Environmental Economics(Econ 260)Economic Efficiency and MarketsChapter 4

This ChapterDiscusses market equilibrium

Introduces the idea of economic efficiency

With examples of open-access resources and public goods, illustrates when the market equilibrium is socially efficient and when it is not

Economic or Social EfficiencyEconomic or social efficiency is achieved when the equilibrium output is at the most desirable level socially. This means marginal social benefits = marginal social costs at the equilibrium output.

Note the following. Social benefits = private benefits + external benefits Social costs = private costs + external costs

Private here means buyers or sellers. External means to the rest of the society. The word externality/ies is used to refer to external benefits or costs. Externalities are often difficult to measure.

Social efficiency requires that all market and non-market values be incorporated into the computations of marginal benefits and marginal costs .

Economic or Social EfficiencyWhen there is no externality, market outcomes and efficient outcomes are the same.

When there is an externality, market outcomes and efficient outcomes are different.

When there is a negative externality, market output is more than socially efficient output. The market (by itself) produces too much. For example, pollution.

When there is a positive externality, market output is less than socially efficient output. The market (by itself) produces too little. For example, education, vaccination.

Economic or Social EfficiencyA socially efficient equilibrium also means that market transactions provide maximum net benefits to the society . Thus, the total surplus ( or net social value) achieved is the maximum possible amount.

When there is no externality, the market equilibrium provides a socially efficient equilibrium because market values and social values are the same. This means there is no market failure.

When there is an externality, the market equilibrium fails to provide a socially efficient equilibrium because market values and social values are different. We call this situation a market failure.

When there is a market failure, we need to do/ can do something to influence the market equilibrium to move towards the socially efficient one.

[This course is mostly about dealing with externalities through use of economic tools.]

Fig. 4-1To see where the socially efficient equilibrium is, determine where MWTP (MSB) and MC ( MSC) curves for the society intersect.

Fig. 4-2To see where the market equilibrium is, determine where market demand (D or MPB) and supply (S or MPC) curves intersect.

External Costs- When firms make decisions, they only care about private costs. These are the costs they bear directly.

- When firms produce, they might sometimes produce things (as byproducts) that can harm the rest of the society (non-participants in the market). For example, environmental pollution. Then, some of the costs are borne by the rest of the society. Those costs are called external costs.

- Social cost accounting makes these ideas clearer. social costs = private costs + external costs

- External costs sometimes are negligible. In such a case, we can ignore it. If it is large, then we have a serious case of market failure and our society will try to do something about it.

External CostsConsider Fig. 4-3. When there are external costs (for example, papermill production causing pollution downstream), then we must look at two marginal cost curves: marginal private costs (MPC) and marginal social costs (MPC+MEC).The two curves will help us see how market equilibrium is different from efficient equilibrium.

External CostsOpen-Access Resources : An open-access resource is a resource or facility that is open to uncontrolled access by individuals who find it profitable or useful in some way to use the resource. For example, ocean fishery, forest, atmosphere. No one owns them personally (absence of property rights). So too many people use them. As a result, it is not used efficiently. In other words, there is a market failure.

When more and more people decide to use these resources, not only they face higher private costs but their decisions also cause other people to face higher costs. When a new fisherman decides to go fishing, it will be more difficult to catch fish immediately because there are more fishermen now. So, marginal private cost (MPC) goes up. Additionally, other fishermen will also face more difficulty catching fish. The added difficulty faced by rest of the fishermen is the external costs in this example.

External CostsText book Example [Water Pollution and Treatment Costs]Initially, four firms situated on a lake. They use water from the lake and discharge emissions back into the lake. To treat water for reuse, a firm spends $40,000/year.

Suppose now a new firm enters. There will now be more discharge in the lake. So, treatment cost now is $60,000/year for a firm. [More firms, more discharge]

What is the marginal social cost of the fifth firm locating to the lake? First consider the new firm . The cost for production for this firm (private cost) is $60,000/year.Now consider other firms. For each firm, cost has increased by $20,000/year due to the entry of the fifth firm and there are four firms being affected. Therefore, external costs is $80,000/year. Hence, social costs have increased by $140,000/year even though private costs only increased by $60,000/year.

External CostsTextbook Example (Road Congestion) #carsaverage travel time 2 10 3 10 411What is the increase in cost of going from 2 cars to 3? 3*10-2*10=10. There is no external costs here. Private cost for the third car is 10 minutes, and having 3 cars instead of 2 does not increase travel time for previous 2 cars. What is the increase in cost of going from 3 cars to 4?4*11-3*10=14. Note that the private costs is 11 (experienced by the fourth car) while the external costs is 3 minutes (1 for each of the 3 cars which face increase of travel time from 10 to 11 minutes).Road is an open access facility and its uncontrolled use can lots of social costs in the form of congestion. Since drivers do not think about the social costs, there can be too many drivers on the road ( so inefficient).All these examples suggest that private markets will not normally produce efficient quantities of output when there is an externality.

External Benefits - When buyers make decisions, they generally only care about private benefits. These are the benefits they receive directly. - When buyers buy and consume goods or services produce, they might some times do some good do the rest of the society as well. For example, education. When a person is educated, the person is likely to get benefits like a good job and salary. At the same time, she can help her society make better choices as a more informed individual. The benefits the society gets from her getting an education is external benefits. Just as for the costs, we have the following. social benefits = private benefits + external benefits- External benefits sometimes are negligible. In such a case, we can ignore it. If it is large, then we have a serious case of market failure and our society will try to do something about it.

External BenefitsTo illustrate positive externalities, we will discuss public goods.

Public Goods: Public goods are characterized by non-rivalness (many people enjoy the good simultaneously) and non-exclusion (if made available to one person, it is automatically available to others) there is joint consumption of the good and, once provided, everyone can enjoy the good whether they pay for it or not.

Public good can also be produced by private firms ( like radio signals).Environmental quality is a public good.

When we discuss production of a public good, we need to keep in mind that, due to positive externalities involved, private market generally does not produce efficient quantity. To see this clearly, we will discuss the example in the textbook.

External BenefitsExample: Controlling fertilizer runoff into a lake.Two houses on the shores of a lake, which is contaminated by fertilizer runoff from surrounding farms. Fertilizer runoff causes algae to grow in the lake (bad for fish population and also the scenery) and this lowers amount of dissolved oxygen in the lake water. To improve water quality, both houses like to treat water.

Useful information to solve the water treatment problem. MC treatment = 5+2*Q ; MWTPA= 14-2*QA and MWTPB=6-QB. [Q is quantity of dissolved oxygen in parts per million]For public goods, we need to add MWTP at each Q to get aggregate MWTP. Therefore, aggregate MWTP=20-3*Q.Now we can find efficient level of Q from 5+2*Q=20-3*Q. Solving this we get Q=3.The next slide shows related graphs for this exercise.

Fig. 4-4

External Benefits - When we are dealing with public goods, private markets (private firm trying to produce and sell ) will not work because of free riding problem. A free rider is a person who pays less for a good than her/his true marginal willingness to pay; a person who underpays, that is , relative to the benefits they receive. [You just want to other to pay more so that you have to pay less. ]

- In the example, household A has to pay price of $8 and B has to pay $3 per unit of Q to get efficient level of treatment. However, it will be difficult to get these households to pay those amounts as each household will try to free ride. Due to this issue, a private market will not be able to produce socially efficient level of output for public goods.

*****************