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Market Failures and Market Efficiency
- See textbook Chapter 4.
- Market outcomes may not be (socially) efficient due to “market failures”.
- Root source of market failures:
- the private costs and private benefits considered by decision-makers ignore some of the costs and benefits of their decisions to society.
i.e. Social Costs ≠ Private Costs
and/or: Social Benefits ≠ Private Benefits
- social costs and benefits include private costs and benefits plus any costs or benefits to others in society.
- Supply-Demand model: implies market prices will reflect private values.
- Equilibrium price equals:- marginal buyer’s willingness-to-pay (marginal benefit) – this
is the buyer’s marginal private benefit;
- marginal cost of producing output: firm’s marginal private cost.
- Exchanges made if WTP>MC: private benefits > private costs.
- when market failure occurs prices measure private benefits and private costs but not social benefits or social costs.
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- Market failures are key motivators for environmental economic policy:
- they suggests when and why economic activity might lead to environmental problems.
- analysis of market failures can suggest policy solutions.
- find policies that move the outcome to the efficient one.
- find policies that align social and private benefits and costs
- Some sources of market failures:
The “big three” in environmental economics: - Externalities- Public Goods- Open-access and Common Property Resources
Other types of market failure? (but not of concern in this course)- Imperfect Competition (few sellers or buyers)- Asymmetric Information Problems
- Market failures concern “efficiency” reasons for policy.
- Other criteria could be used to justify policy.
e.g. equity, fairness or other ethical criteria.
- Focus here is on efficiency reasons.
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Externalities:
- An externality exists when a decision imposes costs or creates benefits for some party not involved in the decision.
i.e. it creates costs or benefits that are external to the decision-makers.
- Benefits and costs the decision-makers take into account are Private Benefits or Private Costs.
- Benefits and costs the decision-makers ignore are the External Benefits or External Costs.
- Social benefits and Social costs include both private and external costs and benefits.
- Externalities are a problem since decisions will ignore the external costs or external benefits.
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External Costs (Negative Externalities):
- Imagine that production, distribution or consumption of a good creates pollution.
e.g. paper mill effluents, air pollution from transport of inputs or finished goods, invasive species and water
transport.
- This pollution is costly: has negative effects on other people.
e.g. - worsens the quality of the air or water these people use. - harms a natural environment that people value.
- say that we can quantify the cost of this externality
(often difficult: how this might be done is discussed later)
- call the pollution cost per extra unit of the good produced: MEC (marginal external cost)
- say that we can graph MEC against output produced (like in Figure 4-3).
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- Neither the buyer or the seller of the good that leads to the pollution will take the external cost into account.
Market outcome: Supply = Demand (PM, QM in the diagram)
- Height of supply curve:
- marginal cost of output to seller
- this is a “private” cost: specific to decision-maker (private supplier).
- call it: Marginal Private Cost (MPC)
- Height of demand curve:
- willingness-to-pay: marginal benefit of output to buyer.
- this is a private benefit: specific to the decision-maker (buyer)
- call it Marginal Private Benefit (MPB).
- At equilibrium:
MPB = MPC ( = Equilibrium Price )
- But cost to society of producing more of the good (Marginal Social Cost = MSC) is:
MPC + MEC (=MSC)
- includes both the cost to the supplier and the external cost.
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- At equilibrium:
MSC > MPB
- too much is produced !
- society loses: MSC – MPB on the last unit of the good produced.
- in fact society is made worse off by any units produced for which:
MPC + MEC > MPB
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- What is the efficient outcome?
- reduce output to the level of output where:
MPC + MEC = MPB (QEFF in the diagram)
- at this point the benefit to buyers of the last unit produced covers both the private and external cost of the last unit.
- At lower levels of output:
MPB > MPC + MEC
- producing these units is efficient. (benefits more than cover all costs)
- Total gain to moving to the efficient outcome?
- area between MPB and MSC on units between the market and the efficient level of output
(Area ‘A’ in the diagram).
- How severe is the problem? - will depend on the size of the MEC.
- if MEC is large enough --- i.e. it may be efficient to set output to 0 (diagram).
i.e. then external costs more than outweigh producer plus consumer surplus created by providing the good.
- Implication: leaving decisions to individual buyers and sellers will result in too much output and too much pollution.
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- Market outcome is inefficient:
- why? neither buyers nor sellers have the incentive to take MEC into account.
- government policy can potentially improve on these outcomes.
i.e. change the balance of private costs and benefits to induce less output and so less
pollution.
e.g. regulate the amount of output, taxes on output or pollution, pollution permits, maybe changes to property rights etc.
(later in the course)
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External Benefits (Positive Externalities):
- Say that provision of a good or service creates benefits that accrue to someone other than the buyer or seller of that good or service.
e.g. buying a quiet lawnmower, tree-planting, purchase of a non-polluting car, beehives (pollination).
