Dr. D. FosterDr. D. Foster

MicroeconomicsMicroeconomics

Market Failure (?):Market Failure (?):

Public Goods, Common Property & Public Goods, Common Property & ExternalitiesExternalities

When do markets fail?When do markets fail?

When will even perfectly competitive When will even perfectly competitive markets fail to produce the markets fail to produce the

allocatively efficient level of output?allocatively efficient level of output?

• Public goods• Common property• Positive externalities• Negative externalities

Public Public GoodsGoods

Non-rival in consumptionNon-rival in consumptionOne person doesn’t use it up.One person doesn’t use it up.

Non-excludableNon-excludableNon-payers can’t be (easily) excluded.

For example:• National defense• Legal system• Lighthouses• TV and radio• Roads

Public Public GoodsGoods

Not all “publicly-provided” goods Not all “publicly-provided” goods meet the test of being public goods.meet the test of being public goods.

For example:• Education• Trash collection• Social security• National parks . . .

• Roads & lighthouses !• The legal system ?!

Public Public GoodsGoods

Non-excludability problem Non-excludability problem leads to leads to free riders.free riders.

How do markets deal with this problem?• “ “Charge” differentlyCharge” differently

- TV & radio ads

• Find way to excludeFind way to exclude - TV & cable/satellite

• Tie-in salesTie-in sales - lighthouses - shopping malls - gated communities

Graphical Graphical AnalysisAnalysis

For For private goodsprivate goods, the market demand is the , the market demand is the horizontal summation horizontal summation of individual demands.of individual demands.

Everyone pays the Everyone pays the same pricesame price, , consumes consumes differing amountsdiffering amounts

$10$10

$5 $5

MC

Tom Sally

The Market

15 25 40

$3

Price

Price

Price

Quantity

Quantity

Quantity

GraphicaGraphical l

AnalysisAnalysis

Everyone consumes Everyone consumes the the same amountsame amount, ,

pays pays differing prices.differing prices.

$11

$10

$5

$15

MC

Tom

Sally

The Market

20

20

20

For public goodspublic goods, the market demand

is the vertical vertical summation summation of

individual demands.

$8

$3

$

$

$

Q

Q

Q

CaveatsCaveats

Government provision may not be desirable:Government provision may not be desirable:

--The free rider problem is replaced with the --The free rider problem is replaced with the forced riderforced rider..

--Government may be --Government may be inefficientinefficient, imposing , imposing higher costs such that we would be better higher costs such that we would be better

off without this good/service!off without this good/service!

Common PropertyCommon Property Weak incentive to preserve/protect.Weak incentive to preserve/protect. Weak incentive to maximize value.Weak incentive to maximize value. Who owns common property?Who owns common property?

Fish in the oceanFish in the ocean

This is another free rider problem.

Common PropertyCommon Property

P1

Q* Q2

D2

Q - Fish

P Supply

D1

Q1 Qmx

Common PropertyCommon Property What to do?What to do?

-- Assign private property rights.-- Assign private property rights.

-- Regulate use . . . -- Regulate use . . . -standards, -standards, -limits, -limits, -prohibit. -prohibit.

Some observationsSome observations

Elephants in AfricaElephants in Africa1970s - 1.2 million1970s - 1.2 million1980s - 600,0001980s - 600,000

1970s 2000Zimbabwe 30,000 70,000Botswana 20,000 68,000

Kenya 140,000 16,000Tanzania 250,000 61,000Uganda 20,000 1,600

With property rights

Without prop. rts.150,000

2007

Can markets really work?Can markets really work?What about non-renewable What about non-renewable

resources?resources? Hotelling Principle:Hotelling Principle:

People treat exhaustible resources like any People treat exhaustible resources like any asset and want to max. value over time.asset and want to max. value over time.

The Simple Version - We can’t run out of . . . D

SP

Q

S’S”

Hotelling PrincipleHotelling Principle The more complicated story:The more complicated story:

Asset value must grow at the market rate of Asset value must grow at the market rate of interest to find interest to find equilibrium extractionequilibrium extraction..

