ECON 391

Economics of the Environment

Chapter 4
Economic Efficiency and Markets

Stefania Strantza Summer 2020

Economics, Concordia University
Learning Objectives
1. Define social efficiency and illustrate it graphically
2. Explain why a competitive market may fail to reach a
socially efficient equilibrium
3. List and explain the causes of market failure
4. Contrast the equilibrium outcomes in markets where
externalities are accounted
5. Explain the distinguishing characteristics of public
goods and why they give rise to free riding

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Economic Efficiency and Markets
• There are two questions of interest:
1. What is the quantity that ought to be produced?
2. What is the quantity that is produced in fact?
• The first question deals with the notion of efficiency,
the second with the way markets normally function

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Economic Efficiency
• Economic efficiency in production is achieved when
the marginal benefits from production equal the
marginal costs
̶ all market and non-market values are incorporated into
the marginal benefits and marginal costs of production

Marginal Willingness To Pay (aggregate demand) =

Marginal Cost (aggregate supply)
MWTP = MC

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Efficiency and Equity
• Efficiency does not distinguish among people
̶ a market that achieves the maximum net benefits is
efficient no matter who receives the benefits (one
person can achieve all of them)
• Equity is a concept that considers distribution of
benefits
̶ to be equitable, the distribution needs to be fair

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Efficiency and Equity
• An efficient outcome may not be considered equitable
if a small number of people benefit and many do not
• It may be hard to define fairness since different people
have different views, but fairness usually means that
benefits are shared widely among the population

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Economic Efficiency and Equity
• Economic efficiency does not demand equity in
distribution
̶ efficiency says to maximize the size of the pie, don’t
worry about how it is sliced
̶ if a project creates more benefits than costs, then it is
good, no matter who pays the costs and who receives
the benefits

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The Use of Markets
• Can a market system, a system where many buyers
and sellers interact with each other, give us results
that are socially efficient?
• Can we rely entirely on the market to reach a socially
efficient outcome?

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The Use of Markets
• Almost all countries, including Canada, rely on markets
to allocate scarce goods
• Markets are not completely efficient, but for most
goods and services they beat the alternatives
• Some alternatives to markets:
̶ distribution based on need
̶ equal distribution
̶ first come first served
̶ lottery
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The Use of Markets
• All the alternatives raise issues with regard to giving
the right incentives to both producers and consumers
• Overall markets are preferred to the alternatives to
allocate goods to those who value them most highly,
and give producers incentives to make the goods that
people value

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Market Equilibrium
• The price where quantity demanded = quantity
supplied is the competitive market equilibrium

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Market Equilibrium

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Market Equilibrium

ECONOMIC EFFICIENCY AND MARKETS 13

Take me home to the equilibrium…
• Markets always try to move toward their equilibrium
level where D = S
• … and they usually get there….
̶ stores do not have lots of items they can not sell (if
they do, they lower the price)
̶ stores are usually not short of items they can sell (if
they are, they raise the price)
̶ stores can adjust prices to reach equilibrium

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Markets and Social Efficiency
• Does an unregulated market lead to a socially
efficient equilibrium?
• Yes, if the market demand and supply curves
represent the willingness-to-pay and marginal cost
curves
• Problem: when environmental values are concerned,
there could be differences between market values
and social values

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Market Failures
• Market failures prevent a socially efficient equilibrium
from being reached
• Market failures can affect both the supply and demand
sides of the market
̶ On the supply side: difference between market supply
curve and social marginal cost curve (external costs)
̶ On the demand side: difference between market
demand curve and social marginal willingness to pay
(external benefits)

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Types of Market Failures
1. Negative externalities (external costs)
• Producers do not pay the full production costs
̶ the production of a good creates pollution that
affects other people
̶ the price of the good in the market is below the
true price
̶ producers produce more than the socially optimal
amount of the good

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Types of Market Failures
2. Positive externalities (external benefits)
• Producers can’t capture the full benefits of production
̶ the production of a good affects positively other people
̶ producers produce less than the socially optimal
amount of the good

