Lecture 4 - Property Rights and Market Failure

8/9/2019 Lecture 4 - Property Rights and Market Failure

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Property Rights and Market Failure

In this lecture we will discuss some of the concepts of standard neo classical Economics that are important in

analyzing environmental and natural resources problems. We will use neo classcal framework as benchmark

paradigm of our analysis.

First, we look into the relationship between economic system and environment as we have discussed in last

class. They have a dynamic relationship that is frequently influenced by static resource constraints and

intermittent technical progress. Figure 2.1 shows this relationship nicely:

Neo classcal economic analysis generally use two types of economic arguments: they are positive arguments

and normative arguments.

• Positive arguments attempts to describe what is, what was, or what will be

• Normative arguments, on the other hand looks for what ought to be

Positive arguments are more popular among economists as these arguments give the solution of the problem

that is in hand after accepting all its real peculiarity. These arguments give us quick solution. Sometimes

pressing need or political pressure forces us to find solution without considering long term consequence of

the decisions made. Contrary to this, normative arguments tell us what it ought to be with an expectations

that the decision will not disturb the overall balance of the system involved. They put little emphasis on

actual demand of the situation rather the arguments are more focused on the issue of general principles on

which the systems are based. In environmental economics, we follow positive arguments with

disproportionately high emphasis on normative aspects.


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Private Property Rights

Property rights are important as they give incentive to most of the people to work hard and work properly.

We are normally more sensitive using our personal laptop compared to the university lab computer. If

property rights are not properly described and preserved then development is hard to expect.

• Property right is a bundle of entitlements

o

Describe an owner’s rights, privileges and limitations for use of a resource.

o

Government can put restrictions on use of private property, after considering greater

interest of the community and state, even when the property is owned by an individual,

example – land (we cannot build multistoried buildings around airport area)

• Characteristics of an eficient property right structure that we normally expect in well-functioning

market economy are:

o Exclusivity—All benefits and costs accrued as a result of owning and using the resources

should accrue to the owner, and only to the owner, either directly or indirectly by sale to

others.

o Transferability—All property rights should be transferable from one owner to another in a

voluntary exchange.

o

Enforceability—Property rights should be secure from involuntary seizure or

encroachment by others.

Four regimes of property ownership

• Private property regimes - individuals hold entitlement

• State-property regimes - governments own and control property.

•

Common-property regimes - property is jointly owned and managed by a specific group. They can

exclude outsiders• Open access regimes - no one owns or exercises control over the resources.

Markets (private property regimes)

Markets - bring buyers and sellers together and create an organized environment. Market is the unit where

properties are bought and sold and contracts are written and executed. In neo classical economics, we argue

for free market, the form of market where there is minimal influences from outside forces.

•

In free market individuals act in their self interest and that lead to an efficient outcome

• Assumptions of a free market

o Large number of buyers and sellers

o

Free entry and exit

• In market both consumers’ and producer’s surpluses are maximized

• Market price communicates information to market participants

o

If price is high, then suppliers could be earning profits, if suppliers are earning profits, then

they should expand production

o If price is low, then suppliers could be earning losses, if suppliers are earning loses, then

they should contract production


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o

Profits and market prices direct resources to the most profitable industries

o

Price discovery process, gives information to the government regarding the most desirable

product of the society

• Transaction costs - costs involved in making a transaction. High transaction costs could prevent

trade

•

Transaction costs include

o Cost for search and information

o Cost for bargaining and decision

o Cost for monitoring and enforcement

o Cost for transportation and setup

• Example - land transfers in the United States have high transaction costs, from 3% to 9% of value

•

Stock Exchange has high setup costs, but once market is operating, costs tend to be low

• A market failure implies wastefulness or economic inefficiency

o Consumer surplus shrinks

o Producer surplus - could expand

o Deadweight loss to market

• Market failure – market fails to perform its expected role in the economy

o Something prevents the market to allocate resources efficiently, if a market has one buyer

(i.e. monopsonist), then the buyer dictates the market price (Walmart - the largest retailer

in the United States has strong control over its suppliers). If a market has one seller (i.e.

monopolist), then the seller dictates the market price

• When there is substantial difference between private cost and social cost of any action then we can

expect to have failure in market behavior. This situation is explained figure 2.5 of your text


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Market Failures

Private goods - goods supplied by producers in private sector

• Characteristics

o Rivalry - if one person buys and consumes a product, then another cannot buy and

consume that product

o

Excludable - producers can restrict consumption of their product to consumers who paid

for it.

Public Goods - the market under supplies public goods and over supplies public bads, like pollution

• Characteristics

o Non-rival – one person consuming and enjoying a good does not prevent another person

from consuming that good.

o Non-excludable – no person can be excluded from consuming that good.

