Market Failures

Market failure occurs when the market outcome does not maximize net-

benefits of an economic activity.

Due to the nature of environmental resources, the market often fail in

dealing with environmental resources.

There are three main environmental market failures.

• a. Externality

• b. Public Goods

• C. Tragedy of the Commons

Externality

• An Externality results when the actions of an individual/firm have

direct, unintentional, and uncompensated effect on the well-being of

other individuals or profits of other firms.

• The key words are:

• Direct: There has to be a direct effect on well-being of an identifiable

individual(s) or profits of firms.

• Unintentional: The effect rather than the action has to be

unintentional. This rules out acts of spite or malice.

• Uncompensated: The responsible actor is not compensated for their

actions.

Examples of Externalities

• Second hand cigarette smoking.

• Air pollution from factories and power plants.

• In the Pacific Northwest, logging in forested headwaters degrades

spawning habitat for salmon- adversely affect commercial fishing

• Hydroelectric dams hinder the fish on their way upstream- adversely

affect commercial fishing.

• Firms R &D often produces knowledge that its rivals can use.

• If a neighbor keep their houses and flower gardens well maintained,

the value of the houses in that neighborhood is likely to rise.

How do Externalities Cause Market Failure?

Lets take the example of a steel industry:

• Steel furnaces typically burn coal, emitting sulfur dioxide, nitrous

oxides and particulate matter.

• Lets assume there is a fixed relationship between the amount of

steel produced and the amount of pollution emitted.

E.g, say for every one thousand tons of steel produced, one ton of

sulphur dioxide is emitted.

The amount of the pollution causes damage to downwind residents.

There is a marginal damage of pollution function which is dependent

on amount of steel produced

Externality

Externality

• In the absence of regulation, steel producers will ignore the

damages caused by pollution.

• The supply curve here corresponds to only the private marginal

costs of steel (PMC)

• The producers of steel ignore another cost of production; damages

from pollution-externality!

• With this externality, the social marginal cost (SMC) is not equal to

the supply curve ( which only reflects the MPC).

SMC = MPC + MD.

• In a free market without regulation, QM would be produced.

• When regulation forces the steel industry to internalize the marginal

damage as part of their cost, the supply curve will now be SMC.

Now the equilibrium output of steel is Q*.

Consequences of Market Failure in this Case.

• Sub-optimal Output: After regulation help internalize the damaging cost, output falls (QM> Q*).

• Sub-optimal Pricing: Price increases after externality is internalized.

• As a consequence of the above, the sum of consumer and producer surplus decreases after internalizing the externality in this case.

• What makes internalizing the externality welfare enhancing?

• Social surplus from steel production is not just the sum of producer and consumer surplus but also the damages from pollution- social welfare deadweight loss.

• Although the reduction in output and the corresponding increase in price hurt both consumers and producers of steel, it benefits people who are harmed by pollution resulting from the steel production.

Public Goods

• Goods that are shared by all but owned by no one.

There are two fundamental characteristics of public goods that lead to

market failure.• Non-rivalry: A good is non rival in consumption if more than one

person can consume the same unit of good at the same time. The consumption from individual does not diminish the amount available for others.

• Non-excludability: A good is non-excludable if the supplier cannot prevent consumption by people who do not pay. If the person does not contribute to the provision of that good, they cannot be prevented from enjoying that good.

• Public good is thus any good that has non-rival in consumption and non-excludable.

Classes of Goods/Resources

EXCLUDABLE NON-EXCLUDABLE

RIVALRY IN

CONSUMPTIONPrivate

Goods/resources:

car, house etc

Common resources:

Atmosphere, aquifer,

fish in the lake etc

NON-RIVALRY Club Goods: cable tv,

wifi, satellite radio etc

Public Goods:

National defense,

public parks etc

Why do markets fail to provide public goods.

• Let’s illustrate that with an example of two people who live on either

side of flower garden.

• They both have access to the garden without diminishing the

enjoyment of the other . Each of them benefit differently from the

park

• Person A enjoy the garden more than person B.

• Their respective marginal benefit curve represented in MBA and

MBB.

• The marginal cost is represented by MC.

• Without any intervention in the market, B would tend the garden until

his/her MB=MC; which is at QB

• A would be willing to tend the garden until QA.

• At QB, A’s MB exceeds MC so he would want more of that public

good.

•

Public Goods• A would be willing to bear the cost of producing up to QA by himself

• In that scenario, B provides QB, and A provides QA. - QB. (the difference).

• In reality, when B recognizes that A benefits more than her, B would have the incentive to free ride.

• Even when they both contribute, A would not provide more than QA..

QA is the maximum that would be provided when both contribute

• However, both of them would be better off if more of the good were provided.

• The combined marginal benefit of both of them is greater than the combined marginal cost but the private benefit to either of them alone is too small to make the extra cost worthwhile.

• Private provision of public good will be inefficiently low.

• Unlike private goods, in the public good setting, every individual experience the same level of the public good, thus, to obtain the total marginal benefit, we must sum all the marginal benefits for all individuals to be able to find the efficient level of the good.

Public Goods

Public Goods

Tragedy of the Commons

• A common Resource is a non-excludable but rivalry in consumption resource.

• Open access resource or common resources lead to over exploitation. Eg is the Ogallala aquifer.

• This happens because each user only bears the a portion of the cost of exploitation but receives the full benefit of exploitation.

• The tragedy is that the resulting over-exploitation reduces the benefits of the resources for all of the users. and thus would be better off if they could agree to restrict each individual’s exploitation.

• The natural resources that are subjected to the tragedy of the commons meet two conditions:

• Open access: the access to the resource must be unrestrictive. The resource must be non-excludable but there is rivalry in consumption.

• Diminishing marginal returns: The benefit from using the resource must be increasing at a decreasing rate

Tragedy of the Commons

• Why does the tragedy of the commons happen?

• Imagine that two countries are deciding to cooperate to clean up a pollutant.

• The total cost of the clean up is $4 and the benefit of the clean per each country is $3 for a total of $6.

Country B

Contribute Shirk

Country A Contribute 1,1 -1,3

Shirk 3,-1 0,0