2 Efficiency - Market Failure, Public Goods and Ex Tern Ali Ties

TheEconomicsofClimateChange C175
Market Failure MarketFailure

PublicGoods&Externalities
Spring09 UCBerkeley Traeger 2 Efficiency 26
Climatechangeasamarketfailure
Environmentaleconomicsisforalargepartaboutmarketfailures:
goods(orbads!)forwhichoneormoreoftheseassumptionsdoes
nothold nothold
2007SternReviewontheEconomicsofClimateChange(political
reportbySirNicholasStern(andcoauthors)toBritishgovernment):
Climatechangeisthebiggestmarketfailuretheworldhasever
seen.
GHGemissionsareduetoanexternality
Lowlevelofinternationalco operationisduetoemission Lowlevelofinternationalcooperationisduetoemission
reductionsbeinga(global)publicgood
2 Efficiency 27 Spring09 UCBerkeley Traeger
PublicgoodsI
Characteristicsofgoods:
Excludability inconsumptionorproduction:Agoodisexcludableifitis
feasibleandpracticaltoselectivelyallowconsumerstoconsumethegood,a
badisexcludableifitisfeasibletoallowconsumerstoavoidtheconsumption p
ofthebad.
Inshort:agentscanbepreventedfromusingthegood/service
Rivalry:Abad(good)isrivalifonepersonsconsumptionofaunitofthebad
(good)diminishestheamountofthebad(good)availableforothersto
consume,i.e.thereisanegative(positive)socialopportunitycosttoothers , g (p ) pp y
associatedwithconsumption.
Inshort:oneagentsuseisattheexpenseofanothers
PublicgoodsI
Characteristicsofprivateandpublicgoods:
Excludable Nonexcludable
Rival Pureprivategood Openaccessresource
Icecream Oceanfishery Icecream Oceanfishery
Nonrival Congestibleresource Purepublicgood
Wildernessarea
Rivalry:oneagentsuseisattheexpenseofanothers y g p
Excludability:agentscanbepreventedfromusingthe
good/service
Problemswiththeprovisionofpublicgoods
NonExcludability:Excludabilityisneededtopricetagagood
Wehavetobeabletodenytheconsumptionifpriceisnotpaid Wehavetobeabletodenytheconsumptionifpriceisnotpaid
NonRivalry:Anadditionalconsumercanenjoythegoodatnoextra
costofprovision.
Efficientequilibriumwillnolongerbewhereindividualmarginalrate
ofsubstitution=priceratio=marginalrateoftransformationor
marginalwillingnesstopay=price=marginalcosts
Wegetbacktothisinamoment
Excursion:Aggregatesupply,demand,andefficiency
Supplyanddemandcurvescanbeobtainedfromutilityandprofit
maximization.
Demandcorrespondstomarginalwillingnesstopay.Aggregatedemandgiven
byhorizontalaggregationofindividualdemandcurves.
Supplycorrespondstomarginalcostcurve.Aggregatesupplygivenby pp y p g gg g pp y g y
horizontal aggregationofindividualsupplycurves.
(Net)Consumersurplus:areabetweendemandcurveandhorizontalline
throughthemarketprice.Measurefor(moneymetric)utilityofconsumers.
(Net)Producerssurplus:areabetweensupplycurveandhorizontalline
throughtheprice.Measureforprofit(revenueminuscosts)
Inacompetitivemarketequilibrium thesumofconsumersandproducers Inacompetitivemarketequilibrium,thesumofconsumersandproducers
surplusismaximized.
Equilibriumgivenwheremarginalcostsequalmarginalbenefits
Demandforprivategood
Assumeaconsumeri withwillingnesstopayV
i
(x
i
)forconsumingquantityx
i
Consumerfacespricep ofthegood
Utilitymaximization: maxV
i
(x
i
)px
i
leadsto p=V
i
(x
i
)
Assumeconsumeri withwillingnesstopayV
i
(x
i
i
Consumerfacespricep atwhichonecanbuythegood
l ( ) (b f ) Utilitymaximization: maxV
i
(x
i
)px
i
(benefits costs)
leadsto p=V
i
(x
i
)
Remark:Formallythesettingcorrespondstoamoneymetricquasilinear
utilityfunctionU
i
(x
i
,M
i
)=V
i
(x
i
)+M
i
whichislinearinmoneyande.g.
