Chapter 2

Theory of market failure and environmental externalities

How much is clean air worth?
Can you charge somebody for damaging your air?
How much are you willing to pay for clean air?
Should you have to pay for clean air?
Is cutting down the rainforests efficient?
What market incentives are there for research on the environment?
How can the environment be priced and sold?
Does Ethiopia have any mechanisms for valuing its environment?
Lecture objectives
Review Advantages and Limitations of Market Economics
 Understand how economics is creating new principles and
guidelines for business activity.
Comparing:
Neo-classical Economics
Environmental Economics
Ecological Economics
Contd.
What is an economy supposed to do?
What is the Neo-classical approach?
What is a market?
A system of exchange
What is exchanged?
Resources: land, labor, capital (i.e. goods or services in some form)
How does the market work?
Matching of supply and demand
Why is the market such a good system?
Optimal use of resources: buyers force competition on suppliers;
greatest return for the efforts of suppliers
Pareto efficiency: “a situation where it is impossible to make one
person better off without making anyone else worse off”
Meaning: allocation of resources to the uses that will bring the
greatest overall increase in production and monetary value by
matching producers with the highest bidders.
Contd.
What enables the market to work?
Price or Value setting
Profit motive
Private property
Government and other regulating institutions
Does the market operate perfectly?
1. General Market Failures:
 Monopoly;
 information asymmetry;
missing markets;
transaction costs.
 Market Failures
2. Environmental Market Failures:
Failure to value the environment: unpriced use values; option values;
existence values; bequest values.
Lack of information
Externalities
Common Access Resources/Sinks
Discounting the future
Missing Markets
Contd.
 Externalities
“An unintended cost or benefit of production or consumption that is
not reflected in the price of the related transactions.
 Externalities are often borne by people who are not parties to the
transactions that create them.”
Externalities can be considered as unpriced goods involved in either
consumer or producer market transactions.
 Externalities
Governments can sometimes improve market outcomes
Why do markets fail to allocate resources efficiently?
How can government policies improve market’s allocation?
Market failure occurs as a result of
Market power
Externalities
Externality is the uncompensated impact of one person’s action on
the well-being of a bystander
Adverse impact on the bystander is called a negative externality
Beneficial impact on the bystander is called a positive
externality
 Externalities and Market Inefficiency
Externalities cause markets to be inefficient, and thus fail.
Demand curve reflects the value to the buyers and supply curve
reflects the cost to the seller
At market equilibrium, total surplus is maximized
In the absence of externalities, market equilibrium is efficient
Both decision-makers fail to take account of the external effects of
their behavior
Negative Externalities in Production
Negative externalities in production or consumption sometimes lead
markets to produce a larger quantity than is socially desirable.
The Social Costs of production or consumption are greater than the
private cost or private benefit by producers and consumers.
This leads to market failure.
•Due to the negative externality, social cost is greater than private
cost
•Social cost is the cost to the society of producing a product with a
 Externalities and Market Inefficiency
The difference between social cost and private cost is the cost of the
negative externality
The intersection between the demand curve and the social cost curve
gives the optimum level of production
In the presence of a negative externality:
Social cost> private cost
Optimum quantity < market equilibrium quantity
The reduction in production raises economic well-being
Economic well-being can be measured using the