Market FailuresMarket Failures

The role of government and economics The role of government and economics is to enhance public welfareis to enhance public welfare

Both seek to allocate scarce Both seek to allocate scarce resources among alternative resources among alternative desirable endsdesirable ends

When the market fails to allocate When the market fails to allocate goods adequately, then the goods adequately, then the government should step in government should step in

Three questionsThree questions

What are the desirable ends towards which What are the desirable ends towards which society should allocate its scarce resources?society should allocate its scarce resources?

What are these scarce resources, and what are What are these scarce resources, and what are their characteristics relevant to allocation?  their characteristics relevant to allocation? 

Based on the nature of the scarce resources Based on the nature of the scarce resources and human nature, what allocative mechanisms and human nature, what allocative mechanisms is best for achieving these desired ends?is best for achieving these desired ends?

What allocative mechanisms are available?What allocative mechanisms are available?

The desirable ends: what improves The desirable ends: what improves social welfare?social welfare?

Is it ever greater consumption of Is it ever greater consumption of market goods?market goods? Can you buy and sell clean water, clean Can you buy and sell clean water, clean

air, stable climate, biodiversity, ozone air, stable climate, biodiversity, ozone layer?layer?

Why are we so obsessed with growth?Why are we so obsessed with growth? Does sustainability matter?Does sustainability matter? Does distribution matter?Does distribution matter?

Who should own goods and services Who should own goods and services created by nature and by society?created by nature and by society?

Is stability desirable?Is stability desirable?

What are the scarce resources?What are the scarce resources?

Economic goods and servicesEconomic goods and services Ecosystem goods and servicesEcosystem goods and services Laws of thermodynamicsLaws of thermodynamics

11stst law: matter energy is constant law: matter energy is constant You can’t make something from nothingYou can’t make something from nothing Economics is transformation, not wasteEconomics is transformation, not waste

22ndnd law: entropy increases in an isolated law: entropy increases in an isolated system (supreme law of nature)system (supreme law of nature)

Economic activity results in wasteEconomic activity results in waste Economy can’t grow forever. We can’t grow Economy can’t grow forever. We can’t grow

our way out of povertyour way out of poverty

From Empty From Empty World to Full World to Full

WorldWorld

What are the characteristics of the What are the characteristics of the scarce resources?scarce resources?

ExcludabilityExcludability

Excludable resource regimeExcludable resource regime One person can prevent another from using One person can prevent another from using

the resourcethe resource Necessary for markets to existNecessary for markets to exist

Non-excludable Non-excludable No enforceable property rights due to No enforceable property rights due to

technology or social institutionstechnology or social institutions Can’t charge for useCan’t charge for use

Some resources non-excludable by nature. Some resources non-excludable by nature. None are inherently excludable. None are inherently excludable.

Excludability is a product of institutions.Excludability is a product of institutions.

RivalnessRivalness Rival GoodsRival Goods

My use leaves less for you to useMy use leaves less for you to use All ecosystem goods are rivalAll ecosystem goods are rival

Non-rival (or non-depletable)Non-rival (or non-depletable) My use does not leave less for you to useMy use does not leave less for you to use Marginal cost for additional user = 0Marginal cost for additional user = 0 Efficient allocation: Price = marginal cost of Efficient allocation: Price = marginal cost of

productionproduction All non-rival resources are servicesAll non-rival resources are services

Rival or non-rival is an innate characteristic Rival or non-rival is an innate characteristic of the good, not a result of institutionsof the good, not a result of institutions

Rivalness (cont.)Rivalness (cont.)

Non-rival but congestibleNon-rival but congestible Non-rival as long as few people use it, Non-rival as long as few people use it,

becomes rival with excessive use (e.g. becomes rival with excessive use (e.g. roads)roads)

Empty planet vs. full planetEmpty planet vs. full planet

So What?So What?

Rival

Non-rival

Excludable Non-Excludable

Market Good: cars, houses, land, oil, timber, waste absorption capacity?

Potential market good but inefficient: patented information, e.g. energy efficiency, toll roads.

Pure Public Good:Information, streetlights, public roads, defense, laws, public health, most ecosystem services

Open Access Regime:Oceanic fisheries, undiscovered minerals, waste absorption capacity

Non-rival,congestible

MG when crowded: toll roads at rush hour, toll bridges, beaches, etc.

OAR when crowded: e.g. public parks, beaches, roads, bridges, etc.

