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Transcript of Modeling Market Failure Chapter 3 © 2004 Thomson Learning/South-Western.
Modeling Market Failure
Chapter 3
© 2004 Thomson Learning/South-Western
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Environmental Problems: A Market Failure Market failure – the result of an inefficient market
condition Environmental problems are modeled as market
failures using either the theory of public goods or the theory of externalities If the market is defined as “environmental quality,” then
the source of the market failure is that environmental quality is a public good
If the market is defined as the good whose production or consumption generates environmental damage, then the market failure is due to an externality
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Environmental Problems: A Public Good Public good – a commodity that is nonrival in
consumption and yields benefits that are nonexcludable
Characteristics of public goods Nonrivalness – the characteristic of indivisible benefits
of consumption such that one person’s consumption does not preclude that of another
Nonexcludability – the characteristic that makes it impossible to prevent others from sharing in the benefits of consumption
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Modeling a Public Goods Market for Environmental Quality Public goods generate a market failure because the
nonrivalness and nonexcludability characteristics prevent natural market incentives from achieving an allocatively efficient outcome
Allocative Efficiency in the Market for a Public Good Achieving an allocatively efficient equilibrium in a public
goods market depends on the existence of well-defined supply and demand functions
Market demand for a public good – the aggregate demand of all consumers in the market, derived by vertically summing their individual demands
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Modeling a Public Goods Market for Environmental Quality Assessing the Implications
Abating at the 100 percent level to reduce pollution to zero involves prohibitive opportunity costs
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Modeling a Public Goods Market for Environmental QualityFigure 3.1 Combined Demand of Two Consumers for Air
Quality (SO2 Abatement)
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Modeling a Public Goods Market for Environmental QualityFigure 3.2 Market Supply and Market Demand for Air Quality
(SO2 Abatement)
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Modeling a Public Goods Market for Environmental Quality Understanding the Market Failure of Public Goods
Market Nonrevelation of preferences – an outcome that arises
when a rational consumer does not volunteer a willingness to pay because of the lack of a market incentive to do so
Free-ridership – recognition by a rational consumer that the benefits of consumption are accessible without paying for them
Imperfect information Market forces alone cannot provide an allocatively
efficient level of a public good
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Modeling a Public Goods Market for Environmental Quality The Solution: Government Intervention
A common means by which government responds to the dilemma of free-ridership and nonrevelation of preferences is through direct provision of public goods
An alternative government response is the use of political procedures and voting rules aimed at identifying society’s preferences about public goods
Government response to imperfect information includes education and public information
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Environmental Problems: Externalities Externality theory specifies the relevant market as
environmental as the good whose production or consumption generates environmental damage outside the market transaction Externality – a spillover effect associated with
production or consumption that extends to a third party outside the market
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Environmental Problems: Externalities Basics of Externality Theory
Negative externality – an external effect that generates costs to a third party
Positive externality – an external effect that generates benefits to a third party
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Environmental Problems: Externalities Environmental Externalities
Environmental economists are interested in externalities that damage the atmosphere, water supply, natural resources, and the overall quality of life
Environmental externalities can occur in relation to both production and consumption
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Environmental Problems: Externalities Relationship Between Public Goods and
Externalities Although public goods and externalities are not the
same concept, they are closely related If the externality affects a broad segment of society and
if its effects are nonrival and nonexcludable, the externality is itself a public good
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Modeling Environmental Damage As a Negative Externality Developing a formal model of a negative
environmental externality Defining the Relevant Market
The market is defined as refined petroleum products Modeling the Private Market for Refined Petroleum
Assume the private market for refined petroleum is competitive
Supply function is the marginal private cost Demand relationship is the marginal private benefit
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Modeling Environmental Damage As a Negative ExternalityFigure 3.3 Competitive Equilibrium in the Market for Refined
Petroleum
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Modeling Environmental Damage As a Negative Externality Inefficiency of the Competitive Equilibrium
The problem with this equilibrium is that it ignores the external costs to society of contaminated water supplies caused by refined petroleum production
Costs of water production are external to market exchange and not factored into private market decisions
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Modeling Environmental Damage As a Negative Externality Modeling the External Costs
Model the hypothetical marginal external cost as MEC = 0.05Q
Modeling the Marginal Social Costs and Marginal Social Benefits Marginal social cost – the sum of the marginal private
cost (MPC) and the marginal external cost (MEC) Marginal social benefit – the sum of marginal private
benefit (MPB) and marginal external benefit
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Modeling Environmental Damage As a Negative Externality Efficient Equilibrium
Competitive equilibrium – the point where marginal private benefit (MPB) equals marginal private cost (MPC), or where marginal profit (M∏)= 0
Efficient equilibrium – the point where marginal social benefit (MSP) equals marginal social cost (MSC), or where marginal profit (M∏) = marginal external cost (MEC).