- now we have a marginal external benefit (MEB) associated with additional units of the good.
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- Market equilibrium (PM, QM in diagram):
Supply = Demand
MPC = MPB
But on the last unit of output:
MPB + MEB > MPC |_____________|
|Marginal Social Benefit > MPC
(MSB)
- Assuming no external costs: MPC = MSC.
- Society would be better off if more of the good is produced.
- additional unit of output generates a gain:
MSB – MPC > 0
- to achieve efficiency keep raising output until:
MSB – MPC = 0
MSB = MPC (at QEFF in the diagram)
- total gain from moving from the market to the efficient outcome:
area between MSB and MPC between market and efficient levels of output (Area ‘B”).
- Government can potentially improve on the market outcome by encouraging production of the good with external benefits.
e.g via regulation, subsidies etc.
(External benefit: Can you draw a case where QEFF>0 and QM=0?)
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Open Access and Common Property Resources:
- Open Access Resources:
- a resource with uncontrolled access to users. (non-excludeable)
- open-access may stem from a lack of property rights.
- Common property resources: (text: common pool resources)- A subset of possible users have open access (shared rights) to use the
resource.
- may be rooted in a system of common (shared) property rights.
Examples: - ocean fishery
- buffalo on the Prairies.
- communally owned grazing or forest land (Hardin’s “tragedy of the commons”)
- oil fields, water resources.
- environment: open-access issues and dumping, pollution (see text lake-water use example).
- road congestion (non-environmental example in text).
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- Source of the problem:
- Each user of the resource considers only their own (private) costs and own (private) benefits of using the resource.
- there is no incentive to take into account the costs that own use imposes on other users.
(effectively there is an external cost to resource use).
- little incentive to limit own-access or conserve if benefits of doing so mostly go to others.
- so an externality exists: what is special about it? - rooted in ownership/access issues - symmetry: each user creates problems for other users.
- How might my use harm other users?
- raise the costs of using the resource
e.g. - water use example in text: clean-up costs for other users.
- the more fish I catch the more difficult/costly it is for someone else to catch a fish.
- lower the benefits to others of current or future use of the resource.
e.g. keep cutting trees, hunting or fishing: only a small part of the benefits of conservation go to the person deciding not to harvest.
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- Consequence:
- overuse of the common property resource is likely.
- social costs of use exceed private costs of use(just like an externality)
- efficient to reduce use until marginal social benefits equal marginal social costs.
- exhaustion or extinction of the resource is possible: little incentive to conserve open-acess or common property resource.
- benefits of conservation (summed across all users) may exceed costs yet benefits to an individual of conserving may be smaller than individual cost.
- race to exploit: use it up before others do even if it will be worth more (socially) later.
- outcome is inefficient for common property resources.
- Government intervention may be able to improve the outcome.
Possibilities:
- Regulate use of the common property resource (licenses; quotas; land use
policies)
- Put a tax or price on resource use; subsidize conservation.
- Establish private property rights over the resource:
- with one user that user has incentives to consider all the costs and benefits of using the resource;
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- outcome is more likely to be efficient.
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Public Goods:
- Most goods or services are “private goods”.
- Private goods are:
(1) Excludable: the buyer or user of the private good can exclude others from its benefits.
e.g. I buy a banana and can exclude others from its enjoyment.
(2) Rival: my consumption of the good diminishes benefits to others
e.g. I eat the banana --- others can’t eat it too.
- Markets may be able to deliver private goods efficiently:
- Benefits and costs likely to be private.
- Public Good: a good that is non-excludable and non-rival.
(1) Non-excludable: - once provided it is available to all: exclusion is impossible.
(2) Non-rival: - one person’s consumption of the good does not diminish
benefits other can obtain from it.
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- Examples:
- National Defence: - Canadian government protects Canada from attack. - Benefit is provided to everyone in Canada (non-excludable).- My enjoyment of security does not diminish your enjoyment
of security (non-rival).
- Police services:- Arrest of violent maniac protects everyone. - My increased safety does not diminish your increased safety.
- Lighthouse:- All ships passing can see the light (non-excludable).- My using the warning light does not diminish its value to
other ships (non-rival).
- Clean air (atmosphere)- Benefit is provided to all who breathe it. - My use does not preclude use by others.
- Greenhouse (GHG) gases in the atmosphere: a public bad? - more GHG affects everyone (non-exclusion) and is non-rival. - limiting GHG: a public good!
- Some other environmental public goods: - Tietenberg: biological diversity. - Climatic system- Ozone layer.- Text: environmental quality (generally)
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- Public goods and market failure:
- Non-excludability gives rise to the “free rider problem”.
- rather than paying for the public good there is an incentive to let others provide it: you can consume it without paying.