Open AccessOpen Access

The “Tragedy of the commons”The “Tragedy of the commons” Common property vs. open accessCommon property vs. open access Individuals try to capture benefits for Individuals try to capture benefits for

themselves, share costs with societythemselves, share costs with society Market alone leads to over-exploitationMarket alone leads to over-exploitation

Threat of extinctionThreat of extinction Loss of profit (to be explained later)Loss of profit (to be explained later)

Role for government to step inRole for government to step in

Non-rival & ExcludableNon-rival & Excludable Patents are protected by Patents are protected by

governmentsgovernments Why do we have patents?Why do we have patents? Patents, profit motive and innovationPatents, profit motive and innovation When did patents come about?When did patents come about?

1790s in US1790s in US 1947 international, rarely used before 1947 international, rarely used before

1980s1980s

Non-rival & Excludable (cont.)Non-rival & Excludable (cont.) Patents and the WTOPatents and the WTO

97% owned by developed nations97% owned by developed nations Neem tree, steel drums, etc.Neem tree, steel drums, etc.

Samuel Slater, “Father of American Samuel Slater, “Father of American industry”industry”

Should government spend scarce Should government spend scarce resources to make these information resources to make these information excludable?excludable?

Public GoodsPublic Goods

Free-ridingFree-riding No price signal as feed-back mechanismNo price signal as feed-back mechanism

Scarcity Scarcity price increase price increase innovation innovation

•Lack of Incentives for market to produce them•Lack of incentives for markets to create technologies that provide them

Public Goods (cont.)Public Goods (cont.)

• How important are public goods?How important are public goods?• Life support functions (Vermont’s forests)Life support functions (Vermont’s forests)• Flood protection (Winooski river)Flood protection (Winooski river)• Water purificationWater purification• Lake ChamplainLake Champlain

InfrastructureInfrastructure• Research and developmentResearch and development

if all the scientists are working for profit, if all the scientists are working for profit, none are making PGsnone are making PGs

Provision widely accepted as government duty

Is government provision efficient?Is government provision efficient?

Privatization debate Privatization debate Read chapter on political economyRead chapter on political economy

Market goods: The theory of Market goods: The theory of ExternalitiesExternalities

ExternalitiesExternalities

DefinitionDefinition ““an activity by one agent causes a loss an activity by one agent causes a loss

(gain) of welfare to another agent”(gain) of welfare to another agent” ““The loss (gain) of welfare is The loss (gain) of welfare is

uncompensated”uncompensated”

Completely Internal to the Economic Completely Internal to the Economic Process. Why?Process. Why?

How are these related to public How are these related to public goods?goods?

ExamplesExamples Individual consumptionIndividual consumption

Waste outputsWaste outputs Status effectStatus effect

IndustryIndustry PollutionPollution BrownfieldsBrownfields

AgricultureAgriculture Ecosystem conversion- loss of Ecosystem conversion- loss of

riparian zonesriparian zones Phosphorous emissionsPhosphorous emissions SiltationSiltation Factory farmingFactory farming

Examples (cont.)Examples (cont.)

Natural resource harvestNatural resource harvest Depletion of ecosystem servicesDepletion of ecosystem services Waste emissionsWaste emissions

Community issuesCommunity issues Crime reductionCrime reduction Economic stabilityEconomic stability EducationEducation HealthHealth

‘ ‘Optimal’ externalities for societyOptimal’ externalities for society

Agricultural production

Property RightsProperty Rights

Who owns the environment?Who owns the environment? polluter rights (privilege, no rights)polluter rights (privilege, no rights) sufferer rights (rights, duties)sufferer rights (rights, duties) What about future generations?What about future generations?

Obstacles to OptimalObstacles to Optimal

Transaction costsTransaction costs in absence of transaction costs, no negative in absence of transaction costs, no negative

externalitiesexternalities What are transaction costs likely to be for What are transaction costs likely to be for

externalities affecting public goods?externalities affecting public goods?

Wealth effectWealth effect Intergenerational externalitiesIntergenerational externalities

Government roleGovernment role

What can the government do about What can the government do about externalities, and how does it relate externalities, and how does it relate to finance?to finance?

RegulationsRegulations Cost money to enforceCost money to enforce

Government roleGovernment role

What can the government do about What can the government do about externalities, and how does it relate externalities, and how does it relate to finance?to finance?

