Modeling Market Failure

Reading: Chapter 4 & 5 of Kolstad; Chapter 2

of Hanley et al.
 What are Markets?
A theorem in welfare economics states that, under
certain conditions, a private enterprise form of
economic organization based on competitive
markets is superior to alternative organizational
forms.
Adam Smith’s conjecture in 1776 proved rigorously
by K. Arrow and G. Debreu in 1952. The
necessary conditions are:
• No increasing returns to scale
• No externalities
• No public goods
• No uncertainty
 When do Markets Fail?
• If there are increasing returns to scale monopoly
emerges
• If there are externalities divergence between
private cost (benefit) and social cost (benefit)
arises. Hence private and social optimum differ
• Markets can not be relied upon to allocate public
goods and there would be under-provision of such
goods and over-provision of public bads
• With uncertainty inter-temporal transactions are
difficult and hence policy intervention would be
necessary
 When do Markets Fail?
Markets fail when private means contradict the
social ends of an efficient allocation of resources.
More generally, markets fail
– When people cannot define property rights clearly
– When people cannot transfer rights freely
– When people cannot exclude others from using a good
– When people cannot protect their rights to use a good
Market failure leads to over-provision of bads like
pollution and under-provision of goods like clean air.
 Public Goods (or Bads)
Two defining characteristics of Public Goods are:
– Non-excludability: It is not possible (except at
excessive cost) to prevent other individuals consuming
the good once it has been provided to one individual.
– Non-rivalry: An individual's consumption of the good
has zero opportunity cost, in that it does not reduce the
amount of the good available for consumption by
anyone else.
For price system to work it must be possible to exclude.
Otherwise ‘free-riding’ would be possible.
Non-rivalry implies that price must be zero (because no
cost associated with incremental use).
• If an entrepreneur stages a fireworks show, people can
watch the show from their backyards. Since the
entrepreneur cannot charge a fee for consumption, the
show may go unproduced, even if demand for the
show is strong.
• Each person tries to ‘free-ride’ by allowing others to
pay for the show, and then watch for free from her
backyard.
• Suppose the entrepreneur manages to exclude non-
contributors from watching the show (say, by charging
a fee to enable people to watch the show in a private
field). But if the field is large enough, exclusion
would be inefficient because even nonpayers could
watch the show without increasing the show’s cost or
diminishing anyone else’s enjoyment. This is
nonrivalrous competition to watch the show.
Public Goods: Scenic views, air quality, biodiversity,
city parks, flood control, lighthouses

Excludable Non-
Excludable
Rival Private goods Common-pool
(food, clothing) Resources
(fish stock,
coal)
Non-Rival Club goods Public goods
(private parks, (free-to-air
satellite TV) TV, national
defense)
 Non-rival Rival
Excludable -Indoor air - Household
pollution garbage Private Bads
(today)
Non- -Noise (?) ?
excludable -Greenhouse
gases

Public Bads
 Rivalry & Excludability:
Redundancy?
Rivalry involves physical possession and
destruction for consumption (eg., samosa).
If this is possible then it may also be
relatively easy to exclude!
 Demand for Public Goods
• The market demand for a private good is found by horizontally
summing the demands of individual consumers.
– It is as if each consumer were asked what quantity of this
good would you consume at each of the following prices?
• But this question is not relevant to the demand for a public good
because once such a commodity is provided, it is available at the
same quantity to all consumers (as a direct consequence of non-
rivalryness)
• The relevant question in deriving demand for public goods is
what price would you be willing to pay for each of the following
quantities?
• Each consumer would express a unique WTP for the public
good based on the benefits each expects to derive from
consumption.
• The market demand for a public good is found by vertically
summing the demands of individual consumers.
Why do Markets Fail with Public
Goods?
– Nonrevelation of preferences – an outcome that arises
when a rational consumer does not volunteer a
willingness to pay because of the lack of a market
incentive to do so
– Free-ridership – recognition by a rational consumer that
the benefits of consumption are accessible without paying
for them.
– Imperfect information – many people may be not
knowledgeable about the health, recreational, and
aesthetic benefits associated with pollution abatement.
Market forces alone cannot provide an allocatively efficient
level of a public good
Public Goods and Government
Intervention
– A common means by which government
responds to the dilemma of free-ridership and
nonrevelation of preferences is through direct
provision of public goods
– An alternative government response is the use of
political procedures and voting rules aimed at
identifying society’s preferences about public
goods
– Government response to imperfect information
includes education and public information
 Externality
Externality exists when the consumption or production
choices of one person or firm enters the utility or
production function of another entity without that entity’s
permission or compensation.
• The basic problem is that the generator of the externality is
deciding how much of the externality to produce but is not
taking into account its effects on others.
• Most externalities can be viewed as a nonexcludable good
or bad being produced by one agent and being consumed
by one or more agents.
• Air pollution and noise are examples of negative
externalities, whereas knowledge is an example of positive
externality.
 Relationship between
Externalities and Public Bads
• Most externalities can be viewed as a
nonexcludable good or bad being produced by one
agent and being consumed by one or more agents.
While the producer chooses how much to produce
based on her calculus, the consumer has no choice
since the good/bad is nonexcludable.
• One can dispense with the term externality and
treat environmental problems using public bad
notion. However, externality term has intuitive
appeal and hence important to understand.
Modeling Environmental Damage As a
Negative Externality
Consider market for refined petroleum products with supply
and demand as:
Supply: P = 10 + 0.075Q
Demand: P = 42 – 0.125Q
Since supply represents marginal costs of production and
demand the marginal benefits of consumption we can also
write
MPC = 10 + 0.075Q
MPB = 42 – 0.125Q
Now, let the discharge from the refineries be flowing directly
into a river which causes external costs to the society. Let
these marginal external costs be
MEC = 0.05Q
Social Optimum

Private Optimum
Private Optimum:
MPB = MPC
or, M = 0
Social Optimum:
MSB = MSC
or, MPB+MEB = MPC+MEC
or, M = MEC (since MEB = 0)
Welfare Gain from Social Optimum

Gain from reduced

health damages

Loss in profits
 Why do Markets Fail with
Externalities?
– There is no market incentive for a rational firm to
incur higher costs than it has to, even if it is for
the good of society
– Market failure models give us a better
understanding of why we observe increasing
damage to the physical environment as industrial
production has intensified throughout the world
 Market Failure and Commons
Consider two fishers (A & B) who cooperate with
each other and limit their fishing activity by
sending one ship every day; or send three ships
everyday by not cooperating. Let the payoffs be as
follows:
B
Coop Non Coop
Coop (30,30) (10,40)
A
Non Coop (40,10) (15,15)
 Market Failure and Commons
Choice of non cooperation is the dominant strategy
for each player
– For B, non cooperation dominates as 40 > 30
– For A, non cooperation dominates as 15 > 10
Non cooperative strategy is Nash equilibrium.

Ostrom documented several examples of actual common

property resources where a group of players achieve
cooperative outcome. Successful self coordination of
strategies depend on information and transaction costs
of achieving a credible commitment, active rules to self
monitor and sanction violators, presence of boundary
rules that define who can appropriate resources from
the commons.