concaveinx
i
ThenthemarginalwillingnesstopayMWTPisthenegativeoftheMRS
betweenmoneyandgoodx
) (
$
i i
i
i
X
X V
U
X
U
MU
MU
X
MRS MWTP
'
=
c
c
c
= =
A
A
= =
Weknowthatinefficientequilibrium
i ldi l V( )
) (
$
i i
i
i
M
U
MU X
c
c
A
p p
p
p
MRS
X
X
= =
$
yieldingalsop=V
i
(x
i
)
p
$
i
(x
i
i
Consumerfacespricep atwhichonecanbuythegood
Utilitymaximization: maxV
i
(x
i
)px
i
leadsto p=V
i
(x
i
)=MWTP
Demand correspondstomarginalwillingnesstopaycurve.
f ( ) h b d f ( ) f ll l ( ) ( ) IfV
i
(x
i
)isconcavethenbydefinitionV
i
(x
i
)isfalling.Example:V
1
(x
1
)=x
1
(100x
1
)
Grossconsumersurplusistheareaunderthedemandcurve.Netconsumersurplus
isareabetweendemandcurveandhorizontallinethroughthemarketprice isareabetweendemandcurveandhorizontallinethroughthemarketprice.
Aggregatedemandgivenbyhorizontalaggregationofindividualdemandcurves.
Example:V (x )=x (100x ) V (x )=x (1000.5x ) Example:V
1
(x
1
) x
1
(100 x
1
) V
2
(x
2
) x
2
(100 0.5x
2
)
Supply ofprivategoods
Wecanbreakdownprofitmaximizationinto
1. Minimizingcostsforagivenoutputbyoptimizinginputs
>costcurveC(x) >costcurveC(x)
2. Maximizingprofitsbychoosingoptimaloutputlevel
Assumeproducerj withcostC
j
(x
j
) forsupplyingquantityx
j
Producerfacespricep atwhichhecansellthegood
Profitmaximization:
maxpx
j
C
j
(x
j
)
leadsto leadsto
p=C
j
(x
j
)
Supplycorrespondstomarginalcostcurve. IncreasingifC
j
(x
j
) convex.
Aggregatesupplygivenbyhorizontal aggregationofindividualsupplycurves Aggregatesupplygivenbyhorizontal aggregationofindividualsupplycurves.
Example:C
1
(x
1
)=8+x
1
2
, C
2
(x
2
)=0.5x
2
2
Supplyofpublicgoods
AssumingthatthepublicgoodG
j
ispriced,everythingasbefore. ssu g t at t e pub c good G
j
s p ced, eve yt g as be o e.
Profitmaximization:
maxpG C(G) maxpG
j
C
j
(G
j
)
leadsto
p=C
j
(G
j
)
Supplycorrespondstomarginalcostcurve.
Aggregatesupplygivenbyhorizontal aggregationofindividualsupplycurves.
Demandforpublicgood
i
(G) forconsumingquantityG
NotethatGnolongercarriesanindex.EveryconsumerconsumesalloftheG ote t at G no longe ca ies an index. ve y co su e co su es a o t e G
asthegoodisnonrival
Consumerfacespricepatwhichonecanbuythegood
Utilitymaximization: Utilitymaximization:
maxV
i
(G)pG
leadsto
p=V
i
(G)
Individualdemandcorrespondsagaintomarginalwillingnesstopaycurve.
Socialdemandgivenbyvertical aggregationofindividualdemandcurves,
becauseallconsumersarewillingtopayforthesamepublicunitofG becauseallconsumersarewillingtopayforthesamepublicunitofG.
Example:V
1
(G)=G(1000.5G) V
2
(G)=2G(1000.5G)
Optimalprovisionofpublicgood
Aggregatemarginalwillingnesstopayshouldequalmarginalcostsof
providingthepublicgood:
forallproducersj. TheproducedquantitiesG
j
sumtothetotalamountof
) ( (G) V
i
i j j
G C
'
=
'
j
publicgoodprovidedG:
G G
j
j
=
Ormoregeneralforthemarginalrateofsubstitutionbetweenprivateand
publicgoodsishastohold
with
good public
good private
MRS
_
A
A
=
MRT MRS
i
=
Thisrelationisknownasthe
Samuelsoncondition
good public _ A
i
Sa ue so co d t o
Optimalprovision ofpublicgoods
MRS
A
+MRS
B
=MWTP
A
+MWTP
B
MC=MRT
MRS
B
MRS
B
=MWTP
B
- MRS
A
=MWTP
A
X
X*
PublicgoodsII
Withprivategood,eachindividualconsumesdifferent amount,but
payssame price:equalmarginalvaluationbyeachindividual.