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Private costs
• Private costs: when firms decide about what and
how much to produce, they take into account the
price of what they produce and the cost of the inputs
̶ e.g., labor, raw materials, machinery, energy
• Any firm that has the objective of maximizing its
profits will try to keep its production costs as low as
possible

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External Costs
• External costs: during production there may be other
costs that represent true costs to society but do not
show up in the firm’s profit-and-loss statement
• They are called “external” because, although they are
real costs to some members of society, they are not
normally taken into account by firms
̶ costs that are external to firms but internal to society
as a whole

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Emissions as a Negative Externality
• Pollution emissions may create a negative externality
• The negative externality exists when there are costs to
society and the environment from the production that
the producer of the good does not pay
• Even if we removed all negative externalities by forcing
producers to pay the full cost of production, pollution
would still exist because of the benefits we receive
from consuming the good

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Water Pollution - Example
• A factory is located close to a river and discharges
wastes due to its production process
• Negative effects: lower quality of water, reduction in
the number of fishes, non-potable water
• If the factory does not take those effects into account,
when deciding how much to produce, it overproduces
discharging too much wastes
• The market fails because there is no incentive for the
factory to include the external costs in their decision-
making process
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Full Social Cost
• To produce output levels that are socially efficient,
decisions about resources used must take into account
both types of costs
̶ the private costs of production plus whatever external
costs arise from adverse environmental impacts
• Social cost = private cost + external (environmental) cost

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Traffic Congestion as a Negative Externality
Number of cars Average travel time between A and B
1 10
2 10
3 10
4 11
5 12
6 14
7 18
8 24
There are already 5 cars, alternative route takes 18 minutes

• Explain the negative external costs in this situation

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Open-Access Resources
• A major cause of market failure is the presence of
open-access resources
• Open-access resources are resources with
uncontrolled access
̶ the ocean, the air, public lands, a forest where
anyone may go and cut wood
• No one controls or owns the resource, therefore it
can be hard to prevent people from overusing or
abusing it

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Negative Externality
• An action imposes some costs to others (society) that
are not taken into consideration by the person making
the decision about how much of a good or service to
produce
• The full social cost is,
Social cost = private cost + external (environmental) cost
MSC = MPC + MEC

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Negative Externality
P
MSC

S (MPC)

External Welfare loss from

cost overproduction

D (MPB=MSB)

0 Qsocial optimum Qmarket Q

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Negative Externality
• Producers do not pay the full production cost
• The output of the good is too large
• Too much pollution is produced
• As long as the costs are external, no incentives to
search for ways to yield less pollution per unit of
output are introduced by the market
• Recycling and reuse of the polluting substances are
discouraged because release into the environment is
so inefficiently cheap

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Review of Negative Externality
• Negative externality:
marginal social cost (MSC) >
marginal private cost (MPC)
• MPC will not reflect the true or full production cost
• If the external costs are not added, the price of the
good in the market will be below the correct price
and too much of the good will be produced

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Positive Externality
• An action has some benefits to others (society) that are
not taken into consideration by the person making the
decision about how much of a good or service to
produce
• The full social benefit is,
Social benefit = private benefit + external benefit
MSB = MPB + MEB

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Positive Externality
P
MPC=MSC

External Welfare loss from

benefit underprovision

MSB
MPB
0 Qmarket Qsocial optimum Q

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Positive Externality
• Producers can’t capture the full benefits of
production
• The production of a good affects positively other
people
• Producers produce less than the socially optimal
amount of the good

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Review of Positive Externality
• Positive externality:
marginal social benefit (MSB) >
marginal private benefit (MPB)
• The producer produces the goods until MPB = MPC
• The good is underprovided in an uncontrolled market

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Positive Externality
• Society would be better off if it finds a way to
compensate individuals, who produce goods with
positive externalities, to encourage them to produce
the socially optimal quantity level
• Public goods are related to positive externalities

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Positive Externalities - Examples
• Examples of positive externality:
̶ flower gardens (everyone enjoys the beauty of the flowers)
̶ firework shows (everyone enjoys the show)
̶ education (you are able to educate other people and
therefore they benefit of your education)
̶ if you walk to work, it will reduce congestion and pollution
(this benefits everyone else in the city)
̶ vaccination (decreases the likelihood of your own infection
and of others becoming infected through contact with you)

