Chapter 3 Modeling Market Failure 1

Environmental Pollution Market failure is the result of an inefficient market condition Environmental problems are modeled as market failures using either the theory of public goods or the theory of externalities If the market is defined as “environmental quality,” then the source of the market failure is that environmental quality is a public good If the market is defined as the good whose production or consumption generates environmental damage, then the market failure is due to an externality

Environmental Quality A Public Good A public good is a commodity that is nonrival in consumption and yields nonexcludable benefits Nonrivalness – the characteristic of indivisible benefits of consumption such that one person’s consumption does not preclude that of another Nonexcludability – the characteristic that makes it impossible to prevent others from sharing in the benefits of consumption Clean air, clean drinking water, clean waste treatment…

A Public Goods Market for Environmental Quality Market failure because the nonrivalness and nonexcludability characteristics prevent market incentives from achieving allocative efficiency Cannot specify / identify / operationalize demand Consumers are unwilling to reveal their demand because they can share in consuming the public good even when purchased by someone else This problem is called nonrevelation of preferences, which arises due to free-ridership In addition, lack of awareness of environmental problems exacerbates the problem

Solution to Public Goods Dilemma Government might respond through direct provision of public goods Government might use political procedures and voting rules to identifying society’s preferences about public goods

Environmental Problems A Negative Externality An externality is a spillover effect associated with production or consumption that extends to a third party outside the market Negative externality – an external effect that generates costs to a third party Positive externality – an external effect that generates benefits to a third party Examples: dumping toxic waste in ocean, emitting gases into local air space EPA Toxic Release Inventory Externalities caused by doing something we want to do: produce or consume

Modeling a Negative Environmental Externality Define the market as refined petroleum Assume the market is competitive Supply is the marginal private cost (MPC) Demand is the marginal private benefit (MPB) Production generates pollution, modeled as a marginal external cost (MEC) Problem: Producers (refineries) have no incentive to consider the externality Result: Competitive solution is inefficient

Finding a Competitive Solution Refined Petroleum Market Marginal Private Cost S: P = 10.0 + 0.075Q Marginal Private Benefit D: P = 42.0 − 0.125Q, where Q is thousands of barrels per day Find the competitive solution

Competitive Solution Set MPB = MPC 42.0 − 0.125Q = 10.0 + 0.075Q Solve: QC = 160,000 PC = $22 Analysis: This ignores external costs from contamination Efficiency requires all costs to be counted in MPC function MPC undervalues (assumes at zero) pollution costs QC is too high; PC is too low

Examples of costs from pollution

April 20, 2010: Deepwater Horizon Explosion

Finding a Socially Efficient Solution Include the external pollution effects, as Marginal External Costs or Marginal External Benefits (MEC, MEB) Use Marginal Social Cost and Marginal Social Benefit (MSC, MSB) Instead of just MPC, use MSC=MPC+MEC Instead of just MPB, use MSB=MPB+MEB Assume Marginal External Cost (MEC) = 0.05Q MSC = 10.0 + 0.075Q + 0.05Q = 10.0 + 0.125Q Assume no external benefits, MEB = 0, so MSB = MPB Find the new efficient (for real) solution

Efficient Solution Set MSC = MSB 10.0 + 0.125Q = 42.0 - 0.125Q QE = 128,000 PE = $26 In the presence of an externality, market forces cannot determine an efficient outcome If externality is negative, market Q is too low, market P is too high

42 MSC = MPC + MEC P per barrel S =MPC PE = 26 PC = 22 10 D = MPB = MSB 128 160 Q (thousands) QE QC

Measuring Society’s Net Gain From Social Efficiency As Q falls from 160 to 128: Refineries lose p (MPB over MPC) for each unit of Q reduced [area WYZ] Society gains accumulated reduction in MEC for each unit of Q reduced [area WXYZ] Net gain = Area WXYZ - Area WYZ = Area WXY

Measuring Society’s Net Gain Refined Petroleum Market Society gains WXYZ; refineries lose WYZ; net gain is WXY 42 P per barrel MSC = MPC + MEC X S = MPC W PE = 26 Y PC = 22 Z 10 D = MPB = MSB QE = 128 QC = 160 Q (thousands)

Pigou’s solution for externalities: Both externality and public goods models show inefficiency of private market solution, i.e., market failure Pigou’s solution for externalities: Make sure consumers and producers work off MSB and MSC curves Make sure consumers and producers do not work of MPB and MPC curves Another solution: by Coase

Ronald Coase

Property Rights Property rights are “valid claims to a good or resource that permit use and transfer of ownership” For environmental goods, it’s often unclear who has property rights Economics says it’s the absence of rights that matters, not who possesses them

Coase Theorem Proper assignment of property rights will allow bargaining between parties such that efficient solution results, regardless of who holds rights Assumes costless transactions Assumes damages are accessible and measurable

Building the Model Refined Petroleum Market Refineries use the river to release chemicals as an unintended by-product of production Objective: to maximize p Recreational users use the river for swimming and boating Objective: to maximize utility

Bargaining When Rights Belong to Refineries Recreational users are willing to pay refineries for each unit of Q not produced Will pay up to the negative effect on utility (MEC) Refineries are willing to accept payment not to produce Will accept payment greater than their loss in profit from reducing production (Mp)

Bargaining When Rights Belong to Refineries Initial point is Qc, since the refineries, who own the rights, would choose this point Recreational users: Willing to offer a payment r r < (MSC - MPC), or r < MEC Refineries: Willing to accept payment r r > (MPB - MPC), or r > Mp

Bargaining Process X W Y Z MSC = MPC + MEC S =MPC D = MPB = MSB 42 Between QC and QE, MEC > M, so bargaining proceeds 42 P per barrel MSC = MPC + MEC X S =MPC W 26 22 Y Z MEC at Qc is XY M at Qc is 0 Bargaining begins 10 At QE, MEC = M, so bargaining ends D = MPB = MSB 128 160 Q (thousands) QE QC

Bargaining Process Bargaining should continue as long as: (MSC - MPC) > r > (MPB - MPC) or MEC > r > Mp At QC: Refineries’ Mp = 0, but MEC > 0, (distance XY) Since MEC > Mp, bargaining begins Between QC and QE, same condition holds At QE: MEC = Mp, (distance WZ); output reductions beyond this point are infeasible, since Mp > MEC

Bargaining When Rights Belong to Recreational Users Bargaining will proceed analogously An efficient outcome can be realized without government intervention

Limitations of the Coase Theorem Bargaining is too difficult Transactions costs are too high Transactions costs: Costs of identifying damage Costs of agreeing on damage Costs of negotiating settlement Costs of enforcing payment Negative incentive (repeat offender)

Coase Theorem Problem; negative externalities Really a problem of property rights Assign property rights Bargain to get to socially efficient solution Cannot bargain because of transactions costs

Solutions One solution: Internalize externality by assigning property rights Make sure bargaining can happen Or: Set policy prescription (standards, taxes…)

Very big issues here Public goods – address with government provision Externalities – address with property rights or other policies Key theory: MSC not MPC / MSB not MPB MSC = MPC+MEC MSB = MPB+MEB