1 env 536: environmental economics and policy (lecture 4) modeling market failure asst.prof. dr....

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ENV 536: Environmental ENV 536: Environmental Economics and Policy Economics and Policy

(Lecture 4)(Lecture 4) Modeling Market Failure Modeling Market Failure

Asst.Prof. Dr. Sasitorn SuwannathepAsst.Prof. Dr. Sasitorn SuwannathepSchool of Liberal ArtsSchool of Liberal Arts

King Mongkut’s University of Technology King Mongkut’s University of Technology ThonburiThonburi

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Market FailureMarket Failure Based on the materials balance model, we Based on the materials balance model, we

know that economic activities generate know that economic activities generate residuals that can damage natural residuals that can damage natural resources.resources.

Why dose pollution persist.Why dose pollution persist. Why is the market unableWhy is the market unable to respond to to respond to

environmental pollution, or can it?environmental pollution, or can it? The answer is due to The answer is due to market failuremarket failure.. Market failureMarket failure occurs because the occurs because the

assumption of perfect competition failed to assumption of perfect competition failed to fully function.fully function.

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Analytical Tools to Understand Analytical Tools to Understand Market FailureMarket Failure

Environmental quality as a Environmental quality as a public public good good the theory of public goodthe theory of public good

Environmental damage as a Environmental damage as a externalityexternality the theory of the theory of externalityexternality

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Environmental Quality: A Public GoodEnvironmental Quality: A Public Good

A public good: a commodity that is A public good: a commodity that is nonrivalnonrival in consumption and yields in consumption and yields benefit that are benefit that are nonexcludablenonexcludable..– NonrivalnessNonrivalness: the characteristic of : the characteristic of

indivisible benefits of consumption: one indivisible benefits of consumption: one person consumption does not preclude person consumption does not preclude another.another.

– NonexcludabilityNonexcludability: the characteristic of : the characteristic of impossibility to prevent other from impossibility to prevent other from sharing the benefits of consumption.sharing the benefits of consumption.

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Environmental Quality: A Public Good Environmental Quality: A Public Good (con’t)(con’t)

the nonrivalness and nonexcludability the nonrivalness and nonexcludability characteristics of characteristics of public goodspublic goods prevent natural market incentives prevent natural market incentives from achieving an allocative efficient from achieving an allocative efficient outcome.outcome.

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A Case Study of Public Good: A Case Study of Public Good: Air Quality *Air Quality *

Air quality can be defined as Air quality can be defined as ““an an acceptable level of pollution acceptable level of pollution abatementabatement”” some percentagesome percentage reduction in sulfur dioxide (SOreduction in sulfur dioxide (SO22) ) emission.emission.

* For details see Callan and Thomas Ch. 4 p. 58-64

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A Case Study of Public Good: A Case Study of Public Good: Air Quality (con’t)Air Quality (con’t)

Market Supply for Air QualityMarket Supply for Air Quality The producersThe producers are willing and able to are willing and able to

supply various reductions in SOsupply various reductions in SO22 at at different price level.different price level.

the aggregation of these production the aggregation of these production decisions gives rise to market supply. decisions gives rise to market supply.

Market supply: P = 4 + 0.75 Qs

Qs: a percentage of SO2 abatement

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Market Demand for Air QualityMarket Demand for Air Quality Market demand for a public good is Market demand for a public good is

different from a private good.different from a private good. Once the public good is provided, it is Once the public good is provided, it is

available at the same quantity to all available at the same quantity to all consumers (nonrivalness consumers (nonrivalness characteristic).characteristic).

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Private goodPrivate good– What What quantityquantity of of

this good would you this good would you consume at each of consume at each of following prices?following prices?

– Horizontally Horizontally summingsumming

– At given price level, At given price level, sum quantities of sum quantities of each consumereach consumer

Public goodPublic good– What What price price would would

you be willing to you be willing to pay for each pay for each quantity?quantity?

