Market Failure, Externalities, Commons, & Public Goods; and Creating Markets

References:
 Economics Today: The Micro View, by Roger LeRoy Miller, 18th edition, Pearson.
 Environmental Economics in Theory & Practice, by Hanley, Shogren, & White, Macmillan Press Ltd. 1997.
 Principles of Microeconomics, by Mankiw, N. Gregory, 5th Edition, 2009.

Recall that a market is an exchange institution where buyers and sellers meet in interactions of
buying/selling. Prices carry information in complete and efficient markets to enable
decentralized decisions that allocate resources to those who value them most. When everyone
thus makes decisions in their best interest knowing all relevant information and prices, because
each person maximizes his/her surplus, the aggregate social surplus (market welfare) is also
maximized. Prices are thus the ‘invisible hand’ (Adam Smith) that lead market outcomes to
efficiency.

Not all markets need be complete and efficient though. In other words there might not be a
price or accurate valuation for every relevant cost or benefit associated with the use or
consumption of a resource. Existing prices then misrepresent the full range of benefits or costs
arising from use of a resource, and thus the information from prices is incomplete. This leads to
market failure where the decisions based on these incomplete prices and information results in
socially inefficient resource allocation.

Think of polluting factories/vehicles, fishing by countries in open waters, poaching of

endangered species for their skin/meat/tusks etc., smoking, grazing land shared by people,
deforestation, crop rotation and stubble burning in northern India, fossil fuel extraction,
production of plastics and the cost of not just pollution created in the process of manufacture
but also the cost of plastic waste, unpaid and un-valued housework, … In each of these cases,
there is some cost or benefit of these activities/uses that is not reflected in the price(s) that
prevail(s). Market failure therefore results.

Activity or Use Effect that is not valued

Polluting factories/vehicles How pollution affects people and environment
around and downwind
Fishing/Poaching How it affects the availability or sustainability
of future numbers of that species and its
surrounding ecosystem
Smoking Its health effects both on the smoker and
other people around
Grazing/Deforestation How it affects availability of
grass/vegetation/forests and the sustainability
of the ecosystem that depends on it
Crop stubble burning How the smoke affects health and
environment of those around and downwind
Fossil fuel extraction Future availability, and how extraction affects
 future of the land as well as its seismic effects
Production of plastics How it affects plant and animal life both on
land and in seas and oceans where it often
ends up as waste
Un-valued housework The housework itself; How it affects supply of
labor, and health and leisure

There is in general a tradeoff between economic activity (the value of which is well measured in
prices and markets) and its effect on the environment (which often lacks valuation or
measurement); some of the above fall under this general story.

Some reasons why prices for all benefits/costs might not exist and that market failure might
happen are:
1. Lack of well-defined property rights
2. Benefits or costs are non-rival and/or non-excludable; Externalities
3. Incomplete markets or transaction costs
4. Asymmetric information

(1) And (2) are closely related;

Also incomplete markets or transaction costs 1 can often lead to gaps in property rights, and
vice versa. Non-existent property rights are often synonymous with non-existent markets.

Ownership or property rights over air and water are often ill defined, and this creates problems
for markets to exist in pollution/costs and the value of clean air and water.

Externalities:
When someone’s consumption or production activity imposes a benefit or cost on a third party
– who did not partake in the decision of consumption or production – we refer to that ‘external’
benefit or cost as a positive or negative externality.

The externality is often unaccounted for by the decision maker of consumption or production,
and this leads to an inefficient level of consumption or production (market failure). We earlier
said that a free and competitive market equilibrium maximizes total surplus. But we assumed
there were no externalities. All individuals making market decisions then fully bear the costs
and benefits of their decisions, and therefore these decisions lead the market to an efficient or
optimal outcome. In case of an externality (cost or benefit), the people making the market
decisions are unable to fully see/know the cost and/or benefits of their decisions and actions.

1
In the absence of transaction costs and if property rights are defined well and markets exist for every
value cost needed to be purchased or sold, then costless mutual bargaining will lead to settlements such
that whatever the initial distribution of property rights, interested parties can reach an efficient
outcome through bargaining (Coase theorem). But such an ideal world does not exist.
This is why they either over-allocate or under-allocate resources and the market outcome is a
failure to optimize total surplus.

Notice that this also implies that often no market exists where the decision maker can
compensate the affected third party for the external benefit/cost imposed on them.

Externalities of economic activities and land development can be pollution, habitat destruction,
loss of life of animals and plants and degradation of the ecosystem, that of smoking is passive
smoking, that of fuel extraction can be earthquakes or oil spills, that of antibiotics is evolution
of antibiotic-immune bacteria and fatal instances of septicemia. It is also possible to have
positive externalities: think of the opening of a new metro station and the business it could
bring for stores and restaurants/cafes near it; or the travel ban due to covid and its effect on
wildlife in places that were too crowded with tourists earlier; educating a woman in the family,
or education of anyone in general.

