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ENVIRONMENTALITIES AND MARKET FAILURE
INTRODUCTION
• Markets allocate scarce resources with forces of supply and demand
• Equilibrium of supply and demand is typically an efficient allocation of resources
• Equilibrium market prices signal information and allocate resources
• Markets sometimes fail to allocate resources efficiently
• Examine in this chapter a type of market failure called externalities
INTRODUCTION
• Market Failure and the Environment For environmental assets, markets can fail if prices do
not communicate society’s desires and constraints accurately
Prices often understate full range of services by environmental assets or do not exist to signal the value of the asset to the market Incomplete or absent markets for environmental assets
Market failure occurs when private decisions based on prices, or lack of them, do not generate Pareto-efficient allocation of resources
INTRODUCTION• Market Failure and the Environment
Inefficiency (Pareto) implies that resources could be reallocated to make at least one person better off without anyone worse off
Wedge is driven between what individuals want privately and what society wants collectively
Due to Market Failure: 1. Inefficient resource allocation 2. Leads to regulation or other public policies Divergence between interests of individual or group from
those of society at large
EXTERNALITIES• Externalities are special case of market failure • Externality
The uncompensated impact of one person or firm’s action on the well-being of a bystander
Creates a cost or benefit Outcome is external to any market transaction (if any)
• Negative Externality or External Cost An adverse impact on bystander Imposes a cost on that bystander
• Positive Externality or External Benefit A beneficial impact on bystander Imposes a benefit on that bystander
EXTERNALITIES• Technological vs. Pecuniary Externality
Externalities can be either technological or pecuniary
Technological Externality External effect is not through market price, but
through its effect on consumption (utility) or production (profit)
Real effect: one person or firm’s gain/loss is not another’s loss/gain
EXTERNALITIES
• Technological vs. Pecuniary Externality Pecuniary Externality
External effect is through market price Leads to transfer or redistribution of income Gain or loss to one party is exactly offset by gain
or loss to another Pecuniary effects cancel out
EXTERNALITIES• Types of Externalities
Symmetric Externality Economic agents who generate externalities receive
reciprocal external effect Each consumer or firm imparts external effect to all other
consumers or producers, who in turn impart reciprocal external effect on initial consumer or producer
Asymmetric (Downstream) Externality Economic agents who generate externality are distinct from
those who experience them Production or consumption decisions of producers or
consumers enter production or utility functions of others, but recipients of the externalithy do not cause any reciprocal effect
EXTERNALITIES• Types of Externalities
Transferable Externality Individual or firm protects itself from external
damages by transferring an environmental risk through space to another location or through time to another generation
Differs from traditional view of external cost in that transferability motivated by intentional behavior, not by unintentional behavior
Example Example through space and time is dumping of
radioactive wastes at sea
EXTERNALITIES
• Types of Externalities Depletable Externality
Also called rivalrous or private Experience of externality by one agent reduces the
amount experienced by other economic agents Share depletable charactistic of usual (private)
goods Example
Dumping of oil to clean oil tankers’ tanks with seawater in one area leaves that much less to be dumped in other areas
EXTERNALITIES
• Types of Externalities Nondepletable Externality
• Also called nonrivalrous or public• Experience of the externality by one agent does
not affect the amount experienced by other agents• Have characteristics of gpublic goods or bads• Example
• Amount of air pollution experienced by one agent does not affect others’ experiencing it
EXTERNALITIES AND MARKET INEFFICIENCY
• Welfare Economics: A Recap Supply and demand curves contain important
information about costs and benefits Demand Curve
Demand curve reflects value to consumer, as measured by the prices they are willing to pay
At any given quantity, height of demand curve shows willingness to pay of marginal buyer
It shows value to consumer of the last unit of the good
EXTERNALITIES AND MARKET INEFFICIENCY
• Welfare Economics: A Recap Supply Curve
Supply curve reflects costs of seller At any given quantity, height of supply curve
shows cost of the marginal seller It shows cost to seller of last unit of good sold
In absence of externalities, price adjusts to balance supply and demand
Quantity produced and consumed in market equilibrium is efficient in the sense that it maximizes consumer and producer surplus
EXTERNALITIES AND MARKET INEFFICIENCY
• Welfare Economics: A Recap
Price
Quantity
Supply
Demand
Equil.Price
EquilibriumQuantity
Demand curve reflects valueto consumer by willingness to pay
Supply curve reflects costs ofsellers
•Equilibrium quantity maximizes total value to buyers minus the total costs of sellers.•In absence of externalities, therefore, market equilibrium is efficient and socially optimal.
