Market Failure

Public Goods, Common

Property and Externality
Aashita Dawer
 • In the beginning of the semester I mentioned that
we will study neo-classical economics with critical
perspective.
• This is why, it is important to spend some time on
discussing the politics of syllabus/textbook in
neo-classical economics.

Why do we • A typical introductory textbook on neo-classical

(micro) economics will first establish that free
study these markets are efficient and then goes on to
deconstruct the demand as well as supply side of

topics now? the analysis.

• Remember we derived the demand and the
supply curves.
• It also establishes that any (government)
intervention in the free market leads to
deadweight loss. (Example: price ceiling, tax etc.)
 Market Failure

• In the second half of the course, the textbook will turn towards “market failure”.
• This is to present cases/situations where the free market fails to be efficient.
• Please note, these failures arises despite of NO INTERVENTION. It’s free market and it fails.
• ‘Market failure’ module is an interesting way of the neo-classical economics to concede that free
markets are not ALWAYS efficient.
• However, the language of the textbook is such that it often comes out that these situations are
anomalies.
• In reality, these situations are rule rather than exceptions.
 • There is no intervention, policy restriction, government
but still market fails to allocate resources efficiently in the
economy.
• Remember what efficiency is- (Yes, in the pareto sense):
• An economy is in a Pareto Efficient state when no further
Why and changes in the economy can make one person better off
without at the same time making another worse off.
how market • Free market equilibrium allocate resources in the
economy in pareto efficient manner.
fails? Recall- • How? By ensuring that price of the commodity is equal to
the marginal cost of the commodity. In other words,
P=MC.
• At any other price, either consumers or producers or
both will experience some welfare loss. (Depicting in
terms of deadweight loss).
Price of
Aluminum

Supply
(marginal cost)

P not equal to MC

Equilibrium
P = MC

Demand
(marginal benefit)
5

0 Qunderproduction QMARKET Qoverrproduction Quantity of

Aluminum
Market and the Social Optimum
 • So far we have studied that government
intervention in the markets lead to deadweight
loss.
• But now we will turn towards intrinsic features
Why and in the market that will lead to market failures.

how market • Also note that, we are going to relax the

assumptions of the perfectly competitive
fails? Recall- market to show market failures.
• This is because, perfect competition by
definition is a fool-proof model. However, it
exists within the cocoon of plethora of
assumptions.
 In the real
world,
markets are
Public Good
characterized
by a lot of
imperfections
(deviation Externalities
Situations from the
perfectly

where competitive
market). The
implication of Imperfect or No Competition
market which is that
market does

may fail- not allocate

resources
efficiently.
Imperfect Information

High Transaction Costs

Example-I
• Intuitively, public good is that commodity which once provided, it is very difficult to
exclude anybody from consuming it. Like a street-light, putting a toll to access the
streetlight, would be more than the cost of producing and running the street light, itself.
• Suppose this commodity is supplied in a free market. The marginal cost of producing this
commodity is given that determines the supply of this commodity.
• However, it is difficult the gauge the correct (actual) demand for this commodity.
• Since, consumers know about the nature of this product that once it is provided, it can be
consumed by all for free, each consumer has a tendency to underreport their willingness
to pay for the product. This would lead to underrepresentation of the demand. As a
result this commodity will be underproduced in a free market.
 • Market fails in the case of public good.
• Characteristics of a public good:
A commodity is non-rivalrous if it is not used
up when someone else consumes it.
Provisioning Example?
A commodity is non-excludable if someone
of Public cannot be kept out from enjoying it even
when she does not pay for it.
Good • A public good is a commodity or service whose
benefits are non rivalrous by an additional user
and from which it is generally difficult or
impossible to exclude people, even if the
people are unwilling to pay for the benefits.

