Market Failures and Market Failures and ThermodynamicsThermodynamics

Another word on Pareto Another word on Pareto efficiencyefficiency

• A Pareto inefficient outcome is one that fails to make all trades that could benefit one person without leaving someone else worse off

• A reallocation or redistribution in which some people are made better off and others worse off is Pareto incomparable to the prior allocation. It is not Pareto inefficient.

Quick ReviewQuick Review

• Excludability– Policy variable– Some resources are inherently non-excludable

• Rivalry– If a resource is rival and scarce, should ration

access– Non-rival resources not depleted through use,

should not be rationed• Marginal cost of use = 0• Rationing creates artificial scarcity

RivalnessRivalness• Anti rival (additive)

– My use makes you better off

– What's an example?

• Abundance, scarcity and rivalry – Rival and abundant: oxygen– Rival and borderline: Crowded beach– Rival and scarce: oil

So What?So What?

Rival

Non-rival,Anti-rival

Excludable Non-Excludable

Market Good: cars, houses, land, oil, timber, waste absorption capacity?

Tragedy of the non-commons: property rights to genetic info., patented information, e.g. non-ozone dep. comp.

Pure Public Good:Information, most ecosystem services, e.g. climate stability, coastline protection, life support functions, etc.

Open Access Regime:Oceanic fisheries, timberetc. from unprotected forests, waste absorption capacity

CongestibleToll Good, club good:

Roads, parks, beaches. natural monopolies.

Free Rider Problem

Open AccessOpen Access

• The “Tragedy of the commons”

• Common property vs. open access

Solutions to Open AccessSolutions to Open Access

• Rival and scarce resources must be rationed

• Rationing requires property rights– Public, private or common

• Private property allows markets and price rationing– Who gets ownership? Distribution matters!

Public GoodsPublic Goods

• Free-riding

• No price signal as feed-back mechanism– Scarcity price increase innovation

•Lack of Incentives to produce or protect them•Costs of degradation ignored

• Private profits, socialize costs•Lack of incentives to create technologies that provide them

Public Goods (cont.)Public Goods (cont.)

• Free-market enthusiasts don’t deny public good problem, but claim they are relatively unimportant

• Increasing scale and public goods• Are stable climate, ozone layer, disturbance

regulation (e.g. storm protection) and other life support functions relatively unimportant?

Solutions for Public GoodsSolutions for Public Goods

• Public goods created by rival, scarce resources– Ecosystem structure– Built infrastructure– Human capital

• Requires public investment in production and protection

• Public goods generate non-rival services– Rationing inefficient– Open access is efficient

Non-rival & Excludable: tragedy of Non-rival & Excludable: tragedy of the non-commonsthe non-commons

• Why do we have patents?

• When did patents come about?– 1790s in US– 1947 international, rarely used before 1980s

Patents: efficiency and Patents: efficiency and sustainabilitysustainability

• Create inadequate incentives for inventions that provide or preserve public goods

• Raise costs for research – Profit motive prevents sharing of knowledge

• Monopolies on non-rival resource– Expensive to enforce

• Prices ration use

• Examples: new technology for highly efficient solar energy; non-ozone depleting technologies; Indonesia’s avian flu

Patents and just distributionPatents and just distribution

• Samuel Slater, “Father of American Industry”

• Developed countries own 97% of all patents

• Raises costs for research that meets the needs of the poor– Golden corn

• “Standing on the shoulders of giants”

Solution to Tragedy of Non-Solution to Tragedy of Non-commonscommons

• Public investment, common ownership• Land grant universities, e.g. UVM• Rate of return on investments in public

sector agriculture R&D 60-80% per year

Natural MonopoliesNatural Monopolies

• Excludable• High fixed costs, low marginal costs• Rival goods (e.g. water, electricity, etc.)• Non-rival goods (e.g. information)

Market goods: The theory of Market goods: The theory of ExternalitiesExternalities

ExternalitiesExternalities

• Definition– “an activity by one agent causes a loss (gain)

of welfare to another agent”

– “The loss (gain) of welfare is uncompensated”

• Completely Internal to the Economic Process. Why?

