Externalities and Market Failure

1. Externalities and Market Failure Let’s just rely on the free market to solve environmental problems…right?

2. Setup & Motivation • What makes an environmental issue an “environmental problem?” • When one party’s actions affect another party without compensation. • Think of the physical “stuff” that makes up the environment as “goods” and “bads” • Goods: clean air, fuzzy critters, safe water • Bads: NOx, CO2, oil slicks, harm to species • A large part of economics is to classify and design/inform regulation of goods and bads. • Characteristics of goods/bads drives policy design

3. Characteristics of goods -- I • Excludability: A good/bad is excludable if it is feasible and practical to selectively allow consumption of the good • Examples (excludable?) • Harvest of a particular fish • Hamburger • Air pollution in LA

4. Characteristics of goods -- II • Rivalry: A good/bad is rival if one person’s consumption reduces amount available to others (holding supply fixed) • Examples (rival?) • A particular fish • Hamburger • Space on an uncongested freeway • A nonrival good can be simultaneously consumed by many people • Nonrival goods can become congested

5. Characteristics of goods -- III • Externalities: An externality exists when one person or firm controls something I consume or that affects my consumption (or well-being) • Smoke • Snowmobiling in Yellowstone • Biodiversity loss

6. Importance of rivalry and excludability • Excludability – necessary for price system to be used…why? • Rivalry – necessary for efficiency of price system….why?

7. Importance of rivalry and excludability • Excludability – necessary for price system to be used…why? • If cannot exclude, nobody will pay • Rivalry – necessary for efficiency of price system….why? • If non-rival, people will free-ride

8. A taxonomy

9. Examples

10. Examples Markets work fine

11. Examples Markets work but poorly

12. Examples Markets don’t work

13. More examples • Rival? Excludable? • Prairie before invention of barbed wire • Litter before anti-littering laws • Municipal garbage • Fisheries subject to ITQs • An important finding: • Excludability can be changed with technology • Rivalry a fundamental characteristic

14. Why important? • Important for diagnosing problems • If we can rely on markets, it is much easier • If we know the market cannot work, we should expect things to need fixing • Important for fixing problems • If we can use technology to make an open access resource excludable, we know we can fix