Market Failures - Washington State University

[Pages:15]Market Failures

Market failure occurs when the market outcome does not maximize netbenefits of an economic activity. Due to the nature of environmental resources, the market often fail in dealing with environmental resources.

There are three main environmental market failures. ? a. Externality

? b. Public Goods

? C. Tragedy of the Commons

Externality

? An Externality results when the actions of an individual/firm have direct, unintentional, and uncompensated effect on the well-being of other individuals or profits of other firms.

? The key words are:

? Direct: There has to be a direct effect on well-being of an identifiable individual(s) or profits of firms.

? Unintentional: The effect rather than the action has to be unintentional. This rules out acts of spite or malice.

? Uncompensated: The responsible actor is not compensated for their actions.

Examples of Externalities

? Second hand cigarette smoking. ? Air pollution from factories and power plants.

? In the Pacific Northwest, logging in forested headwaters degrades spawning habitat for salmon- adversely affect commercial fishing

? Hydroelectric dams hinder the fish on their way upstream- adversely affect commercial fishing.

? Firms R &D often produces knowledge that its rivals can use.

? If a neighbor keep their houses and flower gardens well maintained, the value of the houses in that neighborhood is likely to rise.

How do Externalities Cause Market Failure?

Lets take the example of a steel industry: ? Steel furnaces typically burn coal, emitting sulfur dioxide, nitrous

oxides and particulate matter. ? Lets assume there is a fixed relationship between the amount of

steel produced and the amount of pollution emitted. E.g, say for every one thousand tons of steel produced, one ton of sulphur dioxide is emitted.

The amount of the pollution causes damage to downwind residents.

There is a marginal damage of pollution function which is dependent on amount of steel produced

Externality

Externality

? In the absence of regulation, steel producers will ignore the damages caused by pollution.

? The supply curve here corresponds to only the private marginal costs of steel (PMC)

? The producers of steel ignore another cost of production; damages from pollution-externality!

? With this externality, the social marginal cost (SMC) is not equal to the supply curve ( which only reflects the MPC). SMC = MPC + MD.

? In a free market without regulation, QM would be produced. ? When regulation forces the steel industry to internalize the marginal

damage as part of their cost, the supply curve will now be SMC.

Now the equilibrium output of steel is Q*.

Consequences of Market Failure in this Case.

? Sub-optimal Output: After regulation help internalize the damaging cost, output falls (QM> Q*).

? Sub-optimal Pricing: Price increases after externality is internalized.

? As a consequence of the above, the sum of consumer and producer surplus decreases after internalizing the externality in this case.

? What makes internalizing the externality welfare enhancing? ? Social surplus from steel production is not just the sum of producer

and consumer surplus but also the damages from pollution- social welfare deadweight loss.

? Although the reduction in output and the corresponding increase in price hurt both consumers and producers of steel, it benefits people who are harmed by pollution resulting from the steel production.

Public Goods

? Goods that are shared by all but owned by no one.

There are two fundamental characteristics of public goods that lead to

. market failure

? Non-rivalry: A good is non rival in consumption if more than one person can consume the same unit of good at the same time. The consumption from individual does not diminish the amount available for others.

? Non-excludability: A good is non-excludable if the supplier cannot prevent consumption by people who do not pay. If the person does not contribute to the provision of that good, they cannot be prevented from enjoying that good.

? Public good is thus any good that has non-rival in consumption and non-excludable.

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