Withpublicgood,eachindividualhastoconsumesame amount,but
marginalvaluationcandiffer:onlythesumofthemarginalvaluations
hastoequalthemarginalcost. q g
Publicgoodsarenonexcludable,sonolinkbetweenpaymentand
provision:publicgoodscannotbeprovidedbythemarket.
d bl d d f Governmentcanprovidepublicgoodandfinanceitviataxes.For
efficientamountofpublicgooditneedstoknowmarginalwillingness
topayforallindividuals.However
Nonexcludability givesconsumersincentivetofreeride andto
understatetheirwillingnesstopay!
Lindahl markets
Assumethatanindividualmarketcanbeintroducedforeachconsumerofapublic
goodG
ThenthereareN consumers,eachconsuminggoodG
i
,i=1,Natpricep
G
i
,i=1,N
DenotetheaggregatesupplyofthepublicgoodbyG anditspricebyp
G
ALindahl equilibriumasanallocationofgoods(includingG,G
i
,i=1,N)andasetof
prices(includingp
G
i
,i=1,Nandaprice)suchthat
ll f h f allfirmsmaximizetheirprofits,
allindividualsmaximizetheirutility(giventhebudgetconstraint),
allmarketsclearandforthepublicgooditholdsG=G
i
forall i=1,,N
forthepriceofthepublicgoodholds:p
G
=
i
p
G
i
.
Then(undersomeconditions)aLindahl equilibriumisParetoefficient
PrettymuchsaysthesamethingasourpictureandtheSamuelsonrule.
BecauseofnonexcludabilityandthedifficultiesofpricediscriminationLindahl
marketsgenerallystayatheoreticconstruct
Note:Excludabilitycanbenecessaryforanefficientmarketoutcome,eventhoughin
theefficientmarketoutcome,ingeneral,nobodywillbeexcludedfromconsuming , g , y g
anonrivalgood!
ExternalitiesI
Definition
Anexternality existswhentheconsumptionorproductionchoicesofone
personorfirmnegativelyorpositivelyaffecttheutilityorproductionof
anotherentitywithoutthatentityspermissionorcompensation.
Examples
Drivingacarproducesnoiseandpollutionwhichmightaffectotherpeople.
Theemissionofcarbondioxidebyafirmaddstotheatmosphericstockof
greenhousegasesandtherebycontributestoglobalwarming/climatechange. g g y g g/ g
Dischargingpollutionintoariverorlakecanhavenegativeimpacton
swimming,fishingetc.
Researchinnewdrugsornewtechnologiescanproducepositiveexternalities Researchinnewdrugsornewtechnologiescanproducepositiveexternalities
onotherpotentialusersofthesenewmethods.
ExternalitiesII
E t lit l ifi t i ( h t i t lit i ) Ext ernalit y classificat ion ( here negat ive ext ernalit ies)
Arising in Affect ing Ut ilit y/ product ion funct ion
C t i C t i U
A
(X
A
Y
A
X
B
) Consumpt ion Consumpt ion U
A
(X
A
,Y
A
,X
B
)
Consumpt ion Product ion X(K,L,Y
A
)
+ +

+ +
Product ion Consumpt ion U
A
(X
A
,Y
A
,X)
Product ion Product ion Y(K,L,X)
+ +
+ +
ExternalitiesIII
Beneficial ( posit ive) and harmful ( negat ive) ext ernalit ies
Effect on Originat ing in Originat ing in
ot hers consumpt ion product ion
Beneficial Vaccinat ion against Pollinat ion of blossom Beneficial Vaccinat ion against Pollinat ion of blossom
infect ious decease due t o proximit y t o apiary
Adverse Noise pollut ion from Chemical fact ory discharge
radio playing in park of cont aminat ed wat er int o radio playing in park of cont aminat ed wat er int o
wat er syst ems
GHG emissions can be in all 4 quadrant s! !