EXTERNALITIES AND MARKET INEFFICIENCY
• Negative Externalities or External Cost A cost of an activity that falls on people or
firms other than those who pursue the activity Private Cost
Cost faced by the economic agent pursuing the activity
Social Cost Total cost to society of pursuing the activity Private cost + external cost
EXTERNALITIES AND MARKET INEFFICIENCY
• Negative Externalities or External Costs
Price
Demand
Supply(private marginal cost)
Social cost =Private +external cost
QMARKETQOPTIMUMQuantity
Market Equilibrium
SocialOptimum
POPTIMUM
PMARKET
ExternalCost
•Social cost of good exceeds private cost•Socially optimum quantity exceeds privately optimum quantity•Socially optimum price exceeds privately optimum price
EXTERNALITIES AND MARKET INEFFICIENCY
• External Cost
Price
Quantity
Demand
Supply(private marginal cost)
Social cost =Private +external cost
POPTIMUM
PMARKET
QOPTIMUM QMARKET
ExternalCost
EXTERNALITIES AND MARKET INEFFICIENCY
Figure 11.1
EXTERNALITIES AND MARKET INEFFICIENCY
• Positive Externalities or External Benefits
Price
Quantity
Demand(private value)
Supply(private marginal cost)
QOPTIMUMQMARKET
MBPRIVATE
= PMARKET
MBSOCIAL = POPTIMUM
External Benefit
Social demand =Private demand + external benefit
•Social value exceeds private value.•Socially optimal quantity exceeds private market equilibrium.
A Good Whose Production Generates a Positive Externality for Consumers
Figure 11.2
EXTERNALITIES AND MARKET INEFFICIENCY
• Internalizing the Externality Altering incentives so that people and firms take
account of the external effects of their actions
THE OPTIMAL AMOUNT OF EXTERNALITIES IS NOT ZERO
• Optimal amount of negative externalities is not zero Socially optimal policy is to curtail negative
externality until the cost of further abatement just equals the marginal benefit
Clean up pollution to but only up to a certain point
Beyond this socially optimal level, costs more to society than it will benefit Marginal cost > marginal benefit
THE OPTIMAL AMOUNT OF EXTERNALITIES IS NOT ZERO
• Optimal amount of positive externalities is not zero Socially optimal quantity to expand positive
externality until the benefit of further increase just equals the marginal cost
Expand but only up to a certain point Beyond this socially optimal level, costs more
to society than it will benefit Marginal cost > marginal benefit
PRIVATE SOLUTONS TO EXTERNALITIES
• Introduction Externalities lead markets to allocate
resources inefficiently Both private actors and public policymakers
respond to externalities in various ways All remedies share goal of moving allocation
of resources to social optimum
PRIVATE SOLUTONS TO EXTERNALITIES
• The Types of Private Solutions Government action not always needed People and firms sometimes develop private solutions Sometimes solved with moral codes and social
sanctions Example: littering
Charities Example: Sierra Club to protect environment due to negative
externalities Example: Universities receive gifts from alumni, etc. in part
because education has positive externalities for society
PRIVATE SOLUTONS TO EXTERNALITIES
• The Types of Private Solutions Private market solutions can rely on self-
interest of relevant parties Sometimes can integrate different types of
business Example of bee keeper and orchard owner who integrate
into single firm
Sometimes inerested parties enter into a contract Example of bee keeper and orchard owner Contract specifies number of trees, number of bees, and
perhaps payments
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem The proposition that if private parties can
bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.
Coase theorem says that private economic actors can voluntarily solve the problem of externalities among themselves.
Whatever the initial distribution of rights, the interested parties can always reach a bargain in which everyone is better off and the outcome is efficient.
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem If private parties can bargain without cost over
the allocation of resources (i.e. no transactions costs), then the private market will always solve the problem of externalities and allocate resources efficiently.
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem Real question is should A be allowed to harm
B or should B be allowed to harm A? For example, if by polluter’s activities, a polluter
imposes an externality on someone, by asking polluter to reduce emission of pollutants, pollutee also causes a damage to the polluter.
To whom should the property right be assigned? There are distributive effectives of private
bargaining.
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem Voluntary negotiation will lead to a fully efficiency
outcome provided that: 1. rights are well defined 2. transactions are costless 3. there are no income effects.
When income effects are taken into account, the assignment of property rights will affect resource use.
When damaged party is a consumer, willingness to pay may differ from required compensation, because the former is constrained by the consumer’s income.
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem Implications of Coase Theorem: 1. If markets are incomplete, people will
negotiate and the efficient outcome will result; 2. there is no need for government
intervention; 3. the outcome is independent of the intial
assignment of rights.
