Chapter 3

Modeling Market Failure

2004 Thomson Learning/South-Western

Environmental Problems: A Market Failure

Market failure 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
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Environmental Problems: A Public Good

Public good a commodity that is nonrival in consumption and yields benefits that are nonexcludable Characteristics of public goods
Nonrivalness the characteristic of indivisible benefits of consumption such that one persons consumption does not preclude that of another Nonexcludability the characteristic that makes it impossible to prevent others from sharing in the benefits of consumption

Modeling a Public Goods Market for Environmental Quality

Public goods generate a market failure because the nonrivalness and nonexcludability characteristics prevent natural market incentives from achieving an allocatively efficient outcome Allocative Efficiency in the Market for a Public Good
Achieving an allocatively efficient equilibrium in a public goods market depends on the existence of welldefined supply and demand functions Market demand for a public good the aggregate demand of all consumers in the market, derived by vertically summing their individual demands
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Modeling a Public Goods Market for Environmental Quality

Assessing the Implications
Abating at the 100 percent level to reduce pollution to zero involves prohibitive opportunity costs

Modeling a Public Goods Market for Environmental Quality

Figure 3.1 Combined Demand of Two Consumers for Air Quality (SO2 Abatement)

Modeling a Public Goods Market for Environmental Quality

Figure 3.2 Market Supply and Market Demand for Air Quality (SO2 Abatement)

Modeling a Public Goods Market for Environmental Quality

Understanding the Market Failure of Public Goods Market
Nonrevelation of preferences an outcome that arises when a rational consumer does not volunteer a willingness to pay because of the lack of a market incentive to do so Free-ridership recognition by a rational consumer that the benefits of consumption are accessible without paying for them Imperfect information Market forces alone cannot provide an allocatively efficient level of a public good

Modeling a Public Goods Market for Environmental Quality

The Solution: Government Intervention
A common means by which government responds to the dilemma of free-ridership and nonrevelation of preferences is through direct provision of public goods An alternative government response is the use of political procedures and voting rules aimed at identifying societys preferences about public goods Government response to imperfect information includes education and public information

Environmental Problems: Externalities

Externality theory specifies the relevant market as environmental as the good whose production or consumption generates environmental damage outside the market transaction
Externality a spillover effect associated with production or consumption that extends to a third party outside the market

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Environmental Problems: Externalities

Basics of Externality Theory
Negative externality an external effect that generates costs to a third party Positive externality an external effect that generates benefits to a third party

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Environmental Problems: Externalities

Environmental Externalities
Environmental economists are interested in externalities that damage the atmosphere, water supply, natural resources, and the overall quality of life Environmental externalities can occur in relation to both production and consumption

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Environmental Problems: Externalities

Relationship Between Public Goods and Externalities
Although public goods and externalities are not the same concept, they are closely related If the externality affects a broad segment of society and if its effects are nonrival and nonexcludable, the externality is itself a public good

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Modeling Environmental Damage As a Negative Externality

Developing a formal model of a negative environmental externality Defining the Relevant Market
The market is defined as refined petroleum products

Modeling the Private Market for Refined Petroleum

Assume the private market for refined petroleum is competitive Supply function is the marginal private cost Demand relationship is the marginal private benefit

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Modeling Environmental Damage As a Negative Externality

Figure 3.3 Competitive Equilibrium in the Market for Refined Petroleum

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Modeling Environmental Damage As a Negative Externality

Inefficiency of the Competitive Equilibrium
The problem with this equilibrium is that it ignores the external costs to society of contaminated water supplies caused by refined petroleum production Costs of water production are external to market exchange and not factored into private market decisions

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Modeling Environmental Damage As a Negative Externality

Modeling the External Costs
Model the hypothetical marginal external cost as MEC = 0.05Q

Modeling the Marginal Social Costs and Marginal Social Benefits

Marginal social cost the sum of the marginal private cost (MPC) and the marginal external cost (MEC) Marginal social benefit the sum of marginal private benefit (MPB) and marginal external benefit

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Modeling Environmental Damage As a Negative Externality

Efficient Equilibrium
Competitive equilibrium the point where marginal private benefit (MPB) equals marginal private cost (MPC), or where marginal profit (M)= 0 Efficient equilibrium the point where marginal social benefit (MSP) equals marginal social cost (MSC), or where marginal profit (M) = marginal external cost (MEC).

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Modeling Environmental Damage As a Negative Externality

Figure 3.4 Comparing Competitive and Efficient Equilibria Using
Marginal Benefit and Marginal Cost: Refined Petroleum Market in the Presence of Negative Externality

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Modeling Environmental Damage As a Negative Externality

Figure 3.5 Comparing Competitive and Efficient Equilibria Using
Marginal Profit and Marginal External Cost: Refined Petroleum Market in the Presence of Negative Externality

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Modeling Environmental Damage As a Negative Externality

Measuring the Welfare Gain to Society
If production of a commodity generates a negative externality, the market will yield an inefficient solution with too many resources allocated to production

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Modeling Environmental Damage As a Negative Externality

Figure 3.6 Assessing the Net Gain to Society of Restoring Efficiency in the Refined Petroleum Market

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Modeling Environmental Damage As a Negative Externality

Market Failure Analysis
There is no market incentive for a rational firm to incur higher costs than it has to, even if it is for the good of society Market failure models give us a better understanding of why we observe increasing damage to the physical environment as industrial production has intensified throughout the world

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The Absence of Property Rights

Property rights the set of valid claims to a good or resource that permits its use and the transfer of its ownership through sale

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The Absence of Property Rights

The Coase Theorem assignment of property rights, even in the presence of externalities, will allow bargaining such that an efficient solution can be obtained
Two important underlying assumptions of this theory: Transactions are costless Damages are accessible and measurable

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The Absence of Property Rights

Bargaining When Property Rights Belong to the Refineries
Assigning rights to refineries should have no effect on the outcome at all

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The Absence of Property Rights

Figure 3.7 Bargaining in the Refined Petroleum Market with the Assignment of Property Rights

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The Absence of Property Rights

Bargaining When Property Rights Belong to the Recreational Users
According to Coase Theorem, an efficient outcome can be achieved regardless of which of the affected parties controls the property rights There is an opportunity for bargaining to proceed so long as the following condition holds: M > > MEC The assignment of property rights leads to an efficient outcome without any government intervention

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The Absence of Property Rights

Limitations of the Coase Theorem
Coases model underscores the importance of property rights to market process, regardless of who is assigned those rights For this theory to hold in practice, at minimum it must be the case that very few individuals are involved on each side of the market

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The Absence of Property Rights

Common Property Resources those resources for which property rights are shared
If property rights exist in some form but are ill defined, the outcome will be an inefficient one Because property rights extend to more than one individual, they are not as clearly defined as for pure private goods With common property resources, the problem is that public access without any control leads to exploitation, which in turn generates a negative externality

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The Absence of Property Rights

The Solution: Government Intervention
The general solution to externalities, including those affecting the environment, is to internalize the externality, that is, to force the market participants to absorb the external costs or benefits Other approaches to internalizing environmental externalities are policies that change the effective price of a product by the amount of the associated external cost or benefit

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