• Externalities and profit maximization

• How are these related to public goods?

Example: Conversion of Mangrove Example: Conversion of Mangrove Ecosystems to Shrimp AquacultureEcosystems to Shrimp Aquaculture

•Structure, raw materials, stock-flow resources

•Building materials, charcoal, food•Function, ecosystem services, fund-services

•Storm protection•Habitat, nursery•Waste absorption•Climate stabilization

Values of Natural Capital:Values of Natural Capital:Mangrove EcosystemsMangrove Ecosystems

Values of ConversionValues of ConversionShrimp AquacultureShrimp Aquaculture

•High short term profits, heavily promoted by economistsHigh short term profits, heavily promoted by economists•Shrimp and fish for 3-5 yearsShrimp and fish for 3-5 years

•Carnivorous, net reduction in food productionCarnivorous, net reduction in food production•Less protein than intact ecosystemLess protein than intact ecosystem•Massive waste outputMassive waste output•Irreversible(?) destruction of ecosystemIrreversible(?) destruction of ecosystem•Why convert?Why convert?

•On natural capital: On natural capital: •Loss of Ecosystem servicesLoss of Ecosystem services•Loss of fish productionLoss of fish production

•On social capital?On social capital?•On human capitalOn human capital

Impact of ConversionImpact of Conversion

‘‘OptimalOptimal’’ pollution/degradation pollution/degradation

Solutions for Externalities: Solutions for Externalities: RegulationsRegulations

• Best management practices• Best available technologies• Caps on resource extraction, waste

emissions, e.g. no conversion of mangroves to shrimp aquaculture

• Non-market mechanism. Producers cannot adjust MC to equal MB– But costs and benefits may not be directly

comparable

Market Solution: Property Market Solution: Property RightsRights

• Who owns the environment?

• polluter ‘rights’

• sufferer rights

• What about future generations?

Market Option I: Property RightsMarket Option I: Property Rights

Shrimp aquaculture

Problems with property rightsProblems with property rights

• Transaction costs– in absence of transaction costs, no negative

externalities

– What are transaction costs likely to be for externalities affecting public goods?

– How many Filipinos affected by typhoon?

• Wealth effect

• Intergenerational externalities

Market Solutions 2: Pigouvian Market Solutions 2: Pigouvian TaxesTaxes

• Tax externalities– Ideal tax = marginal cost, e.g. gas tax $12.00

gallon– Can costs be measured in monetary terms?

• Basic idea– Set price, let this determine Q at which

demand = price– Price determines scale

‘‘MarketMarket’’ Option 2: Pigouvian tax: Option 2: Pigouvian tax: Getting prices rightGetting prices right

tax

Market Solutions 3: Cap and Market Solutions 3: Cap and trade/ Cap and auctiontrade/ Cap and auction

• 3 steps– Sustainable scale: Set cap– Just distribution: determine property rights,

e.g. do resources belong to those who exploit them, or to public?

– Efficient allocation: Tradable quotas (Cap and Trade) or public auctions (cap and auction)

• Basic rule: scale is price determining

'Market' Option 3: Tradable Quotas:'Market' Option 3: Tradable Quotas:setting ecologically sustainable scalesetting ecologically sustainable scale

quota

WhatWhat’’s better, tax or quota?s better, tax or quota?

• Prices adjust to ecological constraints faster then ecosystems adjust to economic impacts

• Distributional impacts– Taxes– Quotas

Ignorance and UncertaintyIgnorance and Uncertainty

• Perfect markets require perfect information• Asymmetric information

– Nobel Prize in 2000

– Theory of the Lemon

• Irreducible ignorance

• Time lags

• Ecosystem function

• Solution: better information flows, precautionary principle

Asymmetric Preference FormationAsymmetric Preference Formation

• What forms our preferences?

• In what direction are our preferences pushed, towards market or non-market goods?

• Solution: balanced information flows

Missing marketsMissing markets

• For a market to work, everyone must be able to participate

• Future generations can’t participate in today’s markets

• People without money cannot participate, e.g. many indigenous peoples

• How much would the Mona Lisa sell for if it were auctioned off in St. Albans?

• Solution: inalienable property rights for future generations