Chapter 3

MARKET FAILURE, PROPERTY

RIGHTS AND THE ENVIRONMENT
 Market Failures, public policy and the
environment

Market fails when one of the assumptions

not fulfilled.

1. Monopolies  f ir ms are able to withhold

quantity from the market to raise price,
which results in inefficiency.
2. Lack of market for environmental services
3. Externalities (positive or negative)
4. Collectively Consumed Goods (public goods)
5.
2 Imperfect information etc
1. Lack of Market for Env’tal Services
 For many environmental services
there is no market.
 Ex- for the amenity value of the
env’t it is difficult to find the market
equilibrium and so that enforce
efficiency.
 So market fails to determine the
price of such services.
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 2. Public Goods
Public goods have two key features:
1. Non-rival - one person enjoying the good
does not keep others from enjoying it i.e. the
consumption of the good by one does not
affect the existence of the good for the other.
2. Non-excludable -people cannot be kept
from enjoying the good i.e. every body has a
right to consume the good.
Problem
Leads to free-rider problem.
4
 What is the Free-rider problem?

Free-rider problem is a type of market

failure that occurs when those who benefit
from resources, public goods, or services
of a communal nature do not pay for them
or under-pay.
Free riders are a problem because while
not paying for the good, they may continue
to access or use it.
 What can be done?
The government can provide public

goods and finance them with taxes.

This helps to alleviate the free-rider

problem

6
 EXTERNALITIES
An externality is the uncompensated
impact of one person’s actions on the well
being of another who is not involved in the
activity.

If the impact on the bystander is adverse, it

is called a negative externality. If it is
beneficial, it is called a positive externality.

Buyers and sellers neglect the external

effects of their actions when deciding how
much to demand and supply. As a result,
the market equilibrium leads to either over
or under production/consumption.
 Negative Externality
• When there are negative externalities, the
marginal social cost differs from the
marginal private cost

• The marginal social cost includes the marginal

private costs of production plus the cost of
negative externalities associated with that
production
• It includes all the marginal costs that
society bears
The Effect of a Negative Externality

Cost Marginal social cost

Marginal private cost
Marginal cost
P1 from externality
P0

Marginal
social benefit
0 Q1 Q0 Quantity
 Positive externality
 When there are positive externalities, the
marginal social benefit differs from the
marginal private benefit
• The marginal social benefit includes the
marginal private benefit of consumption
plus the benefits of positive externalities
resulting from consuming that good
• It includesall the marginal benefits
that society receives
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 Positive externality
 Positive production externality: When
a f irm’s production increases the well
-being of others but the f ir m is not
compensated by those others.
 Example: Beehives of honey
producers have a positive impact on
pollination and agricultural output
 Positive consumption externality:
When an individual’s consumption
increases the well-being of others but
the individual
 is not compensated by those others.
 Example: Beautiful private garden
that passers-by enjoy seeing
11
A Positive Externality Example

Cost, P If there are no externalities,

P0Q0 is the equilibrium

If there are externalities,

S = Marginal
Private Cost
the marginal social
benefit differs from the
P1 Benefit of marginal private benefit,
externality and both P0 and Q0 are
P0 D1 = Marginal Social too low to maximize
Benefit social welfare
D0 = Marginal Government intervention
Private Benefit may be necessary to
increase consumption
Q0 Q1 Q

21-12
Government intervention
• Market failure provides governments with the
reason to interv ene in the ec onom y or in
particular markets that are failing.

• Government intervention aims to overcome the

failure of markets to move towards a more
allocative efficient position
 Types of Government Intervention

•.
Taxation
Establish
Property Public Provision
Rights
Types of
Government
Subsidies Intervention Regulation

Education and
Transfer social
Payments marketing
campaigns
 The five categories of property right
and the four ownership regimes are;
1. Access: Non- extractive right to
enjoy benefits of a property
e.g. permission to bike on roads.
2. Withdrawal: Right to extract or
remove some or the entire product
of a property.
e.g. Fishers those with valid
fishing licenses have access and
withdrawal rights.
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3. Management: Right to regulate, use (access,
withdrawal) and improvements.
e.g. Farmers who participate in the mngt of
gov’t-owned irrigation systems hold these
rights.

4. Exclusion: Right to exclude others from

access, withdrawal, and management.
e.g. Proprietors who collectively govern
common-property.

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5. Alienation: Right to sell (“alienate”)
property to someone else.
Owners of cars have the right to sell their
cars to someone else

Ownership Regimes:
a. Private property
b. Common property
c. Government (state) property
d. Open access
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 Internalizing Negative externality
 Negative Externalities Example
 The Market for Aluminum
The quantity produced and consumed in the
market equilibrium is efficient (it maximizes the
sum of producer and consumer surpluses).
If the aluminum factories emit pollution (a
negative externality), then the cost to society of
producing aluminum is larger than the cost to
aluminum producers.
 For each unit of aluminum produced, the social
cost includes the private costs of the producers
plus the cost to those bystanders adversely
affected by the pollution
 Pollution and the Social Optimum
Price of
Social
Aluminum
cost
Cost of
pollution
Supply
(private cost)

Optimum

Equilibrium

Demand
(private value)

