Part I. Principles A.Markets B.Market failure C.Discounting & PV D.Dynamic efficiency E.Pollution solutions

B. Market failure Chapter 2

From last time MSC – marginal cost incurred by entire society, by the producer and by everyone else on whom the cost falls = MC + MEC MSB – marginal benefit enjoyed by society, by the consumers and by everyone else who benefits from it = MB + MEB

Maximizing Social Benefits In order for social net benefits to be maximized, it is necessary that: MB = MSB & MC = MSC

$ Quantity MSB = MSC q* S = MC = MSC D = MB = MSB

Will MB = MSB, MC = MSC? For many goods (sushi, surfboards), YES For many environmental-related goods (paper produced by water polluting paper mill, snorkeling at Hanauma Bay), NO MB ≠ MSB and/or MC ≠ MSC → market failure

Market Failure Occurs when the market does not allocate resources efficiently. 1 possible cause of market failure is a divergence between private and social costs (could also be between benefits). Consider a steel producer.

Production of steel MC reflects all the private costs of production (labor, rent, materials) but does not reflect all the social costs associated with production (for example, air pollution). Steel producers respond to private MC, steel consumers respond to private MB (here same as MSB) → equilibrium at Q1

Figure 2.3. Steel Production Example

Market Failure Market forces generate an equilibrium production level and price associated with private costs, at Q1. This output level is greater than the socially optimal level of Q* (which considers additional cost from pollution). The shaded area in Figure 2.3 represents the costs to society of having this higher than optimal level of output.

5 categories market failure 1.Imperfect competition 2.Imperfect information 3.Public goods 4.Inappropriate government intervention 5.Externalities

1. Imperfect competition – monopoly Profit max: restrict output, raise price Electricity, natural gas companies

2. Imperfect information Consumers and/or producers do not know true costs and/or benefits associated with good or activity Radon leaks into homes – if people don’t know health consequences, do not take proper mitigation measures Deforestation – small farmers cutting and burning (better techniques, but don’t know them)

3. Public goods* 2 characteristics distinguish from private goods: 1.Nonrival – 1 person’s consumption does not diminish amount available for others to consume 2.Nonexcludability – if 1 person can consume it, others can’t be excluded from consuming it

Pure public goods 100% nonrival, 100% nonexcludable Examples? Climate – my consumption doesn’t decrease your consumption (nonrival); cannot exclude me from enjoying benefits (nonexcludable)

Pure or impure PG? Beaches – nonrival, nonexcludable? Rival – as more and more people use it, quality diminishes (congestion, environmental degradation) Excludable – can charge user fees (as in NE, have to buy permits)

Pure or impure PG? Spectator sport (baseball) – nonrival, nonexcludable? 90% Nonrival – if I am watching, you can watch too, but congestion may diminish quality Excludable – pay for admission, or pay for cable to watch on TV

Pure or impure PG? Fish in a lake – nonrival, nonexcludable? Rival – if I catch more fish, less left for you to catch 90% nonexcludable – if I am fishing, you can fish too

Figure 2.5 Spectrum of public goods

Why market failure? Free rider – person who enjoys benefits of good/service without paying for it Clean air is public good – do you pay for it? In general, public goods underprovided (since free riders) → market failure

4. Inappropriate gov’t intervention Gov’t intervention is a potential source of disparity between private and social values. Often gov’t action to address an alternative issue creates this divergence. Gov’t policy regarding timber leases has created a greater than socially optimal level of timber harvest.

USFS policy Treats the forest as a private good – leases right to harvest to timber companies, ignoring other costs such as building roads, loss of ecosystem services, etc. Harvester equates MC = MB But forest has public goods characteristics – recreation, wildlife habitat, wilderness… Therefore, too many trees cut as opposed to socially optimal level.

Inappropriate gov’t intervention USFS provides free roads to companies to cut timber

5. Externalities* Externalities are best described as “spillover costs or benefits”, unintended consequences or side effects, associated with market transactions. These unintended costs or benefits will result in a divergence between private and social benefits and costs Externalities are perhaps the most important class of market failures for the field of environmental and resource economics.

Negative Externalities Can be generated by both producer and consumer side Production – air pollution, noise Consumption – smoking, traffic congestion

Negative production externality, e.g., pollution

Negative consumption externality, e.g., smoking

Positive Externalities Can also be generated by both producer and consumer sides Production – apples and honey, R&D Consumption – gardens, education, vaccines

Pecuniary vs. technological Pecuniary – price effect – unintended price change NOT an externality (demand for jeans ↑, price of cotton ↑, price of t-shirts ↑). Nothing has happened to ability to produce jeans/shirts, just price has changed. Technological – air pollution – cannot grow as much cotton – price cotton ↑ – price of t-shirts ↑ – this is an EXTERNALITY

Figure 2.8- Production Possibilities Frontier

Pecuniary vs. technological Notice the lower curve in Figure 2.8. This represents a situation where the production of steel generates pollution (an externality). Pollution reduces the yield per acre of cotton with the existing resource base.

Pecuniary vs. technological A new lower PPF results from this externality. Pecuniary externality would cause movement along same PPF, not shift of PPF. Technical externality – reduces welfare. Pecuniary shifts preferences.

Property Rights Important reason market failure exists Property rights for many environmental goods not well defined (clean air, water, etc.) Suffer from air pollution – who pays?

Open access externality Lack of or inability to enforce property rights E.g., fisheries, grazing Leads to overfishing, overgrazing Even if rights exist, hard to enforce

Does efficiency = equity? Market allocation of resources, absent of market failure, is efficient. An efficient allocation maximizes the difference between social benefits and social costs. An efficient allocation, however, does not imply equitable allocation. The “best” distribution depends on what view of equity or fairness is held – return to this in Part II of class (criteria for environ. decision making)

Conclusion This section focused on markets and how markets efficiently allocate goods and services. When market failure occurs, MB MSB and/or MC MSC Market failure can result from externalities, public goods, imperfect information, imperfect competition, and inappropriate government intervention.