pollution, where MB =
MC
Marginal Benefit
Q*
Quantity of pollution
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Illustration
 But with incomplete markets, no opportunity
for parties to trade for alternative leels of
pollution, even though both A and B are better
off with trade
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Illustration
 Coast Theorem works as follows
 1. Rights to B: for Clean Water
 Suppose neutral third party creates legal
bargaining framework by assigning property rights
for clean water to B
 MC curve in figure represents B’s supply of clean
water and MB represents A’s demand for clean
water
 Given B has property rights, A would compensate
B by amount MC* for each unit of pollution
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Illustration
 Coast Theorem works as follows
 2. Suppose neutral third party assigns
property rights to pollute to A
 MC curve now represents B’s demand for
pollution control and MB curve now
represents A’s supply of pollution control
 Given A has property right to pollute, B can
offer bribe to A of amount MB* for each unit of
pollution control
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Illustration
 Theoretically, Coase Theorem works
regardless of initial assignment of property
rights
 Optimal per unit bribe MB* equals optimal per unit
compensation MC*, i.e. MB* = MC*, at socially
optimal level of pollution Q*
 Depending on relative magnitude of MB and
MC curves, optimal level of pollution could be
zero (high MC) or private optimum where MB
is zero (low MC)
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Illustration
1. Optimal Level of Pollution = 0: High MC
Price
MC
MC = MB
MB
0
Quantity of pollution
Q*
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Illustration
2. Optimal Level of Pollution = Private Optimum (Low MC)
Price
MC
MB
Q*
Quantity of pollution
PRIVATE SOLUTONS TO
EXTERNALITIES
• Why Private Solutions Do Not Always Work
 Coase theorem applies only when the interested
parties have no trouble reaching and enforcing an
agreement
 Transactions costs can prevent parties from agreeing
to and following through on an agreement
 Transactions Costs: the costs that parties incur in the
process of agreeing and following through on an agreement
 Reaching an efficient agreement is especially difficult
when number of interested parties is large because
coordinating everyone is costly
PUBLIC POLICIES TOWARD
EXTERNALITIES
• Introduction
 When an externality causes a market to reach
an inefficient allocation of resources,
government can respond in one of two ways:
 1. Command-and-control policies
 Regulate behavior directly
 2. Market-based policies
 Provide incentives so that private decision-makers will
choose to solve the problems on their own
PUBLIC POLICIES TOWARD
EXTERNALITIES
• Regulation
 Government remedies an externality by
making certain behaviors either required or
forbidden
 In this case, external costs to society far
exceed benefits to polluter
 Government institutes command-and-control
policy that prohibits this act altogether
 In most cases, situation is not this simple
PUBLIC POLICIES TOWARD
EXTERNALITIES
• Regulation
 Technology Standards
 Government sets standards for type of technology
to be used
 Examples: catalytic converter for smog, mileage
standards for automobiles
 Example: circle hooks and mackerel-type bait for
longliners to lower turtle interactions and mortality
 Production Standards
 Quotas
PUBLIC POLICIES TOWARD
EXTERNALITIES
• Pigovian Taxes and Subsidies
 Instead of regulating behavior in response to
an externality, government can use marketbased policies to align private incentives with
social efficiency
 Government can internalize externality by
taxing activities that have negative
externalities and subsidizing activities that
have positive externalities
PUBLIC POLICIES TOWARD
EXTERNALITIES
• Pigouvian Taxes and Subsidies
 Pigovian Tax
 A tax enacted to correct the effects of a negative externality.
 Pigovian taxes raise cost of generating negative
externality
 Pigovian tax effectively places a price on right to
generate negative externality
 Just as markets allocated goods to those buyers who value
them most highly, a Pigovian tax allocates negative
externality to polluters that face highest cost of reduction
PUBLIC POLICIES TOWARD
EXTERNALITIES
• Pigovian Taxes and Subsidies
 Pigovian taxes generally preferred to
regulation
 Regulation (command-and-control production
standard) dictates a level of pollution
 Tax gives polluter an economic incentive to reduce
pollution
 Tax reduces pollution more efficiently
 Regulation requires same level of reduction for all
polluters
 But equal reduction not necessarily least expensive way
PUBLIC POLICIES TOWARD
EXTERNALITIES
• Pigovian Taxes and Subsidies
 Difficulty in setting right level of tax to
generate socially optimal level of negative
externality
PUBLIC POLICIES TOWARD EXTERNALITIES
• Pigovian Taxes and Subsidies
 Pigovian taxes differ from most other taxes
 Most taxes distort incentives and move allocation
of resources away from social optimum.