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 • The consumption of public good is not rival
because everyone can consume the good
simultaneously; that is one person use of it
does not diminish another’s ability to use it. A
Provisioning public good is likewise not excludable because
once the good is produced, it is prohibitively
of Public costly to exclude anyone from consuming it.
• Example: A Flood control project would allow all
Good the people who live in the flood plain area to
enjoy the protection of the new program
simultaneously . It is very difficult to exclude
someone who lived in the middle of the flood
plain area who said she did not want to pay.

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 Implications (I/II)

• Non paying users usually cannot be excluded from enjoying a public good, suppliers of such
goods will find it difficult or impossible to collect fees for the benefits they provide. This is called
the free rider problem.
• Thus, services such as national defense, which are public good, cannot be provided by private
enterprises because consumer will not pay for what they can get for free.
• And, private enterprises are here not to give away services, but for profit maximization, public
good is undersupplied in a free market.
• This calls for the role of government provisioning and provisioning by non-profit organisation.

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Free-rider problem

• Another example
• –  Suppose you have one roommate
• –  You both like the same TV shows, but you have no TV
• –  Your willingness to pay for a TV is $100.
• –  Your roommate’s WTP=100
• –  A TV costs $150
• –  Without coordination, neither of you will buy the TV; yet each willing to pay
$100
• –  Aggregate MB=WTP=200==>TV should be purchased (efficient to provide 1
TV)
• – But no TVs will be provided if it’s left up to each individual’s private decision
Role of the government
• Note that any sensible roommates will talk over this problem and
solve it
• –  They may agree that it’s fair for each to contribute $75.
• –  One can think of this as the roommates deciding to tax themselves
in order to provide a public good
• –  This is a very primitive form of democratic government (at the
apartment level)
• –  In a similar way, larger societies decide (through some political
mechanism) to tax themselves in order to provide certain public goods
 Implications (II/II)

• Once a public good is provided, the marginal cost of serving an additional user is zero.
• The basic principle of efficient allocation of resources entails that MC = P, thus price of the
public good = 0.
• Therefore, it is not only impossible to charge a market price for a public good, it is often
undesirable as well.
• This again calls for the role of government provisioning and provisioning by non-profit
organization.

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Example II
• Self-interested buyers and sellers neglect the external costs or
benefits of their actions,
so the market outcome is not efficient.
• In other words, there is inefficiency when market determined
quantity ≠ socially optimum quantity because markets only reflect
private costs of production rather than social costs.
• In presence of externalities, public policy can improve efficiency by
internalizing the externality.
• One solution can be to tax producers (Pigouvian tax).
 • Negative externalities lead markets to
produce a larger quantity than is
Externalities socially desirable.
and Market • Positive externalities lead markets to
produce a larger quantity than is
Inefficiency socially desirable.

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 P The market for gasoline
$5 The market equilibrium
maximizes consumer
+ producer surplus.
4
Supply curve shows private
3 cost, the costs directly
$2.50 incurred by sellers.
2 Demand curve shows
private value, the value to
1 buyers (the prices they are
willing to pay).
0
0 10 20 25 30 Q
(gallons)
 Analysis of a Negative Externality
P The market for gasoline
$5 Social cost
= private + external cost
4 external
Supply (private cost)
cost
3
External cost
2 = value of the negative
impact on bystanders
1 = $1 per gallon (value of
harm from smog,
0 greenhouse gases)
0 10 20 30 Q
 Analysis of a Negative Externality
P The market for gasoline The socially optimal
$5 quantity is 20 gallons.
Social
cost
4 At any Q < 20,
S value of additional gas
3 exceeds social cost.
At any Q > 20, social
2 cost of the last gallon is
D greater than its value to
1 society.

