Smokers impose tremendous costs on themselves.

Based solely on the degree to which smoking

shortens their life expectancy, which is by about six years, the cost per pack is $35.64. That cost, of
course, is a private cost. In addition to that private cost, smokers impose costs on others. Those external
costs come in three ways. First, they increase health-care costs and thus increase health insurance
premiums. Second, smoking causes fires that destroy more than $300 million worth of property each
year. Third, more than 2,000 people die each year as a result of secondhand smoke. A 1989 study by
the RAND Corporation estimated these costs at $0.53 per pack.+
In an important way, however, smokers also generate external benefits. They contribute to retirement
programs and to Social Security, then die sooner than nonsmokers. They thus subsidize the retirement
programs of the rest of the population. According to the RAND study, that produces an external benefit
of $0.24 per pack, leaving a net external cost of $0.29 per pack. Given that state and federal excise taxes
averaged $0.37 in 1989, the RAND researchers concluded that smokers more than paid their own way.+
Economists Jonathan Gruber of the Massachusetts Institute of Technology and Botond Koszegi of the
University of california at Berkeley have suggested that, in the case of people who consume addictive
bads such as cigarettes, an excise tax on cigarettes of as much as $4.76 per pack may improve the
welfare of smokers.+
They base their argument on the concept of time inconsistency, which is the theory that smokers seek
the immediate gratification of a cigarette and then regret their decision later. Professors Gruber and
Koszegi argue that higher taxes would serve to reduce the quantity of cigarettes demanded and thus
reduce behavior that smokers would otherwise regret. Their argument is that smokers impose
internalities on themselves and that higher taxes would reduce this.+Where does this lead us? If
smokers are rationally addicted to smoking, i.e., they have weighed the benefits and
costs of smoking and have chosen to smoke, then the only problem for public policy is to assure that
smokers are confronted with the external costs they impose. In that case, the problem is solved:
through excise taxes, smokers more than pay their own way. But, if the decision to smoke is an irrational
one, it may be improved through higher excise taxes on smoking.

Externalities are common everywhere in everyday life but will the market left to its own
devices - take these externalities into account? If not, then market failure can occur and
there is a justification for some form of government intervention.
Economic importance of the environment
The environment plays an essential role in shaping our economic and social welfare. The
environment

Provides services to consumers in the form of living and recreational spaces and the
opportunity to enjoy utility from experiencing natural landscapes and habitats.

It provides us with the natural resources necessary to sustain production and

consumptionincluding the basis for renewable and non-renewable sources of
energy.

It is a dumping ground for the waste products of our society - be it waste from
producers or from households and consumers.

The link between economic activity and our environment is fundamental. We hear
constantly about the need for sustainable welfare, for growth to take into account the
direct and indirect effects on our resources. And increasingly we, as producers and
consumers, are affected by government policies and strategies designed to promote
environmental protection and improvement.
Sustainable development is that which meets the needs of the present without
compromising the ability of future generations to meet their own needs.
Externalities and the environment the basics
For environmental economics, one of the most important market failures is caused
by negative externalities arising from production and/or consumption of goods and
services.
Externalities are third party effects arising from production and consumption of goods and
services for which no appropriate compensation is paid.
Externalities occur outside of the market i.e. they affect people not directly involved in the
production and/or consumption of a good or service. They are also known as spill-over
effects.

One of the major problems facing the environment is that common resources such as fish
stocks and grazing land are not privately owned commonly owned resources may lack the
protection of property rights and are susceptible to over-exploitation because the marginal
cost of extracting the resource for a private agent is close to zero. This is known as
the tragedy of the commons.
When there are environmental externalities, the private equilibrium price and quantity
determined by the interaction of market supply and demand is not the same as the social
equilibrium which includes all internal and external costs.
In a free market, a producer will have little direct incentive to control pollution because it is
external i.e. the profit-maximising supplier considers only his/her own private costs and
benefits.
The market failure arising from negative externalities is shown in the diagram below. The
area labelled ABC is the deadweight loss of welfare due to output being above the social
optimum. At output levels beyond Q2, the marginal social cost exceeds the marginal social
benefit causing overall welfare to drop.