If asset value grows more slowly, If asset value grows more slowly, extraction.extraction. If asset value grows faster, If asset value grows faster, extraction.extraction.

i = market return

r = asset return

r

i

%

QQ*

If we start “running out?”

r'

Q’

Positive ExternalitiesPositive Externalities Some “consumers” benefit w/out Some “consumers” benefit w/out

paying.paying.-- concert-- concert-- flower garden-- flower garden-- flu shot-- flu shot

What to do?What to do?-- Nothing.-- Nothing.-- Subsidize producer/consumer-- Subsidize producer/consumer

- there is a cost to this!- there is a cost to this!

Positive ExternalitiesPositive Externalities

To promote allocatively efficient level of To promote allocatively efficient level of output, subsidize by the vertical distance.output, subsidize by the vertical distance.

Q

PS

D = MPB

Q1

MSB

Q2

P1

Negative Negative ExternalitiesExternalities

Third parties bear part of the cost without Third parties bear part of the cost without receiving any of the benefit.receiving any of the benefit.-- In the case of pollution:-- In the case of pollution:the firm is facing zero-priced waste the firm is facing zero-priced waste disposal.disposal.

How do we deal with this problem?How do we deal with this problem?-- Tax the producer/consumer. -- Tax the producer/consumer. -- Set standards/quotas for pollution.-- Set standards/quotas for pollution.-- Allow parties to negotiate.-- Allow parties to negotiate.-- Sell pollution rights.-- Sell pollution rights.

Pollution - Tax & StandardPollution - Tax & Standard

Tax raises costs; production.

Quota on production would (might?) serve the

same purpose.

Standards for pollution would also raise costs

and production.

Q

P

S = MPC

D = MPB

Q1

MSC

Q2

P1

Pollution & The Coase TheoremPollution & The Coase Theorem

Assign property rights to the resource (!)Assign property rights to the resource (!)

It doesn’t matter who gets the It doesn’t matter who gets the right . . .right . . .

Is zero the “right” level of Is zero the “right” level of pollution?pollution?

Quantity of

pollution

MC

MB

$

Problems: Problems: HoldoutsHoldouts and and Free Free RidersRiders

Q*

NO !!NO !!!!

$400

The Free Rider ProblemThe Free Rider Problem

$1000

The firm owns the The firm owns the rights . . .rights . . .

Quantity of

pollution

MC

MB

$

Q* Qm

0

The Holdout ProblemThe Holdout Problem

The downstream users own the rights . . The downstream users own the rights . . ..

Quantity of

pollution

MC

MB

$

Q* Qm

0 $2000

$20,000

Selling Pollution Rights (!)Selling Pollution Rights (!)Reduce Pollution by 3 UnitsReduce Pollution by 3 Units

How? Cost? Price of permits? Issue 2 each?How? Cost? Price of permits? Issue 2 each?

Cost to Cost to reduce reduce

by:by:

Firm Firm XX

Firm YFirm Y Firm ZFirm Z

11stst unit unit $50$50 $70$70 $800$800

22ndnd unit unit $75$75 $130$130 $1000$1000

33rdrd unit unit $100$100 $200$200 $2000$2000

Reduce Pollution by 3 UnitsReduce Pollution by 3 Units Cut back equally (by 1 unit each):Cut back equally (by 1 unit each):

Cost = $50 + $70 + $800 = Cost = $50 + $70 + $800 = $920$920

Cut back most cheaply (by 3 units Cut back most cheaply (by 3 units total):total): Cost = $50 (X) + $70 (Y) + $75 (X) = Cost = $50 (X) + $70 (Y) + $75 (X) = $195$195

Charge a price of . . .Charge a price of . . . $90$90 per permit. per permit.

Give out 2 each . . .Give out 2 each . . . Firm Z will Firm Z will buy 1buy 1 from X. from X.

Dr. D. FosterDr. D. Foster

MicroeconomicsMicroeconomics

Market Failure (?):Market Failure (?):

Public Goods, Common Property & Public Goods, Common Property & ExternalitiesExternalities