0
0 10 20 25 30 Q
 Analysis of a Negative Externality
P The market for gasoline
$5
Social Market equilibrium
cost of Q = 25 is greater
4 than the social
S
optimum of Q = 20.
3

2 One solution:
D tax sellers $1/gallon,
1 would shift S curve
up $1.
0 More on this later.
0 10 20 25 30 Q
Positive Externalities
• In the presence of a positive externality, the
social value of a good includes:
• private value – the direct value to buyers
• external benefit – the value of the positive impact on
bystanders
• The socially optimal Q maximizes welfare:
• At any lower Q, the social value of additional units
exceeds their cost.
• At any higher Q, the cost of the last unit exceeds its
social value.
 Analysis of a positive externality
P The market for flu shots
$ 50 External benefit
= $10/shot
40  Draw the social
value curve.
S
30  Find the socially
optimal Q.
20
 What policy would
internalize this
10 externality?
D

0 Q
0 10 20 30
22
 Answers
P The market for flu shots
$ 50 Socially optimal Q = 25 shots
external
To internalize the externality,
40 benefit
use subsidy = $10/shot for the
S consumers.
30

20
Social value = private value +
10 $10 external benefit
D
0 Q
0 10 20 25 30
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 • Suppose a shoe factory in a village emits a
lot of smoke. Villagers nearby are getting
affected. What can be a solution?
• A candy factory operating for several years
in the busy Wigmore Street uses grinding
A few more machines. A physician buys the house next
door and builds a consulting room right
examples- next to the factory wall. He finds it too
noisy. What can be a possible solution?
• Taxation? (Government Intervention:
suggested by an economist called AC Pigou
and hence, the name Pigovian Tax).
How can people sometimes
solve the problem of
externalities on their own?
• Private solutions to the problem of
externality.
• Government action is not always needed to
solve the problem of externalities.
 Moral codes and social sanctions
(awareness, e.g. recycling)
 Charitable organizations
 Integrating different types of
businesses
 Contracting between parties

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 In microeconomics, the market is innocent until proven
guilty (and, similarly, the government is often guilty until
proven innocent!).

An excellent application of this principle can be found in a

classic work by Ronald Coase who asked in 1960: Why
won’t the market simply compensate the affected parties
Introducing for externalities?

Coase 1/2 According to him, Pigou didn’t get the problem right. The
victim of the externality is in fact part of the problem.

Let’s start with a simple example-

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Introducing Coase 2/2
• A candy factory operating for several years in the busy Wigmore Street uses grinding
machines. A physician buys the house next door and builds a consulting room right next
to the factory wall. He finds it too noisy and sues the factory owner. So does it make
more sense to shut down the factory or to ask the physician to build the room on the
other side of his house on Wimpole Street?
• Coase argued that Pigouvian solution of imposing a tax on the candy factory owner won’t
work here. Coase had a three-step proposition which could work (Coasian Solution).
• Physician has the right to close down the factory. (well defined rights)
• Mutual bargaining and an offer to compensate the physician. (bargain)
• Assessing the cost of engaging in such bargaining. (transaction cost)

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 • Example: Bart owns a coal power plant and Lisa
fishes for a living downstream from Bart.
Another • Problem: No one owns the river, i.e. there is no
market for river water.
Example: • Bart dumps toxins in the river, i.e. he treats water, a
scarce resource with alternative uses, as a free
Coal Power input. Why

Plant & • The dioxin adversely affects Lisa’s fishing business

• At free market equilibrium, in market for coal: MSC >
Fishery MSB  Market failure
• Coasian Solution: Assigning property rights can
restore efficiency.

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 • The Coase Theorem is a proposition that if
private parties can bargain without cost
over the allocation of resources, they can
solve the problem of externalities on their
Bargaining own.
• Whatever the initial distribution of rights,
and the parties involved in an externality can
solve the problem themselves and reach
the Coase an efficient outcome where both parties
are better off.
Theorem • Transactions Costs
• Transaction costs are the costs that
parties incur in the process of agreeing
to and following through on a bargain.
 Coase Theorem: Part 1

• Coase Theorem (Part I) When there are well-defined property rights and costless
bargaining, then negotiations between the party creating the externality and the party
affected by the externality can bring about the socially optimal market quantity.
• Externalities do not necessarily create market failures, because negotiations between the
parties can lead the offending parties to internalize the externality, or account for the
external effects of their actions.

