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Chapter 6

Markets and Efficiency

Ch6: positive economics; how markets function in the case of natural resourcesCh7: normative economics; public policy

SECTION III General Natural Resource Issues

1. Market Demand and Supply

• Demand curve– downward slope illustrates diminishing marginal

willingness to pay– It reflects consumers’ incomes, tastes, and other

economic factors

• Supply curve– upward slope reflects increasing marginal production

costs– Its exact shape is related to input prices,

technologies, etc.

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2. Markets and Static Social Efficiency

• If a market equilibrium means social efficiency,

– then market demand curve = MSB curve: there are no sources of social value that are not registered by market participants themselves

– and market supply curve = MSC curve: there are no sources of cost to members of society that are not registered in those private cost/supply curves

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• Consider a collection of paper mills located on a river– They produce paper: marginal supply curve is

marginal private costs (MPC) curve– Paper mills emit residuals into the river which lead to

damages suffered by downstream communities: downstream external costs (EC)

– Marginal social costs (MSC) = MPC + EC– Socially efficient quantity and price are q* and p*;

competitive market outcome is qm and pm (qm > q* , market quantity is too high; pm < p*, market price is too low) 4

(a) External Costsa negative production externality

Page 91: Figure 6-3

5

p

q of paper

D = MPB = MSB

42

S =MPC

MSC = MPC + MEC

10

160

pm = 22

128

p* = 26

0q* qm

(a) External Costsa negative production externality

Consumption externalities Production externalities

(c)Positive

(d)Negative

(b) Positive

(a) Negative

The benefits to the rest of society of people being vaccinated before traveling abroad

Noise pollution from using car stereos

The benefits to the environment that arise from the planting of woodland by a forestry company(and pp.92-93 in our text)

Wastes being dumped into a river by a company

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$

q

MPB = MSB

MPC

MSC = MPC + MEC

0 q*qm

b

a

(b) External Costsa positive production externality

and pp.92-93 in our text

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($ millions)

MSC

MPB

MSB=MPB+MEB

0 qm = 200 q* = 210

pm = 170

p* = 175

q

K

L

(c) External Benefitsa positive consumption externality

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$

q

MPB

MSC

MSB = MPB + MEB0 q* qm

(d) External Benefitsa negative consumption externality

• The resource that is open to unrestricted use by anyone who might wish to utilize it: ocean fishery, hunting, public parks…

• “The Tragedy of the Commons” (Garrett Hardin, Science, Vol. 162, 1968, pp. 1243-1248): Open-access externality that leads to overuse of the resource is the diminution in the quality of the pasture as more and more animals are out on it

• Page 95, Table 6-2, public beach: the fifth visitor reduces the value of the beach to the four already there, from $20 to $18 for each one

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Open-Access Resource

• Public beach example: efficient visitation level is 4 visitors; benefits – costs = $80 – $48 = $32

• $32 is a return attributable to the resource itself (the beach); this is the resource rent produced by the beach

• If visitation level had risen to 8 people, then benefits – costs = $96 – $96 = $0; open access had led to the dissipation or disappearance of all natural resource rent

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Open Access and the Dissipation of Resource Rent

5. Environmental Damage:A Negative Externality

• Environmental economists are interested in externalities that damage the atmosphere, water supply, natural resources, and overall quality of life

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Chapter 3 Modeling Market Failure

Modeling a Negative Environmental Externality

• Define the market as refined petroleum – Assume the market is competitive – Supply is the marginal private cost (MPC)– Demand is the marginal private benefit (MPB)– Production generates pollution, modeled as a

marginal external cost (MEC)

• Problem: Producers (refineries) have no incentive to consider the externality

• Result: Competitive solution is inefficient13

Finding a Competitive SolutionRefined Petroleum Market

• S: P = 10.0 + 0.075Q• D: P = 42.0 - 0.125Q, where

Q is in thousands of barrels per day• Since S is MPC and D is MPB, rewrite as MPC = 10.0 + 0.075Q MPB = 42.0 - 0.125Q

(P means private)• Find the competitive solution and analyze

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Competitive Solution

• Set MPB = MPC42.0 - 0.125Q = 10.0 + 0.075Q

• Solve:QC = 160 thousand; PC = $22 per barrel

(C means competitive)• Analysis:

– This ignores external costs from contamination– QC is too high; PC is too low

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Finding a Socially Efficient SolutionRefined Petroleum Market

• Let Marginal External Cost (MEC) = 0.05Q• Marginal Social Cost (MSC) = MPC + MEC

– MSC = 10.0 + 0.075Q + 0.05Q

= 10.0 + 0.125Q• Marginal Social Benefit (MSB) = MPB + MEB

– Assuming no external benefits, MEB= 0, so MSB = MPB

• Set MSC = MSB--10.0 + 0.125Q = 42.0 - 0.125Q--Solving: QE = 128 thousand; PE = $26/barrel

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MSC, MPC, MPB Graph

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P ($ per barrel)

Q (thousands)

D = MPB = MSB

42

S =MPC

MSC = MPC + MEC

10

160

PC = 22

128

PE = 26

0QE QC

• Results of negative externality

--QC (160) is higher than QE (128), since the firm does not bear the full cost of its production, and so will produce more than the socially efficient quantity (overallocation of resources)

--PC (22) is lower than PE (26), since MEC is not captured by market transaction

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