Week 3:

MARKET FAILURE AND ENVIRONMENTALECONOMICS

READING:

Common: Chapter 4Perman et al: Chapter 5 and 6

SOME ENVIRONMENTAL PROBLEM AREAS

Global climate change greenhouse gases ozone depletion

International air pollution acid rain

Local air pollution particulates and ozone smogs

Water pollution nitrate spillovers

Water scarcity intensive agriculture population conglomeration

Miscellaneous Loss of biodiversity Irreversible eco-system change Soil fertility losses Accumulation of toxins in various media

ALL OF THESE CAN USEFULLY BEANALYSED UNDER THEFRAMEWORK OF MARKETFAILURE

MARKET EQUILIBRIUM OUTCOMES:

S = MC = SMC (Social marginal cost)D = MB = SMB (Social marginal benefit)That is: market supply properly takes account of all relevant costs market demand properly takes account of all relevant benefits

And so the competitive market mechanism generates a maximisation ofSOCIAL net benefits.

Also note that CONSUMER AND PRODUCER SURPLUSES (=SOCIAL SURPLUS) are maximised.

But market economies in practice do not satisfy the set of idealconditions, and so privately optimal outcomes do NOT lead to sociallyoptimal ones.

MARKET FAILURE OCCURS WHERE ONE ORMORE OF THESE CONDITIONS IS NOTSATISFIED (AND AN INEFFICIENT OUTCOMEOCCURS AS A RESULT).

We focus in this course on two kinds of market failure:

EXTERNALITY

An externality arises when the activity of a firm orhousehold gives rise to unintended consequences forother firms or households, and do not figure in the costsor benefits of the activity as perceived by theoriginating firm or household.

PUBLIC GOOD

A public good has the property of non-rivalry; that is,consumption of it by one person does not reduce theamount of it available for others.

EXTERNALITIES

An externality occurs when an activity generates unintended effects on others for which no payment or compensation is made.

Externalities arise because of the absence of private property rights – if they existed payment/compensation would occur. They are an example of market failure.

Externalities can be thought of as “missing markets”.

Or, as unpriced goods and services.

Externalities may be beneficial or harmful

In the absence of corrective policy, the level of an activity that gives rise to a harmful/beneficial externality will be too high/low.

Externality

Originating InBeneficial Harmful

Production Activity

Externality

Honey production

Pollination for fruit growing

Fossil fuel combustion

Atmospheric pollution

Consumption Activity

Externality

Vaccination of one person

Reduced risk of infection for rest of population

High stereo volume in apartment

Noise pollution

A classification of externalities

Two ways of visually showing how externalities lead to a divergence between privately efficient (market) and socially efficient outcomes.

In the diagrams, we have an adverse externality such that social costs exceed private costs.

B, C

QQ*

B

C

SC = C + External cost

Q**

Price

Quantity per period

PMC

PMB

P*

Q*

EMC

SMC = PMC + EMC

Q**

P**

Note at Q* that

SMC SMB

But it does at Q** (i.e. in the situation where the externality is internalised).

P

Q

S

D

P*

Q*

Consumer Surplus

Producer Surplus

Situation where no externality exists

P

Q

S = PMC

D = SMB

P*

Q*

SMC

P**

Q**

The efficiency loss due to an externality

P

Q

S = PMC

D = SMB

Q*

SMC

P**

Q**

Consumer and producer surpluses with an externality

CS

NB

QQ*

NBwithout

externality

Q**

NB incl externality

NB0

NB1NB2

Efficiency loss from ignoring externality = NB1 - NB2

Pollution Control: Two Questions for Public Policy

1. How much pollution should be allowed? What is the policy objective?

2. How to affect polluters’ behaviour so as to bring about the desired level of pollution? What policy instrument to use?

We will answer these questions later.

PUBLIC GOODS/PUBLIC BADS

External effects often have the characteristics of public goods/bads.

Public goods/bads have two characteristics

2. Non-rivalry – consumption by one agent does not reduce the amount available to others

3. Non-excludability – if provided for one agent, others cannot be excluded from consumption

Examples of public goods – national defence, lighthouses, air pollution abatement.

Examples of public bads – air pollution

High stereo volume in apartment

Noise pollution

Vaccination of one person

Reduced risk of infection for rest of population

Consumption Activity

Externality

Fossil fuel combustion

Atmospheric pollution

Honey production

Pollination for fruit growing

Production Activity

Externality

HarmfulBeneficialExternality

Originating In

All of these externalities are non-rivalous and non-excludable; so they are public (goods/bads) externalities.

PROBLEMS ASSOCIATED WITH PUBLIC GOODS/BADS

2. Because of non-rivalry and non excludability, the market cannot supply the right amount of public goods/bads – the free rider problem

3. Even if there were no free rider problem, non-rivalry may imply zero marginal costs. So efficient price is zero! (See the bridge example later in CBA).

2. It is difficult to estimate the marginal benefits (or marginal costs) associated with these goods. Why?

Think about pollution abatement, as an example.

Marginal benefits of pollution abatement

£

PROBLEMS ASSOCIATED WITH PUBLIC GOODS/BADS

Pollution abatement.

2. There may be no market here; so nothing to observe directly.

3. Free rider issues again: will people reveal preferences?

4. Even if the good were traded, then market demand curves would not correctly express socially valuation. (Market demand curves are horizontal sums; we need vertical sums here).

LOSS OF BIODIVERSITYKey: Property rights, externalities and appropriability of benefitsBiodiversity is hugely beneficial to society; but what incentives operate ondecision-makers?

CONSERVATION OF NATURAL/PRIMARY FORESTSMultiple functions of woodlands. Many services are public goods.Biased incentives inappropriate (inefficient) useOpen access degradation

WILDERNESS CONSERVATIONCongestion and degradationImportance of corridorsGradual erosion due to encroachmentConflicts with other land usese.g. deer in Scotland

PUBLIC HEALTH PROGRAMMESControl of infectious diseaseWater purification