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An article for today Homework 2 (due May 5); Received only from Jamila and Layal Project: received only from Layal 6-1.

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Presentation on theme: "An article for today Homework 2 (due May 5); Received only from Jamila and Layal Project: received only from Layal 6-1."— Presentation transcript:

1 an article for today Homework 2 (due May 5); Received only from Jamila and Layal Project: received only from Layal 6-1

2 Reminder: project deadlines By May 8 (Friday): define your subject. To do this, you should read 4-5 newspapers articles about the topic. Among others, you can look inside The Economist and The GDAE ( Then you have to write one page (maximum) where you explain your subject and the basic points that you think should be treated based on your readings. E-mail me your discussion and submit a copy of the articles. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-2

3 From a different book: ecological economics CHAPTER 10: MARKET FAILURES (MF)(PP. 157-183); BOOK 6/13/2014 3

4 4 Chapter 10: Market Failures

5 6/13/2014 5 Markets use individual self-interest to efficiently allocate resources (means) among alternative ends via the pricing mechanism However: monopolies undermine the ability of markets to efficiently allocate Monopolies are a market failure arising from a structural problem (absence of competition) How else do markets fail? Inherent characteristics of certain types of resources Lack of institutions defining property rights None of the goods and services provided by natural capital has all of the characteristics required for efficient allocation by the market

6 6/13/2014 6 Characteristics of market goods: excludability Excludability: one for which exclusive ownership is possible (prevent others from using it, if so desired) Consequently: synonymous with property rights Essential for efficiency. Why? What is investment and cost for non-excludable goods, such as fish in the sea? In a market economy, people rarely invest when others will reap the returns Since excludability is the (f) of institutions: it becomes a property of the regime that controls access to the resource Example: have you ever recorded copyrighted music?

7 6/13/2014 7 Characteristics of market goods: excludability Problem: many goods and services are naturally non-excludable Ecosystem fund excludability vs. ecosystem service excludability

8 6/13/2014 8 Characteristics of market goods: rivalness Rival: one for which use of a unity by one person prohibits use of the same unit at the same time by another; all stock-flow resources; not all fund-service resources Nonrival goods produced by nature – climate stability, ozone layer, beautiful views, … Market efficiency requires that the marginal cost to society of producing or using an additional good or service be precisely equal to the marginal benefit. If a good is nonrival, an additional person using the good has no additional cost to society. Therefore: markets will not lead to efficient allocation of nonrival goods, or, a good must be rival to be efficiently allocated by the market

9 6/13/2014 9 Characteristics of market goods: rivalness Two types of nonrival goods and services (1) nonrival services not affected by people using them (UV protection by ozone layer) (2) nonrival goods or services affected by people using them (eg: traffic jams) Nonrival but congestible Congestibility is an issue of scale Congestibility leads some nonrival goods -> rival

10 6/13/2014 10 excludability, rivalness, & congestibility Remember: effective policies must be tailored to the specific combination of excludability, rivalness, and congestibility that characterizes a particular good or service Know table 10.1

11 6/13/2014 11 Open access regimes Nonexcludable and Rival tragedy of the commons; England grazing commons Each person acting in what appears to be rational self-interest degrades the commons, and everyone is worse off No invisible hand bringing the greatest good for the greatest number What is common property? Open access problem (better name) Know the Atlantic cod example (box 10-1)

12 6/13/2014 12 Excludable and Nonrival Goods Information, excellent example, of nonrival and noncongestible Trade secrets protected by patents. Why? Before: Adam Smith: trade secrets equivalent to monopolies monopolists by keeping the market constantly understocked, by never fully supplying the effectual demand, sell their commodities much above the natural price. … the price of monopoly is upon every occasion the highest which be got. Are patents monopolies on information? Now – trade secrets protected Patents: make them legally excludable and thus marketable Why? Assumption is that w/o excludable property rights, people would not profit from inventing new things Once a patent expires, the knowledge becomes a pure public good

13 6/13/2014 13 Excludable and Nonrival Goods But: one persons use of information has no negative impact on someone elses use of infrmation Sharing and using information can lead to improvement in quality; free flow of information creates an efficiency of the commons Patents: keeping existing knowledge artificially expensive during the life of the patent makes production of new knowledge more expensive New, virus-resistant strain of rice: 34 patent holders with competing claims Under pressure from corporate lobbies, US Congress increased copyright longevity from 14 years to 95 years

