Topic 4: Market Failure by safwan

Environmental Pollution: A Market Failure

safwanpelik — 2020-11-07 16:27:54 UTC

Market failure is the result of an inefficient market condition

Environmental Pollution

safwanpelik — 2020-11-07 16:59:20 UTC

- 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.

Public Goods Approach

safwanpelik — 2020-11-07 17:02:24 UTC

- 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

Market Demand for a Public Good

safwanpelik — 2020-11-07 17:22:32 UTC

- 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

Solution to Public Goods Dilemma: Government Intervention

safwanpelik — 2020-11-07 17:24:42 UTC

- 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

Externality Approach

safwanpelik — 2020-11-07 17:27:02 UTC

- 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

Relationship Between PublicGoods and Externalities

safwanpelik — 2020-11-07 17:29:15 UTC

- 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

Modeling a Negative: Environmental Externality

safwanpelik — 2020-11-07 17:31:50 UTC

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

Finding a Competitive Solution: Refined Petroleum Market

safwanpelik — 2020-11-07 17:34:12 UTC

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

Comparing the Equilibria Using Mp and MEC

safwanpelik — 2020-11-07 18:12:12 UTC

- 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)

Measuring Society’s Net Gain

safwanpelik — 2020-11-07 18:24:27 UTC

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

Coase Theorem

safwanpelik — 2020-11-07 18:34:03 UTC

- 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

Building the Model: Refined Petroleum Market

safwanpelik — 2020-11-07 18:35:18 UTC

- 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

Bargaining When Rights Belong to Refineries

safwanpelik — 2020-11-07 18:37:01 UTC

- 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 )

Bargaining When Rights Belong to Refineries

safwanpelik — 2020-11-07 18:38:46 UTC

- 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

Bargaining When Rights Belong to Recreational Users

safwanpelik — 2020-11-07 18:42:00 UTC

- 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

Common Property Resources

safwanpelik — 2020-11-07 18:43:43 UTC

- 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

Solution to Externalities

safwanpelik — 2020-11-07 18:45:28 UTC

- 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