RegulationsRegulations Cost money to enforceCost money to enforce Economically inefficientEconomically inefficient No incentives to go beyond complianceNo incentives to go beyond compliance

TaxesTaxes Auctioned quotasAuctioned quotas

Controlling price or quantityControlling price or quantity

Marginal abatement costs

Firm 1 Firm 2 Firm 3

First 20% $50,000 $10,000 $25,000

2nd 20% $200,000 $25,000 $50,000

3rd 20% $400,000 $50,000 $100,000

4th 20% $800,000 $100,000 $175,000

Final 20% $1600,000 $500,000 $200,000

Marginal pollution abatement costs for three firms emitting 5000 tons of pollution each.

Pigouvian taxes and subsidiesPigouvian taxes and subsidies

Tax (subsidy) equal to value of Tax (subsidy) equal to value of negative (positive) externality negative (positive) externality theoretically leads to efficient theoretically leads to efficient outcomeoutcome

What is value of externality?What is value of externality? IncentivesIncentives

Tradable quotasTradable quotas

Example of sulfur dioxideExample of sulfur dioxide First determine scaleFirst determine scale Next decide on distributionNext decide on distribution

Justice vs. feasibilityJustice vs. feasibility Allow market to allocateAllow market to allocate

Tax or quota?Tax or quota?

With a tax, you can theoretically get right With a tax, you can theoretically get right amount, but amount will change with amount, but amount will change with economic change. Better to let prices vary economic change. Better to let prices vary (economic) than amount of resource to be (economic) than amount of resource to be used (ecological)used (ecological)

tax or quota on single resource leads to tax or quota on single resource leads to substitution, on all resources will notsubstitution, on all resources will not

Tax or quotaTax or quota

UncertaintyUncertainty We don’t know marginal abatement cost curves, We don’t know marginal abatement cost curves,

nor marginal benefit curvesnor marginal benefit curves

not only do we not know where we are on the curve, not only do we not know where we are on the curve, we don’t know the slope of the curvewe don’t know the slope of the curve

Slope of curve very importantSlope of curve very important In full world, lower risks from quotas, in In full world, lower risks from quotas, in

empty world, lower risks from taxempty world, lower risks from tax

Ignorance and UncertaintyIgnorance and Uncertainty

Perfect markets require perfect Perfect markets require perfect informationinformation

Asymmetric informationAsymmetric information Nobel Prize in 2000Nobel Prize in 2000 Poverty insurancePoverty insurance

Irreducible ignoranceIrreducible ignorance Time lagsTime lags Ecosystem functionEcosystem function

How do ignorance and uncertainty relate to How do ignorance and uncertainty relate to budgeting and finance?budgeting and finance?

Who pays clean up costs when Who pays clean up costs when unexpected negative impacts occur?unexpected negative impacts occur? Health impactsHealth impacts Superfund sitesSuperfund sites

Role of government in providing Role of government in providing social security (poverty insurance)social security (poverty insurance)

Natural MonopolyNatural Monopoly

High fixed cost, low marginal costHigh fixed cost, low marginal cost RoadsRoads How should hey be regulated?How should hey be regulated?

ConclusionsConclusions

Many market economists and Many market economists and politicians argue that there is little politicians argue that there is little role for government, market is best role for government, market is best allocative mechanismallocative mechanism

Market systematically fails to provide Market systematically fails to provide many goodsmany goods

Government is essentialGovernment is essential Future lectures will examine just and Future lectures will examine just and

efficient mechanisms for coping with efficient mechanisms for coping with these market failuresthese market failures

Naural Monopolies, Naural Monopolies,

PG: the Privatization debatePG: the Privatization debate

Private ProvisionPrivate Provision

ExamplesExamples 3 private police for every public officer in US3 private police for every public officer in US 2/3 of homes in Denmark with private fire 2/3 of homes in Denmark with private fire

serviceservice SUVs or plowed roads?SUVs or plowed roads?

Relative costsRelative costs Administrative costsAdministrative costs Diversity of tastesDiversity of tastes Distributional issuesDistributional issues SkimmingSkimming

Private Production: examplesPrivate Production: examples

Skating rink in Central parkSkating rink in Central park Trains in WWITrains in WWI Military personnel in IraqMilitary personnel in Iraq Airport securityAirport security Municipal water supplyMunicipal water supply EducationEducation

Private Production : issuesPrivate Production : issues

ExamplesExamples Skating rink in Central parkSkating rink in Central park Trains in WWITrains in WWI Military personnel in IraqMilitary personnel in Iraq Airport securityAirport security Municipal water supplyMunicipal water supply EducationEducation