HS 229
ENVIRONMENTAL ECONOMICS
Mrinal Kanti Dutta
(mkdutta@[Link])
Department of Humanities and Social Sciences
Indian Institute of Technology Guwahati
Guwahati – 781039
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MARKET FAILURE
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▪ Market: an exchange institution that serves
society by organising economic activity
▪ Forces of demand and supply, in equilibrium,
provide signals through price regarding output
to be exchanged in a market
▪ If market provides correct signals regarding
demand and supply, then the decision about
equilibrium output and price can be optimal
▪ Leads to optimal allocation of resources
→Market success
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▪ Market: Different types
▪ Perfect Competition, Monopolistic
Competition, Oligopoly, Duopoly, Monopoly
▪ Nature and functioning of these different
markets vary considerably
▪ Number of sellers and nature of product
determine type of market
▪ The success of a perfectly functioning market
rests on a number of relevant issues
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▪ Market success-efficient allocation of resources
▪ Allocative Efficiency
▪ Also referred to as Pareto Efficiency (After
Vilfredo Pareto, 1848–1923)
▪ Pareto Efficient Allocation – resources cannot
be readjusted to make one consumer better off
without making another worse off
▪ Pareto improvement
▪ Social Efficiency = where external costs and
benefits are accounted for
▪ Technical Efficiency = production of goods and
services using the minimum amount of
resources
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▪ When a set of competitive markets fail to
generate an efficient allocation of resources
between and within economies
▪ Resources could be reallocated to make at least
one person better off without making any one
worse off (Pareto improvement)
▪ Prices often understate the full range of services
provided by an asset or simply do not exist to
send a signal to the market place about the value
of the asset
▪ For environmental assets market can fail if prices
do not communicate society’s desires and
constraints accurately
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▪ Habitat destruction and threat to bio-diversity in
Madagascar
▪ 4th largest island, bio-diversity hotspot but
economically very poor
▪ Deforestation: @200,000 ha/yr.
▪ Eco. cost of env. degradation: $100-290 m (5-15%
GDP)
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▪ Arises from several sources of market failure
▪ Public ownership of large areas of land (open
access regime and limited govt. capacity to
manage land)
▪ Insecure land tenure system
▪ Many of the services are non-rival and non-
excludable
▪ Bio-diversity in and of itself has no value
reflected by market prices
▪ Commodity resources are valued on the market
▪ Pressure to harvest the commodity goods at the
expense of bio-diversity
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▪ Six cases of Market Failure:
▪ Incomplete Markets
▪ Externalities
▪ Non-exclusion
▪ Non-rival and Public Goods
▪ Non-convexities
▪ Asymmetric information
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▪ Markets are complete when enough markets exist
to cover each and every possible transaction or
contingency so that resources can move to their
highest valued use
▪ A complete market requires a set of well-defined
property rights system
▪ Property rights system: a set of entitlements that
define the owner’s privileges and obligations for
use of a resource or asset
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▪ A well-defined property Rights system has
the following key characteristics:
▪ Comprehensively Assigned: all resources or
assets should either be privately or collectively
owned
▪ Exclusive: all benefits and costs should accrue
to the owner only either directly or through
sale
▪ Transferable: from one owner to another in a
voluntary exchange
▪ Secure: from involuntary seizure or
encroachment by other individuals, firms or the
government
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▪ Property rights in case of
▪ Air
▪ Rivers, etc.
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▪ One of the prominent reasons for market failure
▪ Normally actions or decisions by one individual
agent does not directly affect anybody else
▪ For example: purchase of shoes
▪ Some other actions affect others directly
▪ For example: driving near hospital (harmful
effects
▪ Inoculation of children (beneficial effects)
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▪ Decision makers do not take into account
the cost imposed on society and others as a
result of their decision
▪ e.g. pollution, traffic congestion, environmental
degradation, depletion of the ozone layer, etc.
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▪ Two Types of Externality:
▪ Positive and Negative
▪ Positive: when action of individual agent has
beneficial effects
▪ Examples:
▪ Vaccination
▪ Flower gardens
▪ Production of Honey
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▪ Negative: when action has negative effects
on the agents
▪ Examples:
▪ Playing of loud music at 4 a.m.
▪ Riding on a noisy motor cycle
▪ Smoking in a public place
▪ Dumping of waste in a river by a paper
mill
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Externality - the Problem:
▪ A.C. Pigou in his book titled Wealth and Welfare (1912)
dealt with the problem of Externality systematically for
the first time.
▪ Overall economic efficiency requires that:
MSB = MSC MSB = Marginal Social Benefit
MSC = Marginal Social Cost
where, MPB = Marginal Private Benefit
MSB = MPB + MEB MPC = Marginal Private Cost
MSC = MPC + MEC MEB = Marginal External Benefit
MEC = Marginal External Cost
▪ If, MSB>MSC, Output can be expanded because additional output adds
more benefits to the society than the cost.
▪ In a situation when MSB≠MSC, the optimal condition of efficiency can be
obtained through imposition of Tax and Subsidy
Why is externality a problem?
