1. Chapter 3 Modeling Market Failure

2. 1. Environmental Pollution: A Market Failure
Market failure is the result of an __________ market condition
Environmental problems are modeled as market failures using either the theory of public goods (the market is defined as “environmental quality”) or the theory of externalities (the market is defined as the good whose production or consumption generates environmental damage)

3. 2. Environmental Quality: A Public Good
A public good is a commodity that is _________ ______________ and yields _____________ benefits
An example: environmental quality
Two classic examples of public goods are a lighthouse and national defense.

4. Important Characteristics of Goods
A good is excludable if a person can be prevented from using it if he does not pay for it.
excludable: fish tacos
not excludable: national defense
A good is rival in consumption if one person’s use/consumption of it diminishes others’ use/consumption.
rival: fish tacos
not rival: national defense
Review

5. Review
Classic division of goods in economy
Rival in consumption
(consumption
diminishes its value)
Not rival
Excludable
(have to pay)
private goods:
food
clothing
natural monopolies (club goods):
cable TV
Not excludable
common resources: fish in the sea
environmental quality?
public goods:
national defense
tornado siren
environmental quality (our book)?
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Public access without any control leads to depletion/overuse/exploitation

6. 3. A Public Goods Market for Environmental Quality
Air quality (measured by reductions in SO2) market
Market supply:
Some number of hypothetical producers are willing and able to supply various reductions in SO2 at different price levels
Market supply: P = QS

7. “What quantity of this good would you consume at each price?”
Market demand:
In theory, market demand for a public good is found by vertically summing individual demands
Vertical sum because we must ask consumers “What price would you be willing to pay for each quantity of the public good?”
For a private good, the market demand is found by horizontally summing individuals’ demands.
“What quantity of this good would you consume at each price?”

8. Demand for consumer 1: p1 = 10 – 0
Demand for consumer 1: p1 = 10 – 0.12QD + Demand for consumer 2: p2 = 15 – 0.18QD Demand for consumers 1 & 2: p1 + p2 = 25 – 0.3QD Market demand: P = 25 – 0.3QD
Check page 57: Figure 3.1

9. Market supply: P = 4 + 0.75QS Market demand: P = 25 – 0.3QD
Equilibrium found where
QS = 25 – 0.3QD, or
where QE = ___ percent
and PE = $___ million

10. Page 59: Figure 3.2 P ($ millions) S 25 PE = 19 4 D QE = 20
Q (% of SO2 abatement)
QE = 20
PE = 19 4 25 S D

11. Comment 1: QE (=20%): --efficient or optimal level of abatement
--not necessarily 100% (which means zero pollution)
Efficient level is at MB =MC
Zero pollution: forgone production and consumption of any good generating even the smallest amount of pollution

12. Comment 2:
Consumers are unwilling to reveal their WTP because they can share in consuming the public good even when purchased by someone else
--This problem arises due to free-ridership
--Result is that market demand is undefined
--Consequently, allocative efficiency cannot be achieved without third-party intervention
--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

13. Public Goods
Public goods are difficult for private markets to provide because of the free-rider problem.
________: a person who receives the benefit of a good but avoids paying for it
If good is not excludable, people have incentive to be free riders, because firms cannot prevent non-payers from consuming the good.
Result: The good is not produced, even if buyers collectively value the good higher than the cost of providing it.

14. Example: Imagine a city in which 60,000 people are living
Example: Imagine a city in which 60,000 people are living. There is a chance to install a tornado warning system at the cost of $60,000. Each person may be prepared to pay $1. However, it is quite possible that some people will refuse to pay, and instead hope that others will pay for the system anyway, and they receive the benefit for no personal expense. The result is that it is possible no system will be installed. a tornado warning system--______________ some people--______________ the result--________________

15. 4. Environmental Problems: Externalities
An externality is a ____________ 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

16. Pollution: A Negative Externality
Example of negative externality: Air pollution from a factory.
The firm does not bear the full cost of its production, and so will produce more than the socially efficient quantity.
How govt may improve the market outcome:
Impose a tax on the firm equal to the external cost of the pollution it generates

17. 5. Environmental Damage: A Negative Externality
Environmental economists are interested in externalities that damage the atmosphere, water supply, natural resources, and overall quality of life

18. 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 _________ cost (MEC)
Problem: Producers (refineries) have no incentive to consider the externality
Result: Competitive solution is inefficient

19. Finding a Competitive Solution Refined Petroleum Market
S: P = Q
D: P = Q, where
Q is in thousands of barrels per day
Since S is MPC and D is MPB, rewrite as
MPC = Q
MPB = Q
(P means private)
Find the competitive solution and analyze