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How to Correct an Externality?
• Negative externalities: impose a Pigouvian tax equal
to the marginal external cost (MEC) evaluated at the
socially optimal quantity level
• Positive externalities: award a Pigouvian subsidy
equal to the marginal external benefit (MEB)
evaluated at the socially optimal quantity level

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Public Goods
• A pure public good is:
1. Non-rival: one person’s use of the good does not
diminish another person’s ability to use the good
̶ if you breath the air, there is still plenty for me to
breath
̶ just because I am listening to a radio station
doesn't mean that someone else can't

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Public Goods
• A pure public good is:
2. Non-excludable: individuals can not be prevented
from using a good for free
̶ breath the air for free
̶ watch a fireworks show without paying

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 Taxonomy of Goods

Excludable Non-excludable

Rival Pure private goods Examples: common pool resources

Examples: consumption goods, (fishing grounds, groundwater),
food, clothing, housing free parking spaces
Non- Examples: cable TV, cinemas, Pure public goods
private parks Examples: sunlight, atmosphere,
rival environmental quality

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Free Riders
• When a public good is involved, each person may
have an incentive to free-ride on the efforts of others
• Free riders are people who pay less than their
marginal willingness to pay (MWTP) for a good
• Many public goods suffer from free riders because
they are non-excludable
̶ people can’t be excluded from enjoying the benefits
of the good even if they do not pay for it

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Public Park as a Public Good
• A town wants to build a park
• They ask the people of the town if they will contribute
towards the costs
• Everyone says they will, but they also know that even if
they don’t contribute individually, other people will do
• Thus, if a private person pays for the park, other people
enjoy its benefits for free

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Market Failure and Public Goods
• Public goods are underprovided in a free market
̶ non-excludable makes it hard to prevent free riders
̶ people try to avoid paying even with a positive MWTP
because someone else will pay and provide the good
̶ policies can be used to address the issue (they may be
efficient for society but not necessarily for each
individual)

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Aggregate Demand for Public Goods
• People’s demand for a public good expresses their
marginal willingness to pay, just as does their demand
for a private good
• The difference comes in the way individual demand
curves are aggregated across consumers

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 Aggregate Demand for Public
Goods
• Aggregation of individual demand
curves for a public good is done by
vertical summation
̶ for a given quantity of the good,
each person’s MWTP is added
̶ this is because of the joint
consumption of the good

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Aggregate Demand for Public Goods
• Aggregation of individual demand curves for a private
good is done by horizontal summation
̶ add up quantities desired at a given price
• Aggregation of individual demand curves for a public
good is done by vertical summation
̶ for a given quantity of the good, each person’s MWTP
is added
̶ this is because of the joint consumption of the good

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Efficient Provision of Public Goods
• Environmental quality improvements are public goods
• We cannot use the aggregate demand curve to
determine a uniform price for all consumers
̶ each consumer must be charged his MWTP for the
good to achieve an equilibrium where D = S

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Efficient Provision of Public Goods
• An efficient allocation of a public good is determined
by the intersection of the market demand curve and
the marginal cost curve
• Once the optimal quantity of the good has been
determined, the individual demands reveal the
efficient prices that must be charged to each individual
• We cannot use the market demand curve to determine
a uniform price for all consumers

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Problems with the Efficient Provision
• Efficient pricing requires that a different price be
charged to each consumer
̶ consumers may not reveal their true willingness to pay
̶ even if true willingness to pay is revealed, charging
different prices to different people is not easily applicable
• Thus, public goods are generally not supplied socially
efficiently by decentralized private markets
̶ they are underprovided in a private market

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Overview
• We provided an application of the market model to
situations where environmental quality is an issue
• Due to external costs and external benefits, market
prices and quantities may not be at their efficient level
when environmental quality issues are involved
• Markets may fail to deliver efficient levels of
environmental quality, and therefore environmental
policies may be necessary to rectify these market failures

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