Modeling

Market Failure
Environmental Problems:
A Market Failure
 Market failure – the result of an inefficient
market condition
 Environmental problems are modeled as market
failures using either the theory of public goods or
the theory of externalities
 If the market is defined as “environmental
quality,” then the source of the market failure is
that environmental quality is a public good
 If the market is defined as the good whose
production or consumption generates
environmental damage, then the market failure is
due to an externality

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Environmental Problems:
A Public Good
 Public good – a commodity that is nonrival in
consumption and yields benefits that are
nonexcludable
 Characteristics of public goods
 Nonrivalness – the characteristic of indivisible
benefits of consumption such that one person’s
consumption does not preclude that of another
 Nonexcludability – the characteristic that makes
it impossible to prevent others from sharing in
the benefits of consumption

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Modeling a Public Goods
Market for Environmental Quality
 Public goods generate a market failure because
the nonrivalness and nonexcludability
characteristics prevent natural market incentives
from achieving an allocatively efficient outcome

 Allocative Efficiency in the Market for a Public

Good
 Achieving an allocatively efficient equilibrium in
a public goods market depends on the
existence of well-defined supply and demand
functions

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Environmental Problems:
Externalities
 Basics of Externality Theory
 Negative externality – an external effect
that generates costs to a third party
 Positive externality – an external effect
that generates benefits to a third party

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Environmental Problems:
Externalities
 Externality theory specifies the relevant
market as environmental as the good
whose production or consumption
generates environmental damage outside
the market transaction
 Externality – a spillover effect associated
with production or consumption that
extends to a third party outside the market

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Modeling Environmental
Damage As a Negative Externality

 Market Failure Analysis

 There is no market incentive for a rational
firm to incur higher costs than it has to,
even if it is for the good of society
 Market failure models give us a better
understanding of why we observe
increasing damage to the physical
environment as industrial production has
intensified throughout the world

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Environmental Problems:
Externalities
 Environmental Externalities
 Environmental economists are interested in
externalities that damage the atmosphere,
water supply, natural resources, and the
overall quality of life
 Environmental externalities can occur in
relation to both production and
consumption

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Externalities in
Production & Consumption
Consumption Production

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Modeling Environmental
Damage As a Negative Externality
 Developing a formal model of a negative
environmental externality
 Defining the Relevant Market
 The market is defined as refined petroleum
products
 Modeling the Private Market for Refined
Petroleum
 Assume the private market for refined petroleum
is competitive
 Supply function is the marginal private cost
 Demand relationship is the marginal private
benefit
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Modeling Environmental
Damage As a Negative Externality
Competitive Equilibrium

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Modeling Environmental
Damage As a Negative Externality

 Inefficiency of the Competitive Equilibrium

 The problem with this equilibrium is that it
ignores the external costs to society of
contaminated water supplies caused by
refined petroleum production
 Costs of water production are external to
market exchange and not factored into
private market decisions

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Modeling Environmental
Damage As a Negative Externality

 Modeling the External Costs

 Model the hypothetical marginal external cost as
MEC = 0.05Q
 Modeling the Marginal Social Costs and Marginal
Social Benefits
 Marginal social cost – the sum of the marginal
private cost (MPC) and the marginal external cost
(MEC)
 Marginal social benefit – the sum of marginal
private benefit (MPB) and marginal external
benefit
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Modeling Environmental
Damage As a Negative Externality
Comparing Competitive and Efficient Equilibria Using Marginal
Benefit and Marginal Cost in the Presence of Negative Externality

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Modeling Environmental
Damage As a Negative Externality
 Competitive equilibrium – the point
where marginal private benefit (MPB)
equals marginal private cost (MPC), or
where marginal profit (M∏)= 0
 Efficient equilibrium – the point where
marginal social benefit (MSB) equals
marginal social cost (MSC), or where
marginal profit (M∏) = marginal external
cost (MEC).

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Modeling Environmental
Damage As a Negative Externality
Comparing Competitive and Efficient Equilibria Using
Marginal Profit and Marginal External Cost

MSC = MSB
MPC + MEC = MPB assuming
MSB = MPB
MPB – MPC = MEC
M∏ = MEC

If MEC = 0, M∏ = 0

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Modeling Environmental
Damage As a Negative Externality

 Measuring the Welfare Gain to Society

 If production of a commodity generates a
negative externality, the market will yield
an inefficient solution with too many
resources allocated to production

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Modeling Environmental
Damage As a Negative Externality
Assessing the Net Gain to Society of Restoring Efficiency

From QC to QE
WXYZ – Society Gain
WYZ – Loss Profit
WXY – Net Gain

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Cause of
Environmental Damage
 Absent of Property Rights

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The Absence of
Property Rights

 Property rights – the set of valid claims to

a good or resource that permits its use
and the transfer of its ownership through
sale

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The Absence of
Property Rights

 The Coase Theorem – assignment of

property rights, even in the presence of
externalities, will allow bargaining such
that an efficient solution can be obtained
 Two important underlying assumptions of
this theory:
• Transactions are costless
• Damages are accessible and measurable

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 The Absence of
Property Rights
 Assignment of Property Rights either to:
 Polluters
 Users

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 Bargaining Process
P per barrel

Between QC and QE, MEC >

M, so bargaining proceeds
42
MSC = MPC + MEC

X S =MPC
W
26
22
Y MEC at Qc is XY
Z M at Qc is 0
Bargaining begins
10
At QE, MEC = M, so
bargaining ends D = MPB = MSB
0
128 160 Q (thousands)
QE QC
 The Absence of
Property Rights
 Bargaining When Property Rights Belong
to the polluters

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The Absence of
Property Rights
Bargaining with the Assignment of Property Rights to polluters:
M∏ < ρ <MEC => users to pay to polluters as long as ρ is less than
MEC if production at Qc. Polluters have incentive to accept
payment as long as it is greater than M∏ .

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The Absence of
Property Rights
Bargaining with the Assignment of Property Rights to users:
MEC < ρ < M∏ => polluters to pay users more than MEC, but less
than M∏.

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The Absence
of Property Rights
 According to Coase Theorem, an efficient outcome
can be achieved regardless of which of the
affected parties controls the property rights
 There is an opportunity for bargaining to proceed
so long as the following condition holds:
 If the right belongs to polluters: M∏ < ρ <MEC
 If the right belongs to users: MEC < ρ < M∏
 The assignment of property rights leads to an
efficient outcome without any government
intervention

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The Absence
of Property Rights

 Limitations of the Coase Theorem

 Coase’s model underscores the importance
of property rights to market process,
regardless of who is assigned those rights
 For this theory to hold in practice, at
minimum it must be the case that very few
individuals are involved on each side of the
market

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The Absence
of Property Rights
 Common Property Resources – those resources
for which property rights are shared
 If property rights exist in some form but are ill
defined, the outcome will be an inefficient one
 Because property rights extend to more than one
individual, they are not as clearly defined as for
pure private goods
 With common property resources, the problem is
that public access without any control leads to
exploitation, which in turn generates a negative
externality

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The Absence
of Property Rights

 The Solution: Government Intervention

 The general solution to externalities,
including those affecting the environment,
is to internalize the externality, that is, to
force the market participants to absorb the
external costs or benefits
 Other approaches to internalizing
environmental externalities are policies
that change the effective price of a product
by the amount of the associated external
cost or benefit
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