Economists argue that market failures provide a clear rationale for policy intervention to
improve efficiency. But since market failures are pervasive, intervention is only justified if
the benefits exceed the costs. As we shall see, reducing pollution is rarely, if ever, a costfree process.
The Tragedy of the Commons
The contribution of each economic agent is minute, but summed over all agents, these
actions degrade the resource and may cause severe long term damage
The tragedy of the commons is a metaphor used to illustrate the potential conflict
between individualself-interest of producers and consumers versus the common or public
good.
In the original version of the term, the example is used of a stock of common grazing
land used by all livestock farmers in a small village. Each farmer keeps adding more
livestock to graze on the commons, because the marginal cost of doing so is zero. But
because the commonly owned resource is thus over-exploited, the result is a depletion of
the soil and a fall in the value of the resource for all users.
The resource may become irretrievably damaged, an example of a public bad.
The root cause of any tragedy of the commons is that when individuals use a public good,
they do not bear the entire social cost of their actions. If each seeks to maximize individual
benefit, he or she ignores the external costs borne by others. The absence of well-defined
and legally-protected property rights lies at the heart of the problem.
A tragedy of the commons can occur even without complete and permanent destruction of
a resource the term can be used to describe any situation where what was perceived as a
renewable resource becomes less valuable because of over-exploitation.
Good examples of the tragedy of the commons

Burning of fossil fuels carbon emissions contributing to global warming

Pollution of waterways - creating other externalities for users of waterways further

downstream

Logging of forests e.g. the long-term impact on the Brazilian rain forest effects of
illegal logging

Over-fishing of the oceans e.g. the current crisis in the EU fishing industry

Fly-tipping of waste products on public land

Game theory and the tragedy of the commons

The tragedy of the commons can be linked to the prisoner's dilemma that is an important
part of game theory.
Individuals within a group have two options: co-operate with the group or defect from the
group. Cooperation happens when individuals agree to protect a common resource.
Defection happens when an individual decides to use more than his share of a public
resource.
Cooperation has the potential to maximize every individual's benefit in the long run as the
commons are preserved and can be used indefinitely, while defection maximizes an
individual's benefit in the short run at the expense of destroying it in the long run.
Thus in the case of fish stocks, suppliers need to cooperate over a period of time so that
fish stocks can start to rise again. This is the essence of attempts to reform the European
Union Common Fisheries Policy.
An alternative to regulation and taxation by government is to create a market in property
rights in order to control the impact of economic activity on the environment for example
establishing a carbon tradingemissions scheme or introduction tradable fishing permits for
the EU fishing industry.
The Economics of Waste
Waste is an inevitable by-product of production and consumption. But the economics of
waste is now a huge economic as well as social issue. The UK government wants more
waste being disposed of throughincineration rather than dumped in landfill sites. It
has restated its strategy and at the top of the waste hierarchy is the aim of reducing how
much waste is created in the first place and thereby achieve a de-coupling of waste
generation from rising economic activity. Because waste is normally regarded as a de-merit
good creating external costs, there is justification for some form of government
intervention to change market prices, alter incentives and cause a change in the behaviour
of consumers and producers.
Government policy needs to be more effective in enhancing the incentives for individuals
and businesses to recycle more of their waste products.
Hierarchy of principles of waste management:
o

Prevention of waste - reduce the amount of waste created in the first place

Reuse the product

Recycle or compost the product

Recover the energy by incinerating

Disposal of the product using landfill

FREC 424 Natural Resource Economics

More Market Failures: Common Property Resources and Public Goods

This lecture addresses two important classes of market failure, both deriving
from failures of the property rights system.
Common Property Resources
Common property resources are inefficiently allocated because users cannot
earn rents by conserving them from other users--a violation of the "exclusivity"
principle of property rights. Examples include fisheries, game stocks,
subsurface "pools" of oil owned by multiple companies. This is the
formalization of Hardin's "commons" problem.
Competitive firms will extract from the resource to the point where the average
revenue product of extraction effort equals the unit cost of effort. There is no
incentive for any firm to conserve, since no one owns the resource or has the
ability to exclude others from it; whatever one firm leaves the next will
take. As long as firms can cover their harvesting costs, they keep on
harvesting.

Consider the case of an open-access fishery, where we examine the factor

market for fishing effort. Let the unit cost of fishing effort be constant
(MC=AC). The marginal value product (MVP) of fishing effort declines more
rapidly than the average value product (AVP). In a typical market, each firm
owns all its inputs, and maximizes its profits by using each input to the point
where MVP=MC (marginal factor cost). The factor "rent" is the amount the

factor earns minus its cost, which is the portion of firm's total profit attributable
to that factor. This is shown as the yellow rectangle.
As in any competitive market, the existence of positive economic profits
attracts new entrants to the industry. So the open-access fishery attracts new
fishing boats and more fishing effort, making fish scarcer and harder to catch,
and this reduces the MVP and AVP of everybody's effort. This can be
interpreted as a type of externality, where new entrants don't consider how their
entry reduces the productivity of existing boats in the fishery. The new entry
doesn't stop until fish become so scarce that the AVP=AC and all profits are
dissipated.
We will revisit the open-access fishery problem in more detail later in the
course.
Public Goods
A public goods is non-excludable and consumption of it is non-rival. This
means that it is impractical to prevent people who haven't paid for it from using
or enjoying the good, and one person's use or enjoyment of the good does not
use it up or preclude another's use or enjoyment of it.
The aggregate demand for a conventional market good (excludable with "rival"
consumption) is constructed as the horizontal aggregation of the individual
consumers' demand schedules.