0 QOPTIMUM QMARKET Quantity of

Aluminum
 The intersection of the demand curve(private
value)
and the social-cost curve determines the optimal
output level.
 The socially optimal output level is less than
the market equilibrium quantity.
Achieving the Socially Optimal Output:
 The government can internalize an externality by
imposing a tax on the producer to reduce the
equilibrium quantity to the socially desirable
quantity(socially optimal output level).
 internalizing an externality: altering incentives
so that people take account of the external
effects of their actions.
 Internalizing Negative Externalities
through Pigouvian tax

Pigouvian tax: Tax per unit of output

equal to marginal external cost, with tax
revenues being used to compensate
those harmed and/or fix environmental
harms.
 Pigouvian taxes discourage behaviors that
create negative externalities. ...
 Pigouvian taxes can also create more
efficiency in an economy, especially when the
tax covers the cost of the external damage.
 It creates the true cost of producing the good
21 or service.
Taxes on negative externalities are reduces
consumption and creates a more socially
efficient outcome.
 If a good has a negative externality, without a tax,
there will be over-consumption (Q1 where D=S)
because people ignore the external costs.
Consumption of the good has a negative externality
(e.g., consuming gasoline produces local air pollution)
• A tax should be placed on the good equal to the
external marginal cost. It means that consumers will
end up paying the full social marginal cost.
• A tax enables the harmful effects to be internalized.
• After the tax is implemented, the output of the good
will fall from Q1 to Q2. Q2 is socially efficient because
at this level the social marginal benefit (SMB) = Social
marginal cost (SMC)
 Examples:
 Given: Demand: P = 1500 – 0.1Q
 Private-cost supply: P = 100 + 0.1Q
 Marginal external cost: $200
 Social-cost supply: P = 300 + 0.1Q
 Required: Solve for total external cost and the Total gross
gains from trade and the true or net gains.

 Solution: Since marginal external cost is a constant $200,
(that is the difference b/n the private supply and social
supply curves)
 = 300+0.1Q – (100+0.1Q) = 200 (marginal external cost)
 => Total external cost = MEC*Q
 To calculate for Q, equate demand equation and the private
supply cost equations.
 => 1500 – 0.1Q = 100 – 0.1Q => Q = 7000
 => TEC = MEC*Q = 200*7000 = $1,400,000
 Total gross gains from trade = CS+PS
 To solve for CS and PS,
 P

1500

cs

800

ps

100 Q

7000
 Then you can find the areas using the rule followed for
calculating area of right angled triangle i.e. 1/2b*h, where b is
base and h is height. Therefore:
 CS = ½*700*7000 = 2,450,000
 PS = ½*700*7000 = 2,450,000
 Total gross gain is therefore, CS + PS = $4,900,000 and from
above we have TEC of $1,400,000. Thus, net gains from trade
will be the difference between total gains and total external
costs.
 NG = TGG – TEC = $4,900,000 - $1,400,000 = $3,500,000
2. For the above example, solve for equilibrium P, Q, and
total gains from trade assuming a Pigouvian tax. Here since
there is an assumption of Pigouvian tax, we will use the
social supply cost equation to solve for equilibrium P and Q.
Thus, equilibrium Q can be solved by equating demand and
social-cost supply equation.
 1500 – 0.1Q = 300 + 0.1Q  Q = 6000
 By substituting Q in the social-cost supply equation, we
will get equilibrium P to be $900.
 CS = $(1500-900)*6,000/2 = $1,800,000
 PS = $(900-300)*6000/2 = $1,800,000
 Total gains from trade = $3,600,000, which is $100,000
larger than in the free market without the Pigouvian tax.
 Advantages of Taxes

• Provides incentives to reduce the negative externality

such as pollution. E.g. cars have become more fuel

efficient due to the increased petrol tax.
• Social efficiency, 1st best solution (where MSC = MSB)

• Taxes raise revenue for the government. This can be

spent on alternatives, such as public transport or the

tax revenue can be used to tackle the problems
relating to the externality, such as Sugar tax – money
goes to health care.
 Internalizing positive Externalities
When an externality benefits the bystanders,
a positive externality exists.
The social value of the good exceeds the
private value.
Technology spillover is a type of positive
externality that exists when a firm’s
innovation not only benefits the firm, but
enters society’s pool of technological
knowledge and benefits society as a whole
 Education and the Social Optimum

Price of
Education
Supply
(private cost)

Social
value
Demand
(private value)

0 QMARKET QOPTIMUM Quantity of

Education
 The intersection of the supply curve and the social-
value curve determines the optimal output level.
 The optimal output level is more than the equilibrium
quantity.
 The market produces a smaller quantity than is
socially desirable.
 The social value of the good exceeds the private value
of the good.
 Internalizing positive Externalities: Subsidies
 The primary method for attempting to internalize positive
externalities.
 Industrial Policies: government intervention in the
economy that aims to promote technology-
enhancing industries
 Patent laws: a form of technology policy that
give the individual (or firm) with patent
protection a property right over its invention.
 The patent is then said to internalize the
externality
 Activity
1. Given:
 Demand: P = 1600 – 0.1Q
 Private-cost supply: P = 200 + 0.1Q
 Social-cost supply: P = 400 + 0.1Q
1. Solve for total external cost and the Total gross gains
from trade and the Net gains.
2. For the above equation, solve for equilibrium P, Q, and
total gains from trade assuming a Pigouvian tax.
3. By how much does the Pigouvian tax enhance efficiency
(net gains from trade)?
 r 3
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