 Reduction in economic well-being (consumer and
producer surplus) exceeds revenue government
raises, resulting in deadweight loss
 In contrast, when externalities are present,
Pigovian taxes correct incentives for presence of
externalities and thereby move allocation of
resources closer to social optimum.
PUBLIC POLICIES TOWARD EXTERNALITIES
• Pigovian Taxes and Subsidies
 Pigovian taxes differ from most other taxes
 Pigovian taxes generate a double dividend:
 Raise revenue for public purposes and enhance
economic efficiency
PUBLIC POLICIES TOWARD EXTERNALITIES
• Transferable Property Rights
 Establish a property right for negative
externality and let polluters voluntarily
exchange these pollution permits through a
market that develops
 This market is governed by the forces of
supply and demand
 New market efficiently allocates right to
generate negative externalities -- pollute
Transferable Property Rights
Price of pollution
Supply of Transferable
Property Right: Pollution Permits
• Supply is perfectly inelastic
• Quantity of pollution set by
number of permits or total
cap on pollution
P
Demand for Transferable
Property Right: Pollution
Permits
Quantity of pollution
2….which, together with the
demand curve, determines the
price of pollution.
Q
1. Pollution permits set the
quantity of pollution….
PUBLIC POLICIES TOWARD EXTERNALITIES
• Transferable Property Rights
 Firms that can reduce pollution only at high cost will
be willing to pay the most for pollution permits.
 Firms that can reduce pollution at low cost will prefer
to sell whatever permits they have.
 Initial allocation of property right among firms does
not affect economic efficiency, but affects distribution
of wealth
 Can initially allocate transferable property right -- pollution
permits -- to polluters or to society
 Initial allocation of transferable property rights among
polluters affects their distribution of wealth
PUBLIC POLICIES TOWARD
EXTERNALITIES
• Transferable Property Rights
 Both transferable property rights and Pigovian
taxes internalize externality by making it
costly to pollute
 With Pigovian taxes, polluting firms must pay tax to
government
 With transferable property rights, polluting firms
pay when buy and sell permits
PUBLIC POLICIES TOWARD EXTERNALITIES
• Transferable Property Rights
 Government fixes total quantity of pollution
 Position of demand curve for pollution permits
determines the price of pollution
 Government often knows overall level of
pollution (which sets supply of permits) but
not individual firm’s cost structure or demand
curve for pollution
 Hence difficult to set correct size of tax to
achieve that goal but easier and more
accurate to use transferable property rights
Equivalence of Pigovian Taxes and Transferable Property Rights
Pigovian Tax
Transferable Right
Price of Pollution
Price of Pollution
2…which together with the
demand curve, determines
the price of pollution
Pigovian
tax
P
1. A
Pigovian
tax sets
the
price of
pollution…
P
Demand for
pollution rights
Demand for
pollution rights
Q
2…which together with
the demand curve, determines
the quantity of pollution.
Supply of
pollution permits
Quantity of
pollution
Q
1. Pollution permits set the
quantity of pollution…
Quantity of
pollution
PUBLIC POLICIES TOWARD EXTERNALITIES
• Equivalence of Pigovian Taxes and Transferable
Property Rights
 Demand curve for right to pollute differs
 With Pigovian tax
 Government uses tax to set a price for pollution
 Supply curve for pollution rights is perfectly elastic, because
firms can pollute as much as they want by paying the tax
 Position of demand curve determines the price of pollution
PUBLIC POLICIES TOWARD EXTERNALITIES
• Equivalence of Pigovian Taxes and Transferable
Property Rights
 With transferable property right (pollution permits)
 Government sets quantity of pollution by issuing pollution
permits
 Supply curve for pollution rights is perfectly inelastic,
because the quantity of pollution is fixed by the number of
permits
 Position of demand curve determines the price of pollution
 Hence, with any demand curve for negative
externality or pollution, government can achieve any
point on the demand curve either by setting a price
with a Pigovian tax or by setting a quantity with
pollution permits or overall quantity of pollution