Other Examples:
- A factory giving out smoke in its neighborhood (factory is the party making the decision,
smoke is the externality, and the neighborhood is the bystander/third party here).
- A construction firm clearing out trees in a forested patch to build a shopping mall
- A firm dumping its waste in a river upstream
Bhalswa landfill
- A social group cleaning up a river upstream
- A small group of people contributing money to support local public radio
- Releasing an important technological idea into the public realm

Externalities can be positive or negative. When the externality is a cost on the third party or
bystander, it is a negative externality. When it is a benefit to the third party or bystander, it is a
positive externality. The first three of the above examples are examples of negative
externalities, while the last three are examples of positive externalities.

A factory giving off smoke, or a firm dumping its waste, or a firm clearing out trees would only
consider its private costs in doing so and would weigh them against their private benefits. They
therefore, tend to overdo these acts of polluting, dumping, or cutting of trees.

Similarly, the people cleaning up a river, those contributing to public radio, and those
contributing ideas to science, often underestimate the social benefits of these and are likely to
only consider the private benefits, and therefore, underprovide such acts.

Diagrams to illustrate positive and negative externalities.

Rivalry in consumption
If consumption of a good, asset, or resource by one person reduces its availability for (or rivals
the) consumption by other people, it is a rival good. Most private goods are rival; think of the
clothes, food, furniture, housing, computers, etc, that you or your family own or consume.
But for some other goods and resources, consumption by one does not affect availability for
consumption by others; such a good is said to be non-rival in consumption. This means that the
marginal social cost of extending consumption to an additional user is zero. What does this
imply for socially efficient pricing of such a resource? The socially efficient price is zero, or that
it is inefficient to exclude any user who derives positive benefit from its consumption. But no
profit seeking entity can then produce and supply such a resource at zero price.

Think of clean air, (clean) water in a river, sea, ocean or large water body, large national parks
and gardens, large multi-lane highways, natural beauty, firework display.

Why do I specify ‘large’ in the above examples for water bodies, highways, parks, etc. ?

The same resource can be rival or non-rival depending on the number of people using it at one
point in time. Congestion can lead a resource or asset to become rival in consumption.

Excludability of consumption or access

For some goods it is easy to define exclusion from access in exchange for a price or payment,
but not all goods or assets have this characteristic. If it is impossible or costly to define and
enforce access and exclusion from it, the good or asset is said to be non-excludable (such that
there is open access).

Think of (breathing) air which is impossible to exclude anyone from. Many natural resources
would fall in this category where exclusion would be very difficult to enforce. Also intangible
characteristics like safety of a city, immunity toward a disease created by vaccination or
otherwise.

Often public land, parks and gardens, public health & hospitals, police and fire service are free
and thus non-excludable; and sometimes a community or multiple parties/countries share a
resource in which case it is non-excludable within that set of users, for example a grazing area,
fishing waters, forests, groundwater.

Excludable Non-Excludable
Types of goods
Rival Private good Commons
Non-Rival Club good Public good

A resource that is rival in consumption but non-excludable is called a Commons. Rivalry and
non-excludability lead to incentives to overuse the resource before others can deplete it. But
when every user does this, their combined usage is unsustainable and the resource depletes
much faster such that they are all worse off than if they had cooperated to conserve it. This is
called the Tragedy of the Commons; it is another outcome of misallocation of resources, and
thus another type of market failure (to signal the true scarcity of the resource and the
importance of conserving it). The two person game below illustrates.
 Country B
Open access to a Commons resource
Use conservatively Use excessively
Use conservatively 30, 30 10, 40
Country A
Use excessively 40, 10 15, 15

Find :
i) the dominant strategy for each player,
ii) the Nash equilibrium of the game, and
iii) interpret the implications.

Public Goods
Goods (assets or resources) that are characterized by non-rivalry and non-excludability of
consumption are called public goods (or public ‘bads’ in case of negative utility). For example,
the immunity of a society against a disease that is either created through vaccination or is due
to past infections, clean air, a large source of clean water, global warming and climate change,
forests, pollution or its abatement.

Non-rivalry and non-excludability (public good) reduces incentive to contribute toward the
resource and gives incentive instead to free ride – to use without contributing toward – which
leads to underprovision of the public good even though all users would be better off with a
larger allocation toward it. Another example of Market failure.

In the example/game below suppose the benefit from neighborhood street lights to each
household is worth 25 units if there’s just one light but 40 units if there are two; cost of a
streetlight for each (if undertaken) is 30 units; and a dark street with no lights is worth 0 to each
household.

HH B
Contribution to & Production of a Public good
Contribute a light Don’t
Contribute a light 10, 10 -5, 25
HH A
Don’t 25, -5 0, 0

Dominant strategy?
Nash equilibrium? Interpretation

What general category of game do both games above fall under?