– Vertically summingVertically summing– At given quantity At given quantity

level, sum prices of level, sum prices of each consumereach consumer

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In the public good theory, each In the public good theory, each consumer should express a unique consumer should express a unique “willingness to pay (WTP)”“willingness to pay (WTP)” for the for the public good based on the benefits public good based on the benefits each expects to derive consumption each expects to derive consumption

Demand for consumer 1: p1 = 10 – 0.12 QD

Demand for consumer 2: p2 = 10 – 0.18 QD

Market demand: p1 + p2 = 25 – 0.3 QD

A critical assumption is that consumers would reveal their willingness topay for SO2 abatement.

1111Source: Callan, S. J. and Thomas, J. M. 2007. Environmental Economics and Management: Theory, Policy, and Applications.

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Equilibrium in the Air Quality Equilibrium in the Air Quality MarketMarket

Equilibrium in the air quality market Equilibrium in the air quality market comes from the combination of comes from the combination of market demand and market supply.market demand and market supply.

At equilibrium: Market Supply = Market Demand

4 + 0.75 Qs = 25 – 0.3 QD

Since Qs = QD, 1.05Q = 21 , then Q = 20 percent

At Q = 20, P = 4 + 0.75 (20) or 25 – 0.3 (20) then P = 19

Source: Callan, S. J. and Thomas, J. M. 2007. Environmental Economics and Management: Theory, Policy, and Applications.


QE represents the efficientor optimal level of abatementmeasure from left to right and implicitly the optimal level ofpollution measured from right to left.

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Assessing the ImplicationAssessing the Implication

Regarding the air quality market, the Regarding the air quality market, the optimal level is optimal level is not necessarily zeronot necessarily zero..

Abating at the 100 percent level to Abating at the 100 percent level to reduce pollution to zeroreduce pollution to zero involves involves prohibitive prohibitive opportunity costsopportunity costs..

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Market Failure of Public Good MarketMarket Failure of Public Good Market

An allocatively efficient outcome in a public An allocatively efficient outcome in a public good depends on the identification of good depends on the identification of well-well-defined demand and supply functionsdefined demand and supply functions..

In a public good market, there is no In a public good market, there is no incentive for a rational consumer to incentive for a rational consumer to volunteer a WTP for the good that she can volunteer a WTP for the good that she can consume without paying for it.consume without paying for it.– Nonrevelation of preferencesNonrevelation of preferences– Free-ridershipFree-ridership

Even if consumers could be induced to Even if consumers could be induced to express their WTP for a public good, it is express their WTP for a public good, it is highly likely that highly likely that the resulting demand price the resulting demand price would underestimatewould underestimate the true benefits. the true benefits.

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Market Failure of Public Good Market Failure of Public Good Market (con’t)Market (con’t)

In many public goods markets, In many public goods markets, consumer are consumer are not fully aware of the not fully aware of the benefitsbenefits associated with consumption. associated with consumption.

Market forces alone cannot provide an Market forces alone cannot provide an allocatively efficient level of a public allocatively efficient level of a public good, then good, then intervention by third partyintervention by third party (the government)(the government) is required.is required.– A direct provision of public goodsA direct provision of public goods– Political procedures and voting rules.Political procedures and voting rules.

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Environmental Problems: Environmental Problems: ExternalitiesExternalities

This approach specifies the relevant market This approach specifies the relevant market as the good whose as the good whose productionproduction or or consumptionconsumption generates generates environmental environmental damage outside the market transactiondamage outside the market transaction..

Price fails to capture all the benefits and Price fails to capture all the benefits and costs of a market transaction. Market fail.costs of a market transaction. Market fail.

A third party is affectedA third party is affected by the production or by the production or consumption of commodity. consumption of commodity. ExternalityExternality

A negative externality: generates cost to a third partyA negative externality: generates cost to a third party A positive externality: generates benefit to a third partyA positive externality: generates benefit to a third party

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Environmental Problems: Environmental Problems: Externalities (con’t)Externalities (con’t)

If the consumptionIf the consumption generates generates external benefitsexternal benefits, the market , the market price price undervaluesundervalues the good, too little of the good, too little of production.production.