•

Examples:

o National defense

o Radio and television broadcast signals

o Stable monetary and financial environment, central bank - influences inflation, interest, and

foreign exchange rates

•

Examples from environmental economics

o Clean air

o Air Pollution

Non-rival - one person or firm polluting the air does not prevent another from

polluting the air

Non-excludable - difficult to prevent people from polluting the airo

Global Warming

Substitute greenhouse gases for pollution

• Free riders will consume public good, but not pay for it

•

Quasi-public goods - market could supply these goods, but the supply would not be enough

o Highways

o Libraries

o Sewage disposal

o Postal service

•

Could be perverse market conditions for public goods if supplied by private market

o

Rome had no fire department around 115 B.C.

o

Marcus Licinus Crassus - started a private fire department in Rome

As a person house was burning down, Crassus would be negotiating a price for his

services

Crassus had market power and was one of the wealthiest Roman citizens


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•

Lindahl Price - A Lindahl price is paid by the individuals for the provision of a public good

according to their marginal benefits. So each individual pays according to his/her marginal benefit

derived from certain public good.

o If we could ask people the price they would be willing to pay for public good

o Then government charges each person his price (i.e. tax)

o

However, free riders may not truthfully reveal their preferences or willingness to pay

o

Not practical

Asymmetric information, which is characterized, by the case where either the buyer or seller has more

information than the other side can create market failures as well

o Market may undersupply goods with severe asymmetric information problems, examples:

products may be of low-quality, defective or even harmful

•

Moral hazard - one of the parties to a contract change their behavior that imposes a cost on the

other party

o People may act differently once they are hired or signed the contract

• Adverse selection - one of the parties to a transaction withholds critical information

o People may act differently while getting into contract by suppressing important

information and thus inflicting cost on the other party

•

Correcting asymmetric information: There is no solution for the problem of asymmetric

information. We can devise the contract and create an environment so that the cost of hiding

information can be higher for the parties involved.

o Government

Some forms may be illegal and prosecuted by government

Weights and measures - government has inspectors that make sure gas pumps andsupermarket scales are accurate

Government sues producers that make false claims

Regulations - government approves new products and has inspectors that inspect

products, example - BSTI

Licenses - ensures professionals have a high level of competency, professionals like

doctors, lawyers, mechanics, etc. need licenses to practice

o Private market

Brand names

Product warranties Public information - Consumer Reports - magazine that examines consumer

products

Databases - companies compile information about customers and payment history

Open access property - property owned by society or the absence of ownership

• Also called Tragedy of the Commons (Hardin 1968)

• Property rights are not well defined


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o

Open access is non-excludable but rivalrous

o

Outsiders cannot be excluded from using the property

o Outsiders can consume the resource, leaving nothing behind

• People have less incentive to develop, improve, or maintain land, if others cannot be excluded from

consuming it.

•

Examples

o Fishermen over fish in public waters.

o Fishermen catch too many fish, causing fish populations to decrease to such a level that

hurts future fish catching.

o Companies dump wastes onto public lands or waters.

o Air can be an open access resource. Some firms pollute and send pollution into the air

•

Correcting this market failure

o

Allow one firm to control the resource, the firm acts like a monopoly and develops the best

plan to utilize that resource. Sometimes the firm can be abusive and almost all the time

charge price so high that the resource stays out of the hands of many consumers

o Government create a permit system

Anyone harvesting or extracting the resource needs a permit

Common property becomes private property

Permit holders will monitor the resource against invaders and poachers

Government has to monitor the permit holders to ensure they comply with the

terms of the license

Externalities - The consumption or production of one individual or firm affects another person’s utility or

production without their consent.• The externality influences profits and utility, but does not impact market prices

• Therefore, an externality is not efficient (Arrow 1969)

• Positive externality - an individual's or firm's actions generate benefits for nonparticipating parties

•

The private market may not supply enough

• Supply function understates the true value of output

• Example

o Inoculation for diseases, each person who gets an inoculation can prevent spread of a disease

o Scientific knowledge or technological know-how

o

Bee keepers - bees pollinate farmers' crops, so they yield more fruits and vegetables

• Fixing positive externality

o

Subsidies - government provides subsidies so producers will supply more

Example - government grants subsidies to producers of vaccines

Note - government could subsidize the consumer to take advantage of the

externality

o Government provides the good


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Health departments give vaccines to the poor and elderly

o

Government provides legal protection

Patent - grants inventors exclusive right to producer their invention for 17 years in

the United States

• Negative externality - an individual's or firm's choice or action negatively harms others without

their consent

•

Property rights are not defined well

• Not all costs are registered, therefore supply function understates the true cost of production

• Example: A firm emitting pollution will typically not take into account the costs that its pollution

imposes on others.

o Market price is too low

o Market quantity is too high

o The goal is to have firms pay for pollution

o The goal is not to set the pollution to zero!

o The pollution is in excess of the ‘socially efficient’ level.

• Correcting this market failure

o If negative externality is between two firms, govt. could be possible to merge both firms

together

Not likely

Government seizure of property or aiding the growth of a monopoly

There is a societal factor as well

The following example is taken from your text regarding the extent of externalities in shrimp farming


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State property regime is the control by the state which has its own problems. Government is large and

strong with executive and legislative powers, however in practice they do not prove themselves efficient

compared to the fee market solution. Part of this is due to inefficiencies that are so inherent to any large

system. This is not a unique problem that is common among underdeveloped countries only, rather it is a

characteristics that is shared by all governments both developed and underdeveloped.

Common property regime falls between private and open access regimes and in that respect, they have

characteristics of both. A strong management system can manage those properly but that is not commonly

found in practice.

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Lecture 4 - Property Rights and Market Failure