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Advanced Discussion Inability or unwillingness to assign property
rights such that a complete set of markets can be generated provides rationale for government intervention
But Coase observed that if there are zero transactions costs, the set of markets can be expanded beyond normal private goods to include many non-market environmental assets As long as institutional constraints to assigning
well-defined property rights are removed
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Advanced Discussion Coase Theorem posits that disputing parties
will work out Pareto-efficiency private agreement Regardless of intial assignment of property righths
to non-market (environmental) asset
As long as these legal entitlements can be freely exchanged, government intervention is relegated to designating and enforcing well-defined property rights
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Illustration Suppose two firms, A and B, who disagree
about optimal level of pollution in bay A produces pulp and paper and discharges
waste water back into bay B owns a boat marina A’s emissions reduce profitability of B’s
marina
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Illustration Following figure illustrates socially optimal level of
pollution Q*
Price
Quantity of pollution
Marginal Benefit
Marginal Cost
Q*
MB* = MC*
• MC = marginal cost to B from pollution• MB = marginal benefit to A from pollution• Q* = socially optimal level of pollution, where MB = MC
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Illustration But with incomplete markets, no opportunity
for parties to trade for alternative leels of pollution, even though both A and B are better off with trade
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Illustration Coast Theorem works as follows 1. Rights to B: for Clean Water
Suppose neutral third party creates legal bargaining framework by assigning property rights for clean water to B
MC curve in figure represents B’s supply of clean water and MB represents A’s demand for clean water
Given B has property rights, A would compensate B by amount MC* for each unit of pollution
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Illustration Coast Theorem works as follows 2. Suppose neutral third party assigns
property rights to pollute to A MC curve now represents B’s demand for
pollution control and MB curve now represents A’s supply of pollution control
Given A has property right to pollute, B can offer bribe to A of amount MB* for each unit of pollution control
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Illustration Theoretically, Coase Theorem works
regardless of initial assignment of property rights Optimal per unit bribe MB* equals optimal per unit
compensation MC*, i.e. MB* = MC*, at socially optimal level of pollution Q*
Depending on relative magnitude of MB and MC curves, optimal level of pollution could be zero (high MC) or private optimum where MB is zero (low MC)
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Illustration1. Optimal Level of Pollution = 0: High MC
Price
Quantity of pollution
MC
MB
MC = MB
Q*
0
PRIVATE SOLUTONS TO EXTERNALITIES
• Coase Theorem: Illustration2. Optimal Level of Pollution = Private Optimum (Low MC)
Price
Quantity of pollution
MC
MB
Q*
PRIVATE SOLUTONS TO EXTERNALITIES
• Why Private Solutions Do Not Always Work Coase theorem applies only when the interested
parties have no trouble reaching and enforcing an agreement
Transactions costs can prevent parties from agreeing to and following through on an agreement Transactions Costs: the costs that parties incur in the
process of agreeing and following through on an agreement
Reaching an efficient agreement is especially difficult when number of interested parties is large because coordinating everyone is costly
PUBLIC POLICIES TOWARD EXTERNALITIES
• Introduction When an externality causes a market to reach
an inefficient allocation of resources, government can respond in one of two ways: 1. Command-and-control policies
Regulate behavior directly
2. Market-based policies Provide incentives so that private decision-makers will
choose to solve the problems on their own
PUBLIC POLICIES TOWARD EXTERNALITIES
• Regulation Government remedies an externality by
making certain behaviors either required or forbidden
In this case, external costs to society far exceed benefits to polluter
Government institutes command-and-control policy that prohibits this act altogether
In most cases, situation is not this simple
PUBLIC POLICIES TOWARD EXTERNALITIES
• Regulation Technology Standards
Government sets standards for type of technology to be used
Examples: catalytic converter for smog, mileage standards for automobiles
Example: circle hooks and mackerel-type bait for longliners to lower turtle interactions and mortality
Production Standards Quotas
PUBLIC POLICIES TOWARD EXTERNALITIES
• Pigovian Taxes and Subsidies Instead of regulating behavior in response to
an externality, government can use market-based policies to align private incentives with social efficiency
Government can internalize externality by taxing activities that have negative externalities and subsidizing activities that have positive externalities
PUBLIC POLICIES TOWARD EXTERNALITIES
• Pigouvian Taxes and Subsidies Pigovian Tax
A tax enacted to correct the effects of a negative externality.