If there is a If there is a negative externalitynegative externality, the , the market does market does not reflect the external not reflect the external costscosts, and too much of the , and too much of the commodity is produced.commodity is produced.

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Negative Externality: A Case of Negative Externality: A Case of Refined Petroleum ProductsRefined Petroleum Products

Assume the private market for Assume the private market for refined petroleum is competitive and refined petroleum is competitive and no external benefits.no external benefits.

Supply: P = 10.0 + 0.75 Q

Demand: P = 42.0 - 0.125 Q

Where Q: thousands of barrels per dayP: the price per barrel

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Negative Externality: A Case of Negative Externality: A Case of Refined Petroleum ProductsRefined Petroleum Products

SupplySupply represents the represents the marginal costmarginal cost of production (or marginal private of production (or marginal private cost: MPC) and cost: MPC) and demanddemand represents represents the the marginal benefitmarginal benefit of consumption of consumption (or marginal private benefit: MPB).(or marginal private benefit: MPB).

MPC = 10.0 + 0.075 Q

MPB = 42.0 - 0.125 Q

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Inefficiency of the Competitive Inefficiency of the Competitive EquilibriumEquilibrium

At the equilibrium, we ignore the At the equilibrium, we ignore the external external costs to societycosts to society of contaminated water of contaminated water supplies caused by the refined petroleum supplies caused by the refined petroleum production.production.

The The costs of water pollutioncosts of water pollution are are external to external to the market exchangethe market exchange and consequently are and consequently are not factored into private market decisionsnot factored into private market decisions..

The The MPC undervaluesMPC undervalues the opportunity costs the opportunity costs of production, and resultingof production, and resulting output level is output level is too hightoo high..

The economists have identified and The economists have identified and monetized external costs and applied in the monetized external costs and applied in the analysis. Marginal external cost (MEC)analysis. Marginal external cost (MEC)

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Marginal Social Costs (MSC)Marginal Social Costs (MSC)

The marginal social cost (MSC) The marginal social cost (MSC) captures all costs of producing captures all costs of producing refined petroleum.refined petroleum.

Marginal Social Costs (MSC) = MPC + MEC

Where, MPC = 10.0 + 0.075 Q

MEC = 0.05 Q

Then MSC = 10.0 + 0.125 Q

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Marginal Social BenefitMarginal Social Benefit (MSB)(MSB) The The marginal social benefit (MSB)marginal social benefit (MSB) is is

the the sum of the MPBsum of the MPB and any and any marginal marginal external benefit (MEB).external benefit (MEB).

If there is If there is no the MEBno the MEB, then the , then the MPB MPB equals the MSB.equals the MSB.

Efficient equilibriumEfficient equilibrium

MSB = MPB + MEB

MSB = MSC MPB + MEB = MPS + MEC


No MEB, then MSB = MPB

Q

P

Efficient EquilibriumCompetitive equilibrium with a negative externality, overallocationof resource

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Welfare Gain to SocietyWelfare Gain to Society

Based on the refined petroleum Based on the refined petroleum production, if the output were production, if the output were reduced from Qc to Qreduced from Qc to QEE (32,000 (32,000 barrels a day), the social’s welfare is barrels a day), the social’s welfare is higher.higher.

From the firm perspective,From the firm perspective, the the reduction in output causes profit loss reduction in output causes profit loss (at Q(at QEE, MPB > MPC)., MPB > MPC).


Profit loss of firm: area WYZ

Society gain: area WXYZArea under MEC curve above MPC But the net gain area WXY

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Implication on the Refined Implication on the Refined Petroleum ProductionPetroleum Production

Petroleum refineries are motivated Petroleum refineries are motivated by by private gainprivate gain, not by , not by social gainsocial gain..

