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- Internalize externality by:

Assigning property rights, OR Set policy prescription, such as:
- Set standards on pollution allowed
- Tax polluter equal to MEC at QE
- Establish a market and price for pollution

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- Common Property Resources are those for which property rights are shared

- Because property rights extend to more than one individual, they are not as clearly defined as for pure private goods

- Problem is that public access without any control leads to exploitation, which in turn generates a negative externality

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Bargaining When Rights Belong to Recreational Users

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Bargaining When Rights Belong to Recreational Users

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- Bargaining will proceed analogously

- An efficient outcome can be realized without government intervention

- Limitations of the Coase Theorem:
-Assumes costless transactions and measurable damages
- At minimum it must be the case that very few individuals are involved on each side of the market

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Bargaining When Rights Belong to Refineries

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Bargaining When Rights Belong to Refineries

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- Initial point is Qc, since the refineries, who own the rights, would choose this point

- Recreational users: Willing to offer a payment r p r < (MSC - MPC), or r < MEC

- Refineries: Willing to accept payment r p r > (MPB - MPC), or r > Mπ

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Bargaining When Rights Belong to Refineries

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Bargaining When Rights Belong to Refineries

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- Recreational users are willing to pay (WTP) refineries for each unit of Q not produced
- Will pay up to the negative effect on utility (MEC)

- Refineries are willing to accept payment not to produce
- Will accept payment greater than their loss in profit from contracting production (Mπ )

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Building the Model: Refined Petroleum Market

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Building the Model: Refined Petroleum Market

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- Refineries use the river to release chemicals as an unintended by-product of production
- Objective: to maximize π

- Recreational users use the river for swimming and boating
- Objective: to maximize utility

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- Proper assignment of property rights, even if externalities are present, will allow bargaining between parties such that efficient solution results, regardless of who holds rights

-Assumes costless transactions
-Assumes damages are accessible and measurable

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As Q falls from 160 to 128:

- Refineries lose π measured as Mπ  (or excess of MPB over MPC) for each unit of Q contracted
- Defines area WYZ
- Society gains accumulated reduction in MEC for each unit of Q contracted
- Defines area WXYZ
- Net gain = Area WXYZ - Area WYZ = Area WXY

- Both externality and public goods models show inefficiency of private market solution, i.e., market failure - Underlying source of failure is absence of property rights

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Comparing the Equilibria Using Mp and MEC

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Comparing the Equilibria Using Mp and MEC

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- Competitive firm maximizes  π where

MPB = MPC, or where MPB - MPC = 0, or n Mp = 0

since MPB – MPC = Mp by definition

- Efficient firm produces where

MSB = MSC or MPB + MEB = MPC + MEC n or
MPB - MPC = MEC, if MEB = 0, so… Mp = MEC

Mp = MPB - MPC
= (42 - 0.125Q) - (10 + 0.075Q) so
Mπ  = 32 - 0.2Q
MEC = 0.05Q

- Find the competitive and efficient equilibria using these equations

Competitive solution
Set Mp = 0, or 32 - 0.2Q = 0, so QC = 160
Find P by substituting into MPB or MPC
Using MPB, PC = 42 – 0.125(160) = 22

Efficient solution
Set Mp = MEC, or 32 - 0.2Q = 0.05Q, so QE= 128
Find P by substituting into MPB or MPC
Using MPB, PE = 42 – 0.125(128) = 26

QC = 160 thousand
- At this point, MEC = $8.00 per barrel
Note: Mπ ≠ MEC --> not efficient

QE = 128 thousand
- At this point, MEC = Mp = $6.40 per barrel
- Efficiency would improve if output were restricted by 32 thousand (i.e., 160 - 128)

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Finding a Competitive Solution: Refined Petroleum Market

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Finding a Competitive Solution: Refined Petroleum Market

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

Find the competitive solution and analyze

Set MPB = MPC

42.0 - 0.125Q = 10.0 + 0.075Q

Solve:

QC = 160 thousand
PC = $22 per barrel n Analysis:

- This ignores external costs from contamination n Allocative efficiency requires P to equal all MC
- MPC undervalues opportunity costs of production; QC is too high; PC is too low

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

- Find the efficient solution; show graphically

- Set MSC = MSB

10.0 + 0.125Q = 42.0 - 0.125Q

Solving: QE = 128 thousand
PE = $26/barrel

- Observe: In the presence of an externality, market forces cannot determine an efficient outcome

- Results of negative externality
QC is too high, i.e., overallocation of resources
PC is too low, since MEC is not captured by market transaction

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Modeling a Negative: Environmental Externality

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Modeling a Negative: Environmental Externality

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Define the market as refined petroleum n 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 inefficient

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- 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
- If the externality affects a narrower group of individuals or firms, those effects are more properly modeled as an externality

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- An externality is a spillover effect associated with production or consumption that extends to a third party outside the market

Negative externality – an external effect that generates costs to a third party
Positive externality – an external effect that generates benefits to a third party

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

- To model these environmental externalities, the relevant market must be defined as the good whose production or consumption generates environmental damage outside the market transaction

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Solution to Public Goods Dilemma:  Government Intervention

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Solution to Public Goods Dilemma:  Government Intervention

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- Government might respond through direct provision of public goods

- Government might use political procedures and voting rules to identifying society’s preferences about public goods

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- In theory, market D for a public good is found by vertically summing individual demands

- Vertical sum because we must ask consumers “What price would you be willing to pay for each quantity of the public good?”

- But consumers are unwilling to reveal their WTP because they can share in consuming the public good even when purchased by someone else due to the nonrival and non-excludability characteristics

- This problem is called non-revelation of preferences, which arises due to free-ridership

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- A public good is a commodity that is nonrival in consumption and yields nonexcludable benefits

Non-rivalness – the characteristic of indivisible benefits of consumption such that one person’s consumption does not preclude that of another
Non-excludability – the characteristic that makes it impossible to prevent others from sharing in the benefits of consumption n

- The relevant market definition is the public good – environmental quality, which possesses these characteristics

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- 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

Environment as a public good – The market of air quality. Issue: the provision is not efficient.

Environment as an externality problem – Production of palm oil generates air pollution. The pollution is not part of market solution.

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Environmental Pollution: A Market Failure

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Environmental Pollution: A Market Failure

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Market failure is the result of an inefficient market condition