Externalities as a Source of Market Failure

Externalities as a Source of Market Failure
Property Rights, Externalities and Environmental Problems
Introduction
Property Rights: refers to a bundle of entitlement de…ning the
owner’s rights,privileges, and limitations for use of the resource.
An owner of a resource with a well-de…ned property right has a
powerful incentive to use that resource e¢ ciently. WHY?
An e¢ cient structure of property rights has 3 main characteristics:
1
2
3
Exclusivity: all bene…ts and costs should accrue to the owner
Transferability: PR should be transferable from one owner to
another
Enforceability: PR should be secure from involuntary seizure
by others
When well-de…ned property rights are exchanged, as in
market economy, this exchange facilitates e¢ ciency.
Property Rights, Externalities and Environmental Problems
Consumer and Producer Surplus
Consumer Surplus
The incentives consumers and producers face when a well-de…ned
system of property rights is in place.
Price
Consumer Surplus
P*
Demand
Q*
Quantity
Property Rights, Externalities and Environmental Problems
Consumer and Producer Surplus
Producer Surplus
The incentives consumers and producers face when a well-de…ned
system of property rights is in place.
Price
Supply
P*
Producer Surplus
Q*
Quantity
Property Rights, Externalities and Environmental Problems
Externalities as a Source of Market Failure
Introduction
Externality:
1
An activity by one agent causes a loss of welfare to another
agent
2
The loss of welfare is uncompensated
Property Rights, Externalities and Environmental Problems
Externalities as a Source of Market Failure
We can draw a number of conclusions about market
allocations of commodities causing pollution externalities:
1
The output of the commodity is too large
2
Too much pollution is produced
3
The prices of products responsible for pollution are too low
4
As long as the costs are external, no incentives to search ways
to yield less pollution per unit of output are introduced by the
market
5
Recycling and reuse of the polluting substances are
discouraged since release into the environment is so
ine¢ ciently cheap
The e¤ects of a market imperfection for one commodity end
up a¤ecting the demands for raw materials, labor and so on.
Property Rights, Externalities and Environmental Problems
Types of Externalities
Positive Externality (external economy)
Negative Externality (external diseconomy)
Pecuniary Externality
Property Rights, Externalities and Environmental Problems
Externalities as a Source of Market Failure
An externality exists whenever the welfare of some agent,
either a …rm or household, depends not only on his or her
activities, but also on activities under the control of some
other agent.
Simple Externality Examples
The Rat Race Problem
Simple Externality Examples
The Rat Race Problem
It is a contest for relative position. It helps explain:
Why students work too hard when …nal marking takes the form of a
ranking.
The intense competition for a promotion in the workplace when
candidates compete with each other and only the best is promoted
Assume that performance is judge not in absolute terms but
in relative terms
Player 2
Player 1
Low effort
High effort
Low effort
(1/2,1/2)
(0,1-c)
High effort
(1-c,0)
(1/2-c,1/2-c)
Note that 0 < c < 1/2
Simple Externality Examples
RIVER POLLUTION
River Pollution
Simple Externality Examples
RIVER POLLUTION
River Pollution
Assume:
1
Two …rms are located along the same river
2
The upstream …rm u pollutes the river
3
The production of the downstream …rm,d, is a¤ected
4
P=1
5
Both …rms produce the same output
6
Labor and Water are used as inputs
7
Water is free, labor receives w
8
F u (Lu ) and F d (Ld , Lu ) with
9
∂F d
∂L u
<0
Each Firm acts independently and seeks to maximize its own
pro…t: π i = F i ( ) wLi
Simple Externality Examples
RIVER POLLUTION
Equilibrium with river pollution
Upstream
Revenue
πu
Ou
Cost
Revenue
L*u,L*d
Cost
Od
πd
Downstream
Simple Externality Examples
Improperly Designed Property Rights Systems
Other Property Rights Regimes:
1
State Property Regimes: The government owns and control
the property
2
Common-property Regimes: The property is jointly owned and
managed by a speci…c group of co-owners
3
Open-access Regimes: no one owns or exercise control over
the resources
1
Tragedy of the Commons: Nobody is willing to conserve the
natural resource
Simple Externality Examples
Improperly Designed Property Rights Systems
Example of Open-access Regimes