14 6/13/2014 14 Patents and… AIDS medicine A currently available drug cocktail can reduce the level of HIV in the bloodstream The benefits of controlling contagious/deadly diseases are…. … nonexcludable The drug patents has what impact? Irony: patent rights are protected in the name of the free market, yet patents simply create a type of monopoly – the antithesis of a free market

15 6/13/2014 15 Information… If information is free… … it will presumably be used until the marginal benefits of use are = to the marginal costs of additional use; the pre-req for efficient allocation If a good is nonexcludable, market provides no incentive for investment Linux (Box 10.2) - patents not necessary to spur invention Check this out for EC: and write me your thoughts via email in 2 weeks

16 6/13/2014 16 Excludable, congestible goods? Remember: congestible goods are nonrival at low levels of use and rival at high levels of use Same price at different levels of use results in inefficient outcomes at some levels Thus: may treat congestible goods as market goods during peak usage and nonmarket goods at other times multi-tier pricing structures Charging different prices at different times or for different users

17 6/13/2014 17 Pure public goods Nonrival, nonexcludable Anyone can use it regardless of who pays for it One person consuming the good does not leave any less for others Therefore: it is worth producing as long as all individuals together are willing to pay the cost of producing another unit ( Example: public park vs. park with admission fee) Soybeans in the Amazon: ecosystem services (public goods) vs deforestation (private market goods). Free-rider effect: in rational self-interest to not contribute

18 6/13/2014 18 Public goods and scarcity if: - our economic system provides incentives solely for producing and allocating market goods… … it will systematically undermine the production of absolutely invaluable public goods Note: many of the scarcest and most essential resources are public goods; existing economic system only addresses market goods

19 6/13/2014 19 Understand the issue of knowledge and information If information is a private good -> not sufficiently allocated It information is a public good -> not produced in sufficient quantity by market forces What is the opportunity cost on society? What about the public good? Note: 13 of the 1240 new drugs licensed between 1975 and 1996 dealt with lethal communicable diseases primarily in developing countries. Need a social and ethical filter to select the beneficial knowledge

20 6/13/2014 20 If the market is extremely effective at producing market goods but very poor at producing or preserving public goods, then over time public goods inevitably become more scarce relative to private goods, giving rise to marco-allocation … … the allocation of resources between market and nonmarket goods and services.

21 6/13/2014 21 Public goods and substitution Can manmade capital substitute for natural capital? NCE: as a resource grows scarce, price increases, encouraging the invention and innovation of substitutes Is there a guarantee that there will be adequate substitutes for every vital resource? What happens when the resources becoming scarce are public goods (and thus have no price and no profit to be made from substitutes)?

22 6/13/2014 22 Externalities Occurs when an activity or transaction by some parties causes an unintended loss or gain in welfare to another party; no compensation for the change in welfare Marginal external cost: cost to society of the negative externality that results from one more unit of activity by the agent Example: coal-fired utility plant next door to a laundry service that air-dries its wash; Question: will assigning property rights eliminate the externality problem?

23 6/13/2014 23 The Coase theorem Once compensation is paid, the externality is gone Ronald Coase: under certain circumstances, it doesnt matter whether the utility is assigned the right to pollute or the laundry is assigned the right to clean air (1960 paper) The negotiated outcome an identical amount of pollution – at the level marginal costs of pollution to the laundry which are = to the marginal benefits to the utility Implication: externalities requires no government intervention; market forces are perfectly capable of sorting it out Coase Theorem: initial allocation of legal entitlements does not matter from an efficiency perspective so long as they can be exchanged in a perfectly competitive market Economic efficiency demands that Marginal Net Private Benefits (MNPB) = Marginal External Cost (MEC)

24 6/13/2014 24 But… the coase theorem Problems: Assumes that both parties are able to pay (wealth effect) Assumes no real transaction costs (costs of reaching an agreement) Coase: recognized that high transaction costs could justify govt intervention; his followers not Note: perfect information concerning human impacts on ecosystems is unobtainable

25 6/13/2014 25 Missing markets For a market to function optimally, everyone who wants to produce/consume goods marketed must be able to participate But: future generations cannot participate The market can only efficiently allocate resources assuming that future generations have no rights to allocated resources ? – how to provide future generations w/ property rights to resources? Impose sustainability criteria inalienable With unknowns? Ethically – do not risk catastrophic outcomes for the future in exchange for nonessential benefits today

26 6/13/2014 26 Intertemporal discounting A standard cost-benefit analysis … the net present value (NPV) [the value to us today] of a given stream of costs and benefits through time The father off in time that a cost or benefit occurs, the more we discount its present value As time increase, the discount factor is raised to a larger and larger power – thus making it smaller Know the equation (Page 182)

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