- if everyone acts this way then none of the good will be provided.
e.g. climate change: country incentive to free-ride. (let Europe, China, US solve the problem)
- Non-rivalry also is likely to create efficiency problems.
- say one person goes ahead and provides some of the public good;
- person considers only their own private benefits and private costs of providing the good.
- but “non-rivalry” means there are external benefits from providing a unit of the good (others also benefit);
- individual provider ignores these external benefits
- good is undervalued by the private provider;
- too little is provided.
e.g. climate change: Canadian government focus on benefits to Canadians but others benefit too.
(Weitzman: will this become an issue with ‘geo-engineering’ solutions to climate change?)
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- Note even if you could exclude others from consuming the public good this would be inefficient.
- since the good is non-rival not excluding others creates additional benefits at no additional cost;
- exclusion would reduce total benefits but save no costs.
- Consequence:
- Public goods are unlikely to be efficiently provided by markets (perhaps not at all).
- Efficient provision of a public good: (see for example text Fig. 4-4)
- Gather information on the willingness-to-pay (marginal benefit) of each person who will benefit from its provision.
i.e. construct individual demand curves.
- The amount society (all individuals) value a unit of the public good is the sum of their willingness-to-pay for that unit of the good across all people who benefit.
i.e. add the height of demand curves across all individuals.
- now you have the total willingness-to-pay for each unit that might be provided. (call the demand curve DPublic and its height is marginal social benefit (MSB).
- If MSC is the marginal cost of providing the good (assume so external costs) then the efficient level of the public good is where:
MSB = MSC
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- Gain to society of providing the good is area between DPublic and MSC up to the efficient amount of the public good.
- compare this to providing 0 (amount provided privately);
- market failures arising from public goods may be very costly.
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- Government role:
- Government will likely have to provide the public good directly or pay private firms to provide the public good.
Market Failures: A Reason for Environmental Policy
- All three problems : externalities, public goods and open access (common property) resources suggest that environmental policy may be able to improve on market outcomes.
- Important policy questions to consider:
- Market failure suggests that government can improve outcomes: can it in practice?
- Government decision-making via a political process: could this result in inefficient intervention?
i.e. act to meet political not efficiency goals.
- Information issues: can the government measure the social costs and social benefits accurately enough to improve outcomes?
- What type of policy should the government use?
- Direct provision of the good, regulation, tax incentives or subsidies, liability laws, property rights etc.
- Many alternatives: can economics say anything about which may work best?
- Are there other reasons for government policy?
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- Focus above: market failure and efficiency.
- advantage: takes into account both the costs and the benefits to society of the activities creating environmental problems.
- but focus on efficiency assumes $1 is $1: no focus on who the winners and losers are
e.g. should losses or gains to poor people or Third World countries be weighed more heavily?
- Equity and Fairness another important set of criteria but more difficult to obtain consensus on.
- Moral / Philosophical considerations and the evaluation of outcomes.
- Efficiency:
- Roots in “Utilitarian” philosophy:
- source of social value is well-being of individuals (“welfarism”);
- focus on the benefits and costs to individuals as measured by those individuals.
- Are there other criteria for good and bad than individual welfare?
(values arising from other moral, religious, philosophical views?)
- Focus on dollars costs and benefits.
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- implied willingness to trade off costs vs. benefits of economic activity.
- vs. absolute inviolable rights, moral standards: may imply no tradeoffs are acceptable.
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FYI: quote from Martin Weitzman (Harvard) on public goods, externalities and climate change.
This paper begins with the realization that there are really two different externalities involved in the climate change problem, that they have near-opposite properties, that they interact, and that it seems difficult to say offhand which one is more threatening than the other. The first externality, described by the above quotes, comes in the usual familiar form of a public goods problem whose challenge is enormous because so much is at stake and it is so difficult to reach an international governing agreement that divides up the relatively expensive sacrifices that would be required by each nation to really make much of a dent in greenhouse gas (GHG) concentrations. The classic governance problem here is to limit the under-provision of a public good from free riding.
A second less-familiar externality shows up in the scary form of geoengineering the stratosphere with reflective particles to block incoming solar radiation. This geoengineering-type externality is so relativelycheap to enact that it might in principle effectively be undertaken unilaterally by one nation feeling itself under climate siege, to the detriment of other nations. The challenge with this second global externality also appears to be enormous, because here too so much is at stake and it also seems difficult to reach an international governing agreement. If the first externality founders on the free rider problem of under-provision, then the second externality founders on what might be called the “free driver” problem of over-provision. If the first externality is the ‘mother of all externalities’, then the second externality might be called the ‘father of all externalities’. These two powerful externalities appear to be almost polar opposites, with the world forced to confront both.
“A Voting Architecture for the Governance of Free-Driver Externalities, with Application toGeoengineering” Martin L. Weitzman (Harvard, November 28, 2013
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