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Market Failures
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  1. Market Failures

  2. The role of government and economics is to enhance public welfare • Both seek to allocate scarce resources among alternative desirable ends • When the market fails to allocate goods adequately, then the government should step in

  3. Three questions • What are the desirable ends towards which society should allocate its scarce resources? • What are these scarce resources, and what are their characteristics relevant to allocation?  • Based on the nature of the scarce resources and human nature, what allocative mechanisms is best for achieving these desired ends? • What allocative mechanisms are available?

  4. The desirable ends: what improves social welfare? • Is it ever greater consumption of market goods? • Can you buy and sell clean water, clean air, stable climate, biodiversity, ozone layer? • Why are we so obsessed with growth? • Does sustainability matter? • Does distribution matter? • Who should own goods and services created by nature and by society? • Is stability desirable?

  5. What are the scarce resources? • Economic goods and services • Ecosystem goods and services • Laws of thermodynamics • 1st law: matter energy is constant • You can’t make something from nothing • Economics is transformation, not waste • 2nd law: entropy increases in an isolated system (supreme law of nature) • Economic activity results in waste • Economy can’t grow forever. We can’t grow our way out of poverty

  6. From Empty World to Full World

  7. What are the characteristics of the scarce resources?

  8. Excludability • Excludable resource regime • One person can prevent another from using the resource • Necessary for markets to exist • Non-excludable • No enforceable property rights due to technology or social institutions • Can’t charge for use • Some resources non-excludable by nature. None are inherently excludable. • Excludability is a product of institutions.

  9. Rivalness • Rival Goods • My use leaves less for you to use • All ecosystem goods are rival • Non-rival (or non-depletable) • My use does not leave less for you to use • Marginal cost for additional user = 0 • Efficient allocation: Price = marginal cost of production • All non-rival resources are services • Rival or non-rival is an innate characteristic of the good, not a result of institutions

  10. Rivalness (cont.) • Non-rival but congestible • Non-rival as long as few people use it, becomes rival with excessive use (e.g. roads) • Empty planet vs. full planet

  11. So What? Excludable Non-Excludable Market Good: cars, houses, land, oil, timber, waste absorption capacity? Open Access Regime: Oceanic fisheries, undiscovered minerals, waste absorption capacity Rival Potential market goodbut inefficient: patented information, e.g. energy efficiency, toll roads. Pure Public Good: Information, streetlights, public roads, defense, laws, public health, most ecosystem services Non-rival OAR when crowded: e.g. public parks, beaches, roads, bridges, etc. MG when crowded: toll roads at rush hour, toll bridges, beaches, etc. Non-rival, congestible

  12. Open Access • The “Tragedy of the commons” • Common property vs. open access • Individuals try to capture benefits for themselves, share costs with society • Market alone leads to over-exploitation • Threat of extinction • Loss of profit (to be explained later) • Role for government to step in

  13. Non-rival & Excludable • Patents are protected by governments • Why do we have patents? • Patents, profit motive and innovation • When did patents come about? • 1790s in US • 1947 international, rarely used before 1980s

  14. Non-rival & Excludable (cont.) • Patents and the WTO • 97% owned by developed nations • Neem tree, steel drums, etc. • Samuel Slater, “Father of American industry” • Should government spend scarce resources to make these information excludable?

  15. Public Goods • Free-riding • No price signal as feed-back mechanism • Scarcity  price increase  innovation • Lack of Incentives for market to produce them • Lack of incentives for markets to create technologies that provide them

  16. Public Goods (cont.) • How important are public goods? • Life support functions (Vermont’s forests) • Flood protection (Winooski river) • Water purification • Lake Champlain • Infrastructure • Research and development • if all the scientists are working for profit, none are making PGs • Provision widely accepted as government duty

  17. Is government provision efficient? • Privatization debate • Read chapter on political economy

  18. Market goods: The theory of Externalities

  19. Externalities • Definition • “an activity by one agent causes a loss (gain) of welfare to another agent” • “The loss (gain) of welfare is uncompensated” • Completely Internal to the Economic Process. Why? • How are these related to public goods?

  20. Examples • Individual consumption • Waste outputs • Status effect • Industry • Pollution • Brownfields • Agriculture • Ecosystem conversion- loss of riparian zones • Phosphorous emissions • Siltation • Factory farming

  21. Examples (cont.) • Natural resource harvest • Depletion of ecosystem services • Waste emissions • Community issues • Crime reduction • Economic stability • Education • Health

  22. ‘Optimal’ externalities for society Agricultural production

  23. Property Rights • Who owns the environment? • polluter rights (privilege, no rights) • sufferer rights (rights, duties) • What about future generations?

  24. Obstacles to Optimal • Transaction costs • in absence of transaction costs, no negative externalities • What are transaction costs likely to be for externalities affecting public goods? • Wealth effect • Intergenerational externalities

  25. Government role • What can the government do about externalities, and how does it relate to finance? • Regulations • Cost money to enforce

  26. Government role • What can the government do about externalities, and how does it relate to finance? • Regulations • Cost money to enforce • Economically inefficient • No incentives to go beyond compliance • Taxes • Auctioned quotas

  27. Controlling price or quantity

  28. Marginal pollution abatement costs for three firms emitting 5000 tons of pollution each.

  29. Pigouvian taxes and subsidies • Tax (subsidy) equal to value of negative (positive) externality theoretically leads to efficient outcome • What is value of externality? • Incentives

  30. Tradable quotas • Example of sulfur dioxide • First determine scale • Next decide on distribution • Justice vs. feasibility • Allow market to allocate

  31. Tax or quota? • With a tax, you can theoretically get right amount, but amount will change with economic change. Better to let prices vary (economic) than amount of resource to be used (ecological) • tax or quota on single resource leads to substitution, on all resources will not

  32. Tax or quota • Uncertainty • We don’t know marginal abatement cost curves, nor marginal benefit curves • not only do we not know where we are on the curve, we don’t know the slope of the curve • Slope of curve very important • In full world, lower risks from quotas, in empty world, lower risks from tax

  33. Ignorance and Uncertainty • Perfect markets require perfect information • Asymmetric information • Nobel Prize in 2000 • Poverty insurance • Irreducible ignorance • Time lags • Ecosystem function

  34. How do ignorance and uncertainty relate to budgeting and finance? • Who pays clean up costs when unexpected negative impacts occur? • Health impacts • Superfund sites • Role of government in providing social security (poverty insurance)

  35. Natural Monopoly • High fixed cost, low marginal cost • Roads • How should hey be regulated?

  36. Conclusions • Many market economists and politicians argue that there is little role for government, market is best allocative mechanism • Market systematically fails to provide many goods • Government is essential • Future lectures will examine just and efficient mechanisms for coping with these market failures

  37. Naural Monopolies,

  38. PG: the Privatization debate

  39. Private Provision • Examples • 3 private police for every public officer in US • 2/3 of homes in Denmark with private fire service • SUVs or plowed roads? • Relative costs • Administrative costs • Diversity of tastes • Distributional issues • Skimming

  40. Private Production: examples • Skating rink in Central park • Trains in WWI • Military personnel in Iraq • Airport security • Municipal water supply • Education

  41. Private Production : issues • Examples • Skating rink in Central park • Trains in WWI • Military personnel in Iraq • Airport security • Municipal water supply • Education