The firms may be aware of the The firms may be aware of the environmental damage associated environmental damage associated with their production, there is with their production, there is no no incentiveincentive for them to absorb these for them to absorb these costs due to negative affect to their costs due to negative affect to their profits even it is good for the society profits even it is good for the society as a whole.as a whole.

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The Absence of Property RightsThe Absence of Property Rights

The externality is a public good if it The externality is a public good if it affectedaffected a broad segment of society.a broad segment of society.

The environmental good is no The environmental good is no property rightproperty right, the market dose not , the market dose not exist. exist.

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

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The Coase Theorem The Coase Theorem

Nobel laureate, Ronald Coase, proposed Nobel laureate, Ronald Coase, proposed that that the assignment of property rightsthe assignment of property rights alone can provide for an efficient solution alone can provide for an efficient solution even in the presence of an externality.even in the presence of an externality. Coase Theorem Coase Theorem with two assumptionswith two assumptions– Transaction costs are costlessTransaction costs are costless– Damages are accessible and measurable.Damages are accessible and measurable.

The assignment of property rights to any The assignment of property rights to any good will allow good will allow bargaining bargaining between the between the affected parties such that an efficient affected parties such that an efficient solution can be obtained, no matter which solution can be obtained, no matter which part holds the rights.part holds the rights.

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Property Rights Belong to the Property Rights Belong to the RefineriesRefineries

Refineries have the right to pollute Refineries have the right to pollute the river as part of their production the river as part of their production processes.processes.

They prefer to produce up to the They prefer to produce up to the level that maximizes profit, which will level that maximizes profit, which will cause negative impactcause negative impact to the to the recreational users.recreational users. The negotiation The negotiation between these two parties will be between these two parties will be occurred.occurred.

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Property Rights Belong to the Property Rights Belong to the Refineries (con’t)Refineries (con’t)

Recreational users: Willing to offer a payment () such that < (MSC-MPC)

Refineries: Willing to accept a payment () such that > (MPB-MPC)

Note: (MSC – MPC) is MEC (MPB – MPC) is M

The bargaining between two groups should continue as long as the payment is greater than refineries’ loss in profit but less than the recreational users’ damage.

(MSC – MPC) > > (MPB-MPC) or equivalently,

MEC > > M

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If the refineries hold the right, the bargaining will start at Qc to reduce output until (MSC – MPC) = (MPB – MPC)

Source: Callan, S. J. and Thomas, J. M. 2007. Environmental Economics and Management: Theory, Policy, and Applications.

Recreational usersBargaining will startat Q0 until (MPB – MPC) = (MSC – MPC)

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Property Rights Belong to the Property Rights Belong to the Recreational UsersRecreational Users

Refineries: Willing to offer a payment () such that < (MPB-MPC)

Recreational users:

Willing to accept a payment () such that <(MSC-MPC)

(MPB-MPC) > > (MSC – MPC) or equivalently,

M > > MEC

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Limitations of the Coase TheoremLimitations of the Coase Theorem

The application of the Coase Theorem The application of the Coase Theorem depends on two assumptions.depends on two assumptions.– Transaction costs are costlessTransaction costs are costless– Damages are accessible and measurableDamages are accessible and measurable

It will be practical if there is a case It will be practical if there is a case which which few individuals are involvedfew individuals are involved on on each side of the market.each side of the market.

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Common Property ResourceCommon Property Resource

The resources that The resources that property rightsproperty rights are are sharedshared by some group of individual.by some group of individual.– Common property resources are not accessible to Common property resources are not accessible to

everyone, everyone, some excludabilitysome excludability..– The rights extend to more than one individual (The rights extend to more than one individual (co-co-

ownerowner makes decision about using resources makes decision about using resources based only on private costs and benefits ignoring based only on private costs and benefits ignoring the impact of other owners).the impact of other owners).

The solutionThe solution: The : The governmentgovernment would have to would have to make this determinationmake this determination as well as as well as enforce enforce limitations on the rightslimitations on the rights for the good of for the good of society.society.

1 env 536: environmental economics and policy (lecture 4) modeling market failure asst.prof. dr....

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