▪ An externality implies:
Social Cost = Individual Cost
Social Benefit = Individual Benefit
▪ The incentives for the individual are not what
society wants them to do
▪ As a result:
▪ too much of socially costly goods are produced
▪ too little of socially beneficial goods are produced
An Example : One Polluting Supplier of
Paper
Demand for Paper
= Marginal Social Value (Benefit) for Paper
Price
Quantity of Paper
An Example : One Polluting Supplier of
Paper
Supply of Paper
= Marginal Private Cost for Paper
Price
Quantity of Paper
Private Equilibrium determined by private
costs and demand
Price
Marginal Private Cost
Marginal Social Value
(Benefit)
Quantity of Paper
Suppose the social costs of paper production were higher
than the private costs (a negative externality)
Marginal Social
Cost
Price
Marginal Private Cost
Marginal Social
Value (Benefit)
Quantity of Paper
Consequences
▪ Too much of paper is produced
▪ The price of paper is too low and does not
reflect its true costs of production
So,
▪ Who gains here?
▪ What are the monetary values of the costs
imposed on society?
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Negative Externality in Production
Figure 1: Negative Externality in Production
Price, MC MSC
D
Fig. 1 illustrates negative MPC
externality in Production Po
(MSC>MPC) P1
C0
Assuming no externalities
in consumption, DD
shows MSB and MPB D (MSB=MPB)
(MSB=MPB)
Q0 Q1 Quantity
With MSC the optimal output produced is Q0 corresponding to
Price P0 (where MSC=MSB)
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The Competitive Market (when left alone) produces Q1
with a price P1 - there is a tendency to overproduce.
At Q0 the Price is P0 but the MPC is C0
Therefore the Govt. can levy a per unit tax of (P0 - C0 )
which in turn will increase MPC by (P0 -C0) and reduce
output from Q1 to Q0
At Q0, the consumers would pay P0, the full marginal
social cost of Production.
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The extra revenue earned from taxation can be used for
external damage from production of this product.
The tax revenue could be more or less than the external
damage
The tax revenue is equal to (P0 - C0)Q0 whereas the total
external cost would be equal to area between MSC and
MPC
The Net Gain to the Society is equal to (MSC-MSB)
over Q0 to Q1 (the shaded area) which is eliminated by
tax.
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Positive Externality in Production
Figure 2: Positive Externality in Production
Price, MC MPC
D
Fig 2 illustrates positive MSC
Co
externality in Production P1
(MSC<MPC) P0
Assuming no externalities
in consumption, DD
shows MSB and MPB D (MSB=MPB)
(MSB=MPB)
Q1 Q0 Quantity
With MSC the optimal output produced is Q0 corresponding to
Price P0 (where MSC=MSB)
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The Competitive Market (when left alone) produces Q1
with a price P1 where DD intersects MPC, under
production from social point of view
At Q0 the Price is P0 but the MPC is C0
Therefore to produce more output (from Q1 to Q0) the
Govt. has to provide a subsidy of (C0-P0)
At Q0 the consumers would pay P0 {Or (C0-P0)}.
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Govt. could collect the money from people reaping the
external benefits
The expenditure on subsidy could be more or less than the
external benefit
The Net Gain to the Society is equal to (MSB-MSC) over
Q1 to Q0 which is obtained through subsidy.
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Externality in Consumption: Negative and Positive
Figure 3: Negative Externality in Consumption
Price, MC MSB D
Fig. 3 illustrates negative MPC=MSC
Po
externality in
P1
Consumption (MPB>MSC)
C0
Assuming no externalities
in production (MSC=MPC) D=MPB
Q0 Q1 Quantity
The optimal quantity is given by Q0 (the point where MSB=MSC)
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In the absence of any intervention, the quantity supplied
and produced is Q1 with a price P1
At Q1 there is overproduction of the commodity
compared to social optimality
To restrict the output to Q0 , the price has to be increased
to P0
But the supply price for Q0 is C0
Hence a tax equal to (P0 - C0 ) needs to be levied
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The price consumers pay is P0 (=MPC + Cost of Externality
in Consumption)
The revenue generated from the consumption of the tax
could be used to compensate those who are hurt by the
external cost arising from the consumption of the product
The shaded area measures net benefit of the tax policy.
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Externality in Consumption: Negative and Positive
Figure 4: Positive Externality in Consumption
Price, MC D
Fig. 4 illustrates positive MPC=MSC
externality in
Consumption (MPB<MSC) C0
P1
Assuming no externalities Po
MSB
in production (MSC=MPC)
D=MPB
Q1 Q0 Quantity
The optimal quantity is given by Q0 (the point where MSB=MSC)
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In the absence of any intervention, the quantity supplied
and produced is Q1 with a price P1
At Q1 there is underproduction compared to socially
optimal level
To produce output Q0 , the price is P0 But the supply price
for Q0 is C0
Hence a consumers need be given a subsidy equal to (C0 -
P0)
The price consumers pay is P0 the producers get C0
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At least part of the cost of the subsidy (C0 - P0)×Q0 could
be collected from those reaping external benefits
arising from the consumption of this good
The shaded area measures net benefit to the society
from the subsidy. It’s the (MSB-MSC) for the output
range Q1 to Q0
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Summary:
1. In the presence of externalities, the socially optimal level of
output (Q0 in our example) is given by the condition MSB=MSC
2. The private production of output Q1 is given by the condition
MPB=MPC
3. To bring about an output to Q0 we can use the tax and subsidy
programs shown in Table-1.
Table 1: Taxes and Subsidies in the presence of Externalities
Condition Tax or Subsidy Amount of Tax or Subsidy*
MSC>MPC Tax Producers MSC – MPC
MSC<MPC Subsidize Producers MPC – MSC
MSB<MPB Tax Consumers MPB – MSB
MSB>MPB Subsidize Consumers MSB - MPB
*These amount are measured at the socially optimal level