Pigovian taxes raise cost of generating negative externality
Pigovian tax effectively places a price on right to generate negative externality Just as markets allocated goods to those buyers who value
them most highly, a Pigovian tax allocates negative externality to polluters that face highest cost of reduction
PUBLIC POLICIES TOWARD EXTERNALITIES
• Pigovian Taxes and Subsidies Pigovian taxes generally preferred to
regulation Regulation (command-and-control production
standard) dictates a level of pollution Tax gives polluter an economic incentive to reduce
pollution Tax reduces pollution more efficiently
Regulation requires same level of reduction for all polluters
But equal reduction not necessarily least expensive way
PUBLIC POLICIES TOWARD EXTERNALITIES
• Pigovian Taxes and Subsidies Difficulty in setting right level of tax to
generate socially optimal level of negative externality
PUBLIC POLICIES TOWARD EXTERNALITIES
• Pigovian Taxes and Subsidies Pigovian taxes differ from most other taxes
Most taxes distort incentives and move allocation of resources away from social optimum.
Reduction in economic well-being (consumer and producer surplus) exceeds revenue government raises, resulting in deadweight loss
In contrast, when externalities are present, Pigovian taxes correct incentives for presence of externalities and thereby move allocation of resources closer to social optimum.
PUBLIC POLICIES TOWARD EXTERNALITIES
• Pigovian Taxes and Subsidies Pigovian taxes differ from most other taxes
Pigovian taxes generate a double dividend: Raise revenue for public purposes and enhance
economic efficiency
PUBLIC POLICIES TOWARD EXTERNALITIES
• Transferable Property Rights Establish a property right for negative
externality and let polluters voluntarily exchange these pollution permits through a market that develops
This market is governed by the forces of supply and demand
New market efficiently allocates right to generate negative externalities -- pollute
Transferable Property Rights
Price of pollution
Quantity of pollution
Supply of TransferableProperty Right: Pollution Permits
Demand for TransferableProperty Right: PollutionPermits
P
Q2….which, together with the demand curve, determines the price of pollution.
1. Pollution permits set the quantity of pollution….
• Supply is perfectly inelastic• Quantity of pollution set by number of permits or total cap on pollution
PUBLIC POLICIES TOWARD EXTERNALITIES
• Transferable Property Rights Firms that can reduce pollution only at high cost will
be willing to pay the most for pollution permits. Firms that can reduce pollution at low cost will prefer
to sell whatever permits they have. Initial allocation of property right among firms does
not affect economic efficiency, but affects distribution of wealth Can initially allocate transferable property right -- pollution
permits -- to polluters or to society Initial allocation of transferable property rights among
polluters affects their distribution of wealth
PUBLIC POLICIES TOWARD EXTERNALITIES
• Transferable Property Rights Both transferable property rights and Pigovian
taxes internalize externality by making it costly to pollute With Pigovian taxes, polluting firms must pay tax to
government With transferable property rights, polluting firms
pay when buy and sell permits
PUBLIC POLICIES TOWARD EXTERNALITIES
• Transferable Property Rights Government fixes total quantity of pollution Position of demand curve for pollution permits
determines the price of pollution Government often knows overall level of
pollution (which sets supply of permits) but not individual firm’s cost structure or demand curve for pollution
Hence difficult to set correct size of tax to achieve that goal but easier and more accurate to use transferable property rights
Equivalence of Pigovian Taxes and Transferable Property Rights
Pigovian Tax Transferable Right
Price of Pollution Price of Pollution
Quantity ofpollution
Quantity ofpollution
PP
Demand forpollution rights
Demand forpollution rights
Pigoviantax
Supply ofpollution permits
1. A Pigoviantax sets theprice ofpollution…
2…which together withthe demand curve, determinesthe quantity of pollution.
1. Pollution permits set the quantity of pollution…
2…which together with the demand curve, determines
the price of pollution
PUBLIC POLICIES TOWARD EXTERNALITIES
• Equivalence of Pigovian Taxes and Transferable Property Rights Demand curve for right to pollute differs With Pigovian tax
Government uses tax to set a price for pollution Supply curve for pollution rights is perfectly elastic, because
firms can pollute as much as they want by paying the tax Position of demand curve determines the price of pollution
PUBLIC POLICIES TOWARD EXTERNALITIES
• Equivalence of Pigovian Taxes and Transferable Property Rights With transferable property right (pollution permits)
Government sets quantity of pollution by issuing pollution permits
Supply curve for pollution rights is perfectly inelastic, because the quantity of pollution is fixed by the number of permits
Position of demand curve determines the price of pollution Hence, with any demand curve for negative
externality or pollution, government can achieve any point on the demand curve either by setting a price with a Pigovian tax or by setting a quantity with pollution permits or overall quantity of pollution