Exampleofanexternality: Productiononconsumption
Exampleofanexternality:Productiononproduction
TwoproducersofgoodsX andY,withcosts
( )
2
X
( )
Y
2
,
E.g.twostylizedCalifornianfarms:awindmillfarmandawinery
Wh tt f t lit d f h ?
( )
100
X
X C
X
= ( ) X
Y
X Y C
Y
=
100
,
Whattypeofexternalitydowefacehere?
Letpricesbep
X
=2 andp
Y
=3
Unregulatedmarketoutcomeis Unregulatedmarketoutcomeis
X=
x
=
Y=
Y
=
IsthataParetooptimum,i.e.efficient?
Exampleofanexternality:Production,Inefficiency
( )
2
X
( )
Y
2
,
Letpricesbep
X
=2 andp
Y
=3.
( )
100
X
X C
X
= ( ) X
Y
X Y C
Y
=
100
,
TryincreasingthenumberofwindmillsbyX=10
X=110 = X 110
x
Y=150
Y
=
IsthataParetoimprovementasopposedtothesituationX=100and IsthataParetoimprovementasopposedtothesituationX=100and
Y=150?
Exampleofanexternality:Production,Inefficiency
( )
2
X
( )
Y
2
,
Letpricesbep
X
=2 andp
Y
=3.
( )
100
X
X C
X
= ( ) X
Y
X Y C
Y
=
100
,
OnlyifwecompensateproducerX,thewindmillfarmer!
E.g producerY,thewinegrower,canpayhim5 monetaryunits(orsome E.g producerY,thewinegrower,canpayhim5 monetaryunits(orsome
amountofwine)fortheadditional10 windmills
Mightsuchbargainingactuallytakeplace?
WillitleadtoParetooptimality?
Whataretheobstacles?
ExampleofanExternality:!Homework!
( )
2
X
( )
Y
2
,
Letpricesbep
X
=2 andp
Y
=3.
( )
100
X
X C
X
= ( ) X
Y
X Y C
Y
=
100
,
HowdowefindtheParetooptimalallocationofXandY?
Onewayistocombinebothfarms: Onewayistocombinebothfarms:
max=
x
+
y
= p
X
X+p
Y
Y C
X
(X) C
Y
(Y)jointlyoverXandY
Calculateathomeandletmeknowtheoutcomenexttime!! Calculateathomeandletmeknowtheoutcomenexttime!!
X=
Y=
=
ExternalitiesandPublicGoods
Anexternalityinvolvesagoodorbadwhoselevelenterstheutilityor
productionfunctionofseveralpeople/firms.
Thatimplieseffectivelyadegreeofnonrivalryandnonexcludability.
Thereforenegative (positive)externalitiescangenerallyalsobeframed Thereforenegative (positive)externalitiescangenerallyalsobeframed
aspublicbads (goods)andviceversa
ClimateChangeandGHGs
Sowhatdoesthetheoryonpublicgoodsandexternalitiestellusabout
GHGemissions?
GHGsareapublicbad,mitigationisapublicgood.Thus
Acompetitivemarketequilibrium alonewillnotyieldaPareto
optimal(efficient)allocation p ( )
>Inprinciplewecanmakesomeindividualsbetterofwithout
makinganyoneworseof
Nonexcludability ofthebenefitsfrommitigationmakesindividuals Non excludability ofthebenefitsfrommitigationmakesindividuals
wanttofreeride
Becauseofnonrivalrythemarginalcostofmitigation (costoflast
unitemitted)shouldequal thesumofthemarginalbenefitsfrom unitemitted)shouldequal thesumofthemarginalbenefitsfrom
mitigation(includingthebenefitsofavoidingclimatechange
impactsinallcountries,industriesandforallindividuals)
ClimateChangeandGHGs
AnotherwaytothinkaboutGHGemissions:
GHGemissionscausenegativeexternalitiesinproductionaswellas
directlyonwelfare
Theseexternalitiesaffecteveryonearoundtheglobeandinparticular
alsoindividualsnotyetalive y
HOWCANWECORRECTFOREXTERNALITIESANDPROVIDE
PUBLICGOODSATANOPTIMALLEVEL?
WHATDIFFICULTIESDOWEFACEDEPENDINGONTHE
CHOICEOFOURINSTRUMENT(policymeasure)?

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TheEconomicsofClimateChange C175

Market Failure MarketFailure

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