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Modeling Environmental Damage As a Negative ExternalityFigure 3.4 Comparing Competitive and Efficient Equilibria Using
Marginal Benefit and Marginal Cost: Refined Petroleum Market in the Presence of Negative Externality
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Modeling Environmental Damage As a Negative ExternalityFigure 3.5 Comparing Competitive and Efficient Equilibria Using
Marginal Profit and Marginal External Cost: Refined Petroleum Market in the Presence of Negative Externality
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Modeling Environmental Damage As a Negative Externality Measuring the Welfare Gain to Society
If production of a commodity generates a negative externality, the market will yield an inefficient solution with too many resources allocated to production
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Modeling Environmental Damage As a Negative ExternalityFigure 3.6 Assessing the Net Gain to Society of Restoring
Efficiency in the Refined Petroleum Market
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Modeling Environmental Damage As a Negative Externality Market Failure Analysis
There is no market incentive for a rational firm to incur higher costs than it has to, even if it is for the good of society
Market failure models give us a better understanding of why we observe increasing damage to the physical environment as industrial production has intensified throughout the world
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The Absence of Property Rights
Property rights – the set of valid claims to a good or resource that permits its use and the transfer of its ownership through sale
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The Absence of Property Rights
The Coase Theorem – assignment of property rights, even in the presence of externalities, will allow bargaining such that an efficient solution can be obtained Two important underlying assumptions of this theory:
Transactions are costless Damages are accessible and measurable
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The Absence of Property Rights
Bargaining When Property Rights Belong to the Refineries Assigning rights to refineries should have no effect on
the outcome at all
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The Absence of Property Rights
Figure 3.7 Bargaining in the Refined Petroleum Market with the Assignment of Property Rights
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The Absence of Property Rights
Bargaining When Property Rights Belong to the Recreational Users According to Coase Theorem, an efficient outcome can
be achieved regardless of which of the affected parties controls the property rights
There is an opportunity for bargaining to proceed so long as the following condition holds:
M∏ > ρ > MEC The assignment of property rights leads to an efficient
outcome without any government intervention
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The Absence of Property Rights
Limitations of the Coase Theorem Coase’s model underscores the importance of property
rights to market process, regardless of who is assigned those rights
For this theory to hold in practice, at minimum it must be the case that very few individuals are involved on each side of the market
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The Absence of Property Rights
Common Property Resources – those resources for which property rights are shared If property rights exist in some form but are ill defined,
the outcome will be an inefficient one Because property rights extend to more than one
individual, they are not as clearly defined as for pure private goods
With common property resources, the problem is that public access without any control leads to exploitation, which in turn generates a negative externality
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The Absence of Property Rights
The Solution: Government Intervention The general solution to externalities, including those
affecting the environment, is to internalize the externality, that is, to force the market participants to absorb the external costs or benefits
Other approaches to internalizing environmental externalities are policies that change the effective price of a product by the amount of the associated external cost or benefit