20. Competitive Solution Set MPB = MPC 42.0 - 0.125Q = 10.0 + 0.075Q
Solve:
QC = _____ thousand; PC = $___ per barrel
(C means competitive)
Analysis:
This ignores external costs from contamination
QC is too high; PC is too low

21. Finding a Socially Efficient Solution Refined Petroleum Market
Let Marginal External Cost (MEC) = 0.05Q
Marginal Social Cost (MSC) = MPC + MEC
MSC = Q Q
= _______________
Marginal Social Benefit (MSB) = MPB + MEB
Assuming no external benefits, MEB= 0, so MSB = MPB
Find the efficient solution; show graphically

22. Socially Efficient Solution
Set MSC = MSB
Q = Q
--Solving: QE = ___ thousand; PE = $___/barrel

23. MSC, MPC, MPB Graph P ($ per barrel) Page 67 42 MSC = MPC + MEC S =MPC10
D = MPB = MSB
128
160
Q (thousands) QE QC

24. Results of negative externality
--QC (160) is higher than QE (128), since the firm does not bear the full cost of its production, and so will produce more than the socially efficient quantity (overallocation of resources)
--PC (22) is lower than PE (26), since MEC is not captured by market transaction

25. Important Observations
Both externality and public goods models show inefficiency of private market solution, i.e., market failure
Underlying source of failure is absence of property rights
Recall Boston Harbor application
Because no one owns the atmosphere or the earth’s rivers, there is no market incentive to prevent or correct contamination of these resources. Government is needed.

26. 6. Absence of Property Rights
The Coase Theorem
Ronald Coase, Nobel Laureate, 1991

27. Property Rights
Valid claims to a good or resource that permit the use and transfer of ownership through sale
For environmental goods, it’s unclear who “owns” rights
Economics says it’s the absence of rights that matters, not who possesses them

28. Coase Theorem
Proper assignment of property rights, even if externalities are present, will allow bargaining between parties such that efficient solution results, regardless of who holds rights
Assumes costless transactions
Assumes damages are accessible and measurable
In economics, a transaction cost is a cost incurred in making an economic exchange. It includes: search and information cost, bargaining cost, and enforcement cost.

29. The Coase Theorem: An Example
Dick owns a dog named Spot.
_____________ externality: Spot’s barking disturbs Jane, Dick’s neighbor.
The socially efficient outcome maximizes Dick’s + Jane’s well-being.
If Dick values having Spot more than Jane values peace & quiet, the dog should stay. Otherwise, the dog should go.
Coase theorem: The private market will reach the efficient outcome on its own…
See Spot bark.

30. The Coase Theorem: An Example
CASE 1: Dick has the right to keep Spot (Jane needs to pay Dick to get rid of Spot). Benefit to Dick of having Spot = $500 Cost to Jane of Spot’s barking = $800
Socially efficient outcome: Spot goes bye-bye.
Private outcome: Jane pays Dick $600 to get rid of Spot, both Jane and Dick are better off.
Private outcome = efficient outcome

31. The Coase Theorem: An Example
CASE 2: Dick has the right to keep Spot (Jane needs to pay Dick to get rid of Spot). Benefit to Dick of having Spot = $1000 Cost to Jane of Spot’s barking = $800
Socially efficient outcome: See Spot stay.
Private outcome: Jane not willing to pay more than $800, Dick not willing to accept less than $1000, so Spot stays.
Private outcome = efficient outcome

32. The Coase Theorem: An Example
CASE 3: Jane has the legal right to peace & quiet (Dick needs to pay Jane to keep Spot).
Benefit to Dick of having Spot = $500 Cost to Jane of Spot’s barking = $800
Socially efficient outcome: Spot goes bye-bye.
Private outcome: Dick not willing to pay more than $500, Jane not willing to accept less than $800, so Spot goes bye-bye.
Private outcome = efficient outcome

33. The Coase Theorem: An Example
CASE 4: Jane has the legal right to peace & quiet (Dick needs to pay Jane to keep Spot).
Benefit to Dick of having Spot = $1000 Cost to Jane of Spot’s barking = $800
Socially efficient outcome: Spot stays.
Private outcome: Dick pays Jane $900 to keep Spot, both Jane and Dick are better off.
Private outcome = efficient outcome

34. The private market achieves the efficient outcome regardless of the initial distribution of rights.

35. Solution to Externalities Government Intervention
Internalize externality by:
Assigning property rights, OR
Setting policy prescription, such as:
Set standards on pollution allowed
Tax polluter (= MEC at QE)
Establish a market and price for pollution
a private solution
public solutions
Ch4
Ch5
Ch5

36. Consumption externalities Production externalities
Positive
Negative
The benefits to the rest of society of people being vaccinated before traveling abroad
Noise pollution from using car stereos
The benefits to the environment that arise from the planting of woodland by a forestry company
Wastes being dumped into a river by a company