In contrast, the non-excludable, non-rival nature of a

public good implies that its aggregate demand
schedule is the vertical summation of the individual
demand schedules.
In the diagram to the right, A buys Q' units for
herself, and since A cannot keep B from using or
enjoying it too, B simply free-rides on the quantity
A purchased rather than buying his own.
The social optimum quantity of the public good is
Q*, where A and B's collective marginal
willingness-to-pay equals MC.

Unfortunately, it will be difficult for A and B to agree on a collective purchase

of Q*, since their marginal WTP's for any level of Q are different. In general,
public goods are under-supplied unless each user can be induced to contribute
his or her marginal WTP. The costs of negotiating such collective purchases are
often prohibitive.
Examples of public goods include national defense, scenic landscapes, air and
water quality, biological diversity, etc. Note that public goods
are not necessarily publicly-owned or publicly provided. Public goods
motivate free-rider behavior: the person who wants it the most pays for as
much as he or she wants, and everyone else enjoys it for free.
Many pollution problems can be analyzed as public "bads." Your discomfort
from air pollution does not prelude my discomfort. Indeed the persistence of
pollution problems suggests that public action to make polluters stop polluting
is an undersupplied public good. As we noted in the previous lecture, Coasian
bargaining between polluters and victims assumes the costs of negotiation are
negligible. But in cases where the number of victims is very large, effective
bargaining requires organized collective action against the polluter. If no
individual is harmed enough to be motivated to organize such collective action,
Coasian bargaining will not occur. Since victims have an incentive to free-ride
on the organizational efforts of others rather than contribute to the effort
themselves, collective action efforts are likely to be under-funded and
ineffective.
In cases where free-rider incentives cause an under-supply of collective public
action, it is appropriate for government to adopt a facilitative role, perhaps
negotiating with the polluter on behalf of the public. This function is
formalized in environmental laws and regulations, and in the creation of
environmental agencies such as the EPA.
Civil courts in the US facilitate collective action by permitting class action
lawsuits in which several lawsuits of plaintiffs against a common defendant
may be combined into a single case, with the named plaintiffs representing the
entire class of plaintiffs. Successful class action lawsuits recover damages on
behalf of all plaintiffs in the plaintiff class. The contingency fee system, under
which lawyers are paid a percentage of the total damage award, creates a strong
incentive for lawyers to get cases certified as class actions.
Other categories of market failure
We briefly note several other cases in which competitive markets may fail to
achieve Pareto efficiency:
Imperfect markets involve monopoly powers generating market distortions
and deadweight losses.

Diverging social and private rates of discount may reflect risk premiums
which are higher for individuals than for society as a whole. Privately-owned
resources will be depleted too rapidly if private rates of discount exceed social
rates of discount,
Government failure involves regulatory distortions of market incentives.
Special interests use the political process for rent-seeking (protectionist
legislation, tax loopholes, etc.). Most of the public remains "rationally
ignorant" of these: it's not personally worthwhile for individual citizens to
oppose them. In effect, citizen action to counter special interests is an
undersupplied public good.

Free Rider Problem Definition

Definition of the Free Rider Problem A situation where public goods are underprovided
or not provided at all because individuals are able to consume the good by paying little or
nothing towards the cost.
Because a firm struggles to prevent people free riding, (enjoying without paying), many
goods are underprovided.

Example Free Rider Problem

A king asked his subject to bring milk and pour it into a big pot to distribute among the poor.
When the large pot was examined, it was all water. The villagers had each brought water
hoping to just dilute the milk from other people.
In other words, people were free riding on the others hoping other people would bring milk
so they could bring water and no-one would know.
This is a common situation, where individuals face little or no incentive to bear the cost for
an action, preferring to wait and hope it is done by others.
For example, if you live in student accommodation, you may not do any washing up, hoping
that it will be done by others. In a private street, there may be a benefit for setting up street
lights, but there is no incentive to bear the cost yourself when you could wait and hope
someone else does it.
The free rider problem is common amongst public goods. These are goods that have two
characteristics

Non-excludability Once provided it is for everybody, you cant stop anyone using it.
Non-rivalry when you consume good it doesnt reduce amount available to others.