Market Failures

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Market Failures
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The role of government and economics is to
enhance public welfare

• Both seek to allocate scarce resources among
  alternative desirable ends
• When the market fails to allocate goods
  adequately, then the government should step in

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Three questions

• What are the desirable ends towards which society
  should allocate its scarce resources?
• What are these scarce resources, and what are
  their characteristics relevant to allocation? 
• Based on the nature of the scarce resources and
  human nature, what allocative mechanisms is best
  for achieving these desired ends?
• What allocative mechanisms are available?

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The desirable ends what improves social welfare?

• Is it ever greater consumption of market goods?
• Can you buy and sell clean water, clean air,
  stable climate, biodiversity, ozone layer?
• Why are we so obsessed with growth?
• Does sustainability matter?
• Does distribution matter?
• Who should own goods and services created by
  nature and by society?
• Is stability desirable?

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What are the scarce resources?

• Economic goods and services
• Ecosystem goods and services
• Laws of thermodynamics
• 1st law matter energy is constant
• You cant make something from nothing
• Economics is transformation, not waste
• 2nd law entropy increases in an isolated system
  (supreme law of nature)
• Economic activity results in waste
• Economy cant grow forever. We cant grow our way
  out of poverty

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From Empty World to Full World
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What are the characteristics of the scarce
resources?
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Excludability

• Excludable resource regime
• One person can prevent another from using the
  resource
• Necessary for markets to exist
• Non-excludable
• No enforceable property rights due to technology
  or social institutions
• Cant charge for use
• Some resources non-excludable by nature. None are
  inherently excludable.
• Excludability is a product of institutions.

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Rivalness

• Rival Goods
• My use leaves less for you to use
• All ecosystem goods are rival
• Non-rival (or non-depletable)
• My use does not leave less for you to use
• Marginal cost for additional user 0
• Efficient allocation Price marginal cost of
  production
• All non-rival resources are services
• Rival or non-rival is an innate characteristic of
  the good, not a result of institutions

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Rivalness (cont.)

• Non-rival but congestible
• Non-rival as long as few people use it, becomes
  rival with excessive use (e.g. roads)
• Empty planet vs. full planet

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So What?
Excludable
Non-Excludable
Market Good cars, houses, land, oil, timber,
waste absorption capacity?
Open Access Regime Oceanic fisheries,
undiscovered minerals, waste absorption capacity
Rival
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
Non-rival
OAR when crowded e.g. public parks, beaches,
roads, bridges, etc.
MG when crowded toll roads at rush hour, toll
bridges, beaches, etc.
Non-rival, congestible
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Open Access

• The Tragedy of the commons
• Common property vs. open access
• Individuals try to capture benefits for
  themselves, share costs with society
• Market alone leads to over-exploitation
• Threat of extinction
• Loss of profit (to be explained later)
• Role for government to step in

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Non-rival Excludable

• Patents are protected by governments
• Why do we have patents?
• Patents, profit motive and innovation
• When did patents come about?
• 1790s in US
• 1947 international, rarely used before 1980s

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Non-rival Excludable (cont.)

• Patents and the WTO
• 97 owned by developed nations
• Neem tree, steel drums, etc.
• Samuel Slater, Father of American industry
• Should government spend scarce resources to make
  these information excludable?

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Public Goods

• Free-riding
• No price signal as feed-back mechanism
• Scarcity ? price increase ? innovation

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

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Public Goods (cont.)

• How important are public goods?
• Life support functions (Vermonts forests)
• Flood protection (Winooski river)
• Water purification
• Lake Champlain
• Infrastructure
• Research and development
• if all the scientists are working for profit,
  none are making PGs
• Provision widely accepted as government duty

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Is government provision efficient?

• Privatization debate
• Read chapter on political economy

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Market goods The theory of Externalities
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Externalities

• Definition
• an activity by one agent causes a loss (gain) of
  welfare to another agent
• The loss (gain) of welfare is uncompensated
• Completely Internal to the Economic Process.
  Why?
• How are these related to public goods?

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Examples

• Individual consumption
• Waste outputs
• Status effect
• Industry
• Pollution
• Brownfields
• Agriculture
• Ecosystem conversion- loss of riparian zones
• Phosphorous emissions
• Siltation
• Factory farming

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Examples (cont.)

• Natural resource harvest
• Depletion of ecosystem services
• Waste emissions
• Community issues
• Crime reduction
• Economic stability
• Education
• Health

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Optimal externalities for society
Agricultural production
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Property Rights

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

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Obstacles to Optimal

• Transaction costs
• in absence of transaction costs, no negative
  externalities
• What are transaction costs likely to be for
  externalities affecting public goods?
• Wealth effect
• Intergenerational externalities

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Government role

• What can the government do about externalities,
  and how does it relate to finance?
• Regulations
• Cost money to enforce

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Government role

• What can the government do about externalities,
  and how does it relate to finance?
• Regulations
• Cost money to enforce
• Economically inefficient
• No incentives to go beyond compliance
• Taxes
• Auctioned quotas

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Controlling price or quantity
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Marginal pollution abatement costs for three
firms emitting 5000 tons of pollution each.
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Pigouvian taxes and subsidies

• Tax (subsidy) equal to value of negative
  (positive) externality theoretically leads to
  efficient outcome
• What is value of externality?
• Incentives

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Tradable quotas

• Example of sulfur dioxide
• First determine scale
• Next decide on distribution
• Justice vs. feasibility
• Allow market to allocate

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Tax or quota?

• With a tax, you can theoretically get right
  amount, but amount will change with economic
  change. Better to let prices vary (economic)
  than amount of resource to be used (ecological)
• tax or quota on single resource leads to
  substitution, on all resources will not

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Tax or quota

• Uncertainty
• We dont know marginal abatement cost curves, nor
  marginal benefit curves
• not only do we not know where we are on the
  curve, we dont know the slope of the curve
• Slope of curve very important
• In full world, lower risks from quotas, in empty
  world, lower risks from tax

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Ignorance and Uncertainty

• Perfect markets require perfect information
• Asymmetric information
• Nobel Prize in 2000
• Poverty insurance
• Irreducible ignorance
• Time lags
• Ecosystem function

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How do ignorance and uncertainty relate to
budgeting and finance?

• Who pays clean up costs when unexpected negative
  impacts occur?
• Health impacts
• Superfund sites
• Role of government in providing social security
  (poverty insurance)

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Natural Monopoly

• High fixed cost, low marginal cost
• Roads
• How should hey be regulated?

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Conclusions

• Many market economists and politicians argue that
  there is little role for government, market is
  best allocative mechanism
• Market systematically fails to provide many goods
• Government is essential
• Future lectures will examine just and efficient
  mechanisms for coping with these market failures

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Naural Monopolies,
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PG the Privatization debate
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Private Provision

• Examples
• 3 private police for every public officer in US
• 2/3 of homes in Denmark with private fire service
• SUVs or plowed roads?
• Relative costs
• Administrative costs
• Diversity of tastes
• Distributional issues
• Skimming

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Private Production examples

• Skating rink in Central park
• Trains in WWI
• Military personnel in Iraq
• Airport security
• Municipal water supply
• Education

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Private Production issues

• Examples
• Skating rink in Central park
• Trains in WWI
• Military personnel in Iraq
• Airport security
• Municipal water supply
• Education