ENVIRONMENTALITIES AND MARKET FAILURE

1
ENVIRONMENTALITIES AND MARKET FAILURE
2
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

3
INTRODUCTION

• Market Failure and the Environment
• For environmental assets, markets can fail if
  prices do not communicate societys 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

4
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

5
EXTERNALITIES

• Externalities are special case of market failure
• Externality
• The uncompensated impact of one person or firms
  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

6
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 firms gain/loss is
  not anothers loss/gain

7
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

8
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

9
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

10
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

11
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

12
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

13
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

14
EXTERNALITIES AND MARKET INEFFICIENCY

• Welfare Economics A Recap

• 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.

Supply curve reflects costs of sellers
Price
Supply
Equil. Price
Demand curve reflects value to consumer by
willingness to pay
Demand
Equilibrium Quantity
Quantity
15
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

16
EXTERNALITIES AND MARKET INEFFICIENCY

• Negative Externalities or External Costs
• Price

Social cost Private external cost

• Social cost of good
• exceeds private cost
• Socially optimum
• quantity exceeds
• privately optimum
• quantity
• Socially optimum price
• exceeds privately
• optimum price

Social Optimum
Supply (private marginal cost)
POPTIMUM
Market Equilibrium
PMARKET
External Cost
Demand
QMARKET
Quantity
QOPTIMUM
17
EXTERNALITIES AND MARKET INEFFICIENCY
Social cost Private external cost

• External Cost

Price
External Cost
POPTIMUM
Supply (private marginal cost)
PMARKET
Demand
Quantity
QOPTIMUM
QMARKET
18
EXTERNALITIES AND MARKET INEFFICIENCY
Figure 11.1
19
EXTERNALITIES AND MARKET INEFFICIENCY

• Positive Externalities or External Benefits

Price
Supply (private marginal cost)

• Social value exceeds private
• value.
• Socially optimal quantity exceeds
• private market equilibrium.

External Benefit
MBSOCIAL POPTIMUM
MBPRIVATE PMARKET
Social demand Private demand external benefit
Demand (private value)
Quantity
QMARKET
QOPTIMUM
20
A Good Whose Production Generates a Positive
Externality for Consumers
Figure 11.2
21
EXTERNALITIES AND MARKET INEFFICIENCY

• Internalizing the Externality
• Altering incentives so that people and firms take
  account of the external effects of their actions

22
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 gt marginal benefit

23
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 gt marginal benefit

24
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

25
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

26
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

27
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.

28
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.

29
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 polluters 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.

30
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
  consumers income.

31
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.

32
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

33
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

34
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
• As emissions reduce profitability of Bs marina

35
PRIVATE SOLUTONS TO EXTERNALITIES

• Coase Theorem Illustration
• Following figure illustrates socially optimal
  level of pollution Q

• MC marginal cost to
• B from pollution
• MB marginal benefit to
• A from pollution
• Q socially optimal level
• of pollution, where MB
• MC

Marginal Cost
Price
MB MC
Marginal Benefit
Quantity of pollution
Q
36
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

37
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 Bs supply of clean
  water and MB represents As demand for clean
  water
• Given B has property rights, A would compensate B
  by amount MC for each unit of pollution

38
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 Bs demand for pollution
  control and MB curve now represents As 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

39
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)

40
PRIVATE SOLUTONS TO EXTERNALITIES

• Coase Theorem Illustration

1. Optimal Level of Pollution 0 High MC
Price
MC
MC MB
MB
0
Quantity of pollution
Q
41
PRIVATE SOLUTONS TO EXTERNALITIES

• Coase Theorem Illustration

2. Optimal Level of Pollution Private Optimum
(Low MC)
Price
MC
MB
Quantity of pollution
Q
42
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

43
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

44
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

45
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

46
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

47
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

48
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

49
PUBLIC POLICIES TOWARD EXTERNALITIES

• Pigovian Taxes and Subsidies
• Difficulty in setting right level of tax to
  generate socially optimal level of negative
  externality

50
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.

51
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

52
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

53
Transferable Property Rights

• Price of pollution

Supply of Transferable Property Right Pollution
Permits

• Supply is perfectly inelastic
• Quantity of pollution set by
• number of permits or total
• cap on pollution

P
Demand for Transferable Property Right
Pollution Permits
Quantity of pollution
Q
2.which, together with the demand curve,
determines the price of pollution.
1. Pollution permits set the quantity of
pollution.
54
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

55
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

56
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
  firms 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

57
Equivalence of Pigovian Taxes and Transferable
Property Rights

• Pigovian Tax
  Transferable Right

Price of Pollution
Price of Pollution
2which together with the demand curve,
determines the price of pollution
Supply of pollution permits
Pigovian tax
P
P
1. A Pigovian tax sets the price of pollution
Demand for pollution rights
Demand for pollution rights
Quantity of pollution
Q
Q
Quantity of pollution
2which together with the demand curve,
determines the quantity of pollution.
1. Pollution permits set the quantity of
pollution
58
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

59
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