6. Market Failure: Public bads and externalities Market failure: The price system often fails to achieve reasonable consumption and production decisions. On the production side scale economies and natural monopoly On the consumption side: goods with characteristics of publicness or involve externalities 6.1 Public goods and bads Two important characteristics of a public good (or a bad): rivalry and excludability 6.1.1 Rivalry Definition: A good is rival if one person s consumption of a unit of the good diminishes the amount of the good available for others to consume. There is a social opportunity cost associated with consumption by others. A good is nonrival otherwise. You can adjust this definition to apply to a bad. Eg. Hamburger is a rival good. Garbage is a rival bad. Flower garden is a non-rival good. Air pollution is a non-rival bad. Some goods become rival with congestion. 6.1.2 Excludability Definition: A good is excludable if it is feasible and practical to selectively allow consumers to consume the good. A bad is excludable if it is feasible and practical to selectively allow consumers to avoid consumption of the bad. A hamburger is an excludable good. Household garbage is an excludable bad if there are littering and dumping laws. Air pollution is not excludable. Two important factors in excludability: cost of exclusion and technology. Examples: (i) fencing Algonquin park (ii) Exclusion of television programs disseminated by satellite. Price system cannot work without excludability. Public goods and bads possess some degree of non-rivalry and nonexcludability. Econ 357, 6. Market failure 1
Excludable Non-rival Rival Non-excludable Place these examples in the appropriate box in the grid above: Noise from the neighbouring apartment Smoke from your roommate s cigar Greenhouse gases Garbage Baseball Biodiversity Blue jeans Water pollution in a small lake Changing temperature of the ocean Fishing in a lake Econ 357, 6. Market failure 2
6.2 Optimal provision of public goods and bads Find the aggregate MWTP for this private good. Sketch the MC curve MC = 0.2Q and show the optimal quantity. MWTP A = 15-0.1875 Q A ; MWTP B =20-0.4 Q B Private Good 25 20 Ann's MWTP Bob's MWTP MWTP 15 10 5 0 0 50 100 150 quantity per month Econ 357, 6. Market failure 3
Find the aggregate MWTP for this public good. Sketch the MC curve MC = 0.2Q and show the optimal quantity, Q*. Is the MC at Q* the optimal price that should be charged for the public good? Why or why not? Public Good MWTP $/unit 35 30 25 20 15 10 5 0 0 50 100 150 Quantity per month Ann's MWTP Bob's MWTP Econ 357, 6. Market failure 4
6.3 Pricing Public Goods and Bads 6.3.1 Market provision of public goods What happens when markets are left to supply a public good? Consider a good that is non-excludable in consumption, but it is produced at a cost. Would we expect there to be some private provision of this public good? Would the total amount provided be the efficient amount? Two problems: Incentive for free riding If an individual provides some of a public good, the benefits will not be fully enjoyed by that individual, but will also be enjoyed by others. When deciding how much to supply, he/she takes into account the benefits accruing to him/her self and likely does not fully take account of the benefits that accrue to others. Consider some examples of private provision of a public good. One example is the Nature Conservancy private supply of protected lands. What if you knew that if you purchased some land to be preserved as wilderness, everyone else would do the same? Apply a similar logic to the case of a public bad pollution. Suppose if you reduce your automobile use, everyone else will too. Econ 357, 6. Market failure 5
6.3.2 Efficient public good pricing: consumers Example 1: a public good. A park with a fence around it can control access. Congestion is never a problem. What would be the efficient price to charge? Example 2: a public bad. Noise bothers people who live near an airport. Should these individuals be compensated? (Note the airport was in existence before individuals moved nearby.) 6.3.3 Optimal producer price The optimal provision of nonrival goods involves a price of zero to consumers. The producer cannot afford to supply a nonrival good at zero price would result in a budget deficit. For a nonrival bad there is a similar result. The price should be zero, meaning no compensation should be paid to consumers. The producer benefits from generating emissions, and pays no price (compensation). Thus there is an incentive to overproduce the bad. Optimal producer price differs from the optimal price for the consumer. Note that if compensation is done in a fashion that does not distort the consumer s decision then it is neutral in terms of efficiency and may be desirable on the grounds of equity. Econ 357, 6. Market failure 6
6.3.4 Lindahl pricing for a public good Charge each person according to their MWTP Problem is the amount of information required need to know each individual s demand curve. An incentive to understate what you are willing to pay free riding. 6.4 Externalities 6.4.1 What do we mean by the term externality? Definition: An externality exists when the consumption or production choices of one person or firm enter the utility function of another entity without that entity s permission or compensation. Demonstrate the concept of an externality with a production possibilities diagram and show that elimination of the externality represents a potential Pareto improvement. Laundry steel mill example: o Production function for laundry: L=f(x 1,, x n, e), where x i represents various inputs and e is smoke form a steel mill. o Steel mill produces steel, S, and smoke, e. S=f(z 1,, z m ) e=f(z 1,, z m ) o Laundry has no say over production of e. o A production externality impact is on other firms production o Show the production possibilities of steel and laundry Econ 357, 6. Market failure 7
Laundry production Steel production Econ 357, 6. Market failure 8
Example of a consumption externality: river pollution from a mill degrades swimming experience for an individual Indifference curves with a consumption externality for a good and a bad U(W,e) Assume the only impact of pollution is a decrease in the time when swimming is allowed Other goods River pollution Pecuniary externality: price change due to the actions of others affects your utility. It has distributional consequences but no efficiency effect. Externalities can be positive an external benefit or negative an external cost. - The notion of externality is redundant with the concept of public bads. Draw a partial equilibrium diagram for the market for widgets. Suppose that widget production generates pollution. Show the market equilibrium and the Econ 357, 6. Market failure 9
socially optimal quantity. Indicate the efficiency gain when moving from the market equilibrium to the social optimum. Econ 357, 6. Market failure 10