Give an example of a good which can be termed a public good when the number of users is
small and which becomes a commons when the number of users increases such that there is
congestion.
Possible corrections to externalities, market failure, and the incentives to not contribute and
free ride:
Market failure due to any of the above reasons (and maybe more) presents the opportunity for
Government intervention in markets to improve its efficiency and functioning. The idea is to
make decision makers internalize the externality: altering incentives so that people take
account of the external effects of their actions; whether it is the external cost or benefit.

Command-and-Control Policies: Direct regulation of behavior

Laws, Rules & regulations, Caps, Licenses, and Bans – problems?
- Arriving at exact estimates of how much pollution or external cost is permitted.
- Implementation of these rules.
- Cost of monitoring.
- With regulation of caps or bans, firms will not reduce emissions once they reach the
requirement: Explain
- Regulation in the form of caps or bans require everyone to obey in the same way :
Explain

Market-based Policies:
a. Corrective taxes and subsidies. Also called Pigouvian taxes/subsidies.

What should be the ideal level of tax (in case of negative externality) ?
and the ideal level of subsidy (in case of positive externality)?
Diagrams.
 - Help to internalize the externality.
- A tax allows every emitter to make decisions according to his/her cost of reducing
emissions: Explain
- Tax is therefore like a price for polluting
- If cost to reduce pollution is more than tax then producer may choose to pollute and
pay the tax, and otherwise would clean up or reduce pollution or invest in abatement

- Corrective tax moves the allocation toward the social optimum. Therefore there is no
deadweight loss. Rather there is a net gain in welfare.

Beijing is planning a car congestion fee on car owners.

https://www.resources.org/common-resources/congestion-pricing-in-beijing-who-bears-the-
burden/
https://www.sciencedirect.com/science/article/abs/pii/S1361920915300067

b. Tradable pollution permits (Creating Markets where they don’t exist)

Like we said earlier, different firms have different costs of reducing pollution. And it is the total
level of pollution/emissions that really matter. So why not set a limit to total emissions and let
people trade and decide who will pollute and who will not.

Pollution permits: an allowance to pollute in exchange for payment

Permits will end up with firms that value them most. Which means for these firms, the cost of
reducing pollution (abatement) is the highest because only then are they ready to buy permits
at relatively high prices rather than reduce pollution. The more costly it is for a firm to reduce
pollution, the more willing it is to buy permits.

Pricing Water sharing:

https://www.ted.com/talks/rob_harmon_how_to_keep_rivers_and_streams_flowing OR
https://www.youtube.com/watch?v=YeJhVtJKJU8

List at least three ideas or concepts used or alluded to in this talk that we have talked about in
class.
Which type of good/resource is water in above? Before/after trading in certificates
What is the effect of the certificates based on water rights ?
Creating Market/price for donated food:
https://www.npr.org/sections/money/2019/09/11/565736836/episode-665-the-free-food-market
https://review.chicagobooth.edu/economics/2020/article/market-forces-can-help-fill-food-banks
https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.31.4.145

The donation market in food before at the non-profit Feeding America:

- Client bases decided priority for each food bank
- Offers made based on priority; 6 hours to accept/decline; penalty for declining pushed
to the bottom of the priority list for next offer
- Transportation (responsibility of receiver) & spoilage due to waiting for acceptance and
(not being able to) determining the best recipient
- Food valued by weight; no way to put relative values on different kinds of foods
What reflects relative value?
After the design intervention creating artificial currency (shares):
- Shares proportional to client bases distributed to food banks
- Demand for food is placed through sealed bids made with these shares; auctions
- Can re-sell excess food to another food bank in exchange for shares that act as currency
(although this didn’t really take-off; what is the resulting problem?)
- Artificial currency (shares) put value on who wants what and whose want is greater;
enables an informative price to form; for different goods that are more/less valuable,
store-able, and/or scarce : relative prices
- Shares can be saved and can store value
- Savings of time, less spoilage
- Credit possible in shares; loans
- Joint bidding allowed
- Food banks can now choose to bid for food at locations closer to them, taking into
account their own transportation costs
More efficient allocation because prices were enabled and thus the market made capable of
using information (expressed as willingnesses to pay or prices).
Explain with diagram the difference between corrective tax and tradable permits given a
demand for (the right to) pollution.

Other important Government functions that can enable efficient functioning of markets in
these contexts:
 1. Providing legal institutions and Protecting Property Rights (right of an owner to own and
control and use property).
2. Providing Public goods (non-rival and non-excludable goods)

Aside: https://www.nytimes.com/2022/06/08/opinion/environment/defense-production-act-
solar-power-australia.html
https://www.deccanherald.com/science-and-environment/satellites-show-high-methane-
emissions-from-indian-landfills-1139592.html