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 Coase Theorem: Part 1

• The Coase theorem suggests a very particular and limited role for the government in
dealing with externalities: establishing property rights.
• In Coase’s view, the fundamental limitation to implementing private sector solutions to
externalities is poorly established property rights.
• If the government can establish and enforce those property rights, then the private market
will do the rest.

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 Coase Theorem: Part 2

• Coase Theorem (Part II) The efficient solution to an externality does not depend on which
party is assigned the property rights, as long as someone is assigned those rights.
• Suppose that the coal plant, rather than the fishermen, owned the river.
• If the fishermen promised the plant owner a payment for each unit he did not produce,
then the plant owner would rationally consider it.
• Remember, opportunity costs are included in estimating profit.

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 • When the costs of bargaining are low.
• When the parties can identify the source of
damages to their property and legally prevent
them. However, …
 Which pollutants do harm? (scientifically
proving causation is much more difficult than
proving correlation)

When will this  What activities produce pollutants? (the

blame assignment problem - natural or

work? anthropogenic; transborder effect of GHGs)

 Hold out problem when rights are held by
multiple parties.
 Free rider problem.
 Determining the value of damage. (Difficult
to measure WTP in the absence of a market.
Can use housing data to estimate WTP for
clean air.)
 • Turns out economic good is not always private.
• Our theory of perfect competition assumed a
private good.
• The harm and benefit of a private accrues to the
immediate consumers and producers.
Conceptualizi • However, if not only the private producer but the
ng economic society at large bears the cost of producing a
commodity like ‘leather shoes’, it will be
good inefficient to let the private entities (market) to
set the price of the commodity.
• There are many other categories of good, as
defined in no-classical economics.
• We discuss a few of them in the next slide.
 Neo-classical
economics literature
defines different kinds
of economic good!
 • These are ponderous claims, difficult to grasp
in the moment.
• Not well-defined categories-
• Note that sometimes the level of use of a good
affects rivalness
• – For example, an empty road is non-rival

Difficult to – Adding one person to the road probably

• has no effect on your ability to use it

conceptualise? • – But as it becomes congested, other

people’s use diminishes your ability to use
it.
• Many times, government may take a conscious
policy choice of making certain commodities
non-excludable.
• -Free compulsory primary education
 Critique of the definition of ‘public good’

• Marc Wuyts “concluded that public goods are socially defined and constructed according to
what is perceived as a ‘public need’, rather than containing certain inherent characteristics of
non-excludability and non- rivalry.”
• In Development Policy and Public Action Wuyts says “public goods are socially defined and
constructed: the outcome of complex political processes which evolve around the definition of
public need...Public goods...result from public action...
• Neo classical economics theory, by contrast, defines public goods as specific types of goods or
services (such as law and order, defense, the use of a road or a bridge, etc.) which markets find
it hard to deal with.
 The curious case of ‘common good’

• Ecologist Garrett Hardin explored the issues with the common good in his article “The Tragedy of
Commons” (1968).
• This article is often referred to as a living expression of neo-classical thinking.
• What were its major claims?
• A common property resources would be over-used and therefore, abused.
• No individual has an incentive to invest in the maintenance of a common property, resulting in further deterioration.
• Such a tragedy-”The Tragedy of Commons”!
•  He saw two solutions to this problem; 1) resource regulation through government intervention and
2) privatization.
Hardin’s Original
Example:
• The tragedy of the commons develops in this
way. Picture a pasture open to all. It is to be
expected that each herdsman will try to keep
as many cattle as possible on the commons.
Such an arrangement may work reasonably
satisfactorily for centuries because tribal wars,
poaching, and disease keep the numbers of
both man and beast well below the carrying
capacity of the land. Finally, however, comes
the day of reckoning, that is, the day when the
long-desired goal of social stability becomes a
reality. At this point, the inherent logic of the
commons remorselessly generates tragedy.
Hardin’s Original Example:
• As a rational being, each herdsman seeks to maximize his gain. Explicitly or implicitly,
more or less consciously, he asks, "What is the utility to me of adding one more animal to
my herd?" This utility has one negative and one positive component. 
• 1) The positive component is a function of the increment of one animal. Since the
herdsman receives all the proceeds from the sale of the additional animal, the positive
utility is nearly +1.
• 2) The negative component is a function of the additional overgrazing created by one
more animal. Since, however, the effects of overgrazing are shared by all the herdsmen,
the negative utility for any particular decision-making herdsman is only a fraction of –1.
• Adding together the component partial utilities, the rational herdsman concludes that
the only sensible course for him to pursue is to add another animal to his herd. And
another; and another... But this is the conclusion reached by each and every rational
herdsman sharing a commons. Therein is the tragedy.
Elinor Ostrom’s Critque
• Ostrom suggests that far from a tragedy, the commons can be
managed from the bottom-up for a shared prosperity — given the
right institutions.
• Ostrom went out into the field to see what people and communities
were doing differently — and then thought about how it worked.
• Her field research in Maine, Indonesia, Nepal and Kenya led to the
development of a set of design principles which have supported
effective mobilization for local management of common pool
resources (CPR) in a variety of areas.
Elinor Ostrom’s Critque
• She argued that common resources are well managed when those
who benefit from them the most are in close proximity to that
resource.
• For her, the tragedy occurred when external groups exerted their
power (politically, economically or socially) to gain a personal
advantage.
• She was greatly supportive of the “bottom up” approach to issues;
government intervention could not be effective unless supported by
individuals and communities.
Property as bundles of rights
• Access: The right to enter a defined physical area and enjoy
nonsubtractive benefits
• Withdrawal: The right to obtain resource units or products of a
resource system (for example, catch fish, divert water).
• Management: The right to regulate internal use patterns and
transform the resource by making improvements.
• Exclusion: The right to determine who will have access rights and
withdrawal rights, and how those rights may be transferred.
• Alienation: The right to sell or lease management and exclusion rights
Bundle of Rights
• In much of the economics literature, private property is defined as
equivalent to alienation. Property-rights systems that do not contain
the right of alienation are considered to be ill-defined.
• Instead of focusing on one right from the bundle, it is more useful to
classify five types of property-rights holders
• In this view, individuals or collectivities may hold well-defined property
rights that include or do not include all five of the rights defined above.
• This approach separates the question of whether a particular right is
well-defined from the question of the effect of having a particular set of
rights.
Categorization
• ‘Authorized entrants’ include most recreational users of national
parks, etc.
• ‘Authorized users’ - entry and withdrawal use-right units – collective
choice rights (or authority) of management and exclusion
• ‘Claimants’ possess the operational rights of access and withdrawal
plus a collective-choice right of managing a resource
• ‘Proprietors’ hold the same rights as claimants with the addition of
the right to determine who may access and harvest from a resource
• ‘Owners’ possess the proprietorship plus the right of alienation
Blurred boundaries
• What should be obvious by now is that the world of property rights is far more
complex than simply government, private and common property.
• These terms better reflect the status and organization of the holder of a
particular right than the bundle of property rights held. All of the above rights
can be held by single individuals or by collectivities.
• The modern corporation is frequently thought of as the epitome of private
property. While buying and selling shares of corporate stock is a clear example of
the rights of alienation at work, relationships within a firm are far from being
‘individual’ ownership rights. Since the income that will be shared among
stockholders, management, and employees is itself a common pool to be shared,
all of the incentives leading to free riding (shirking) and overuse (padding the
budget) are found within the structure of a modern corporation
• https://www.youtube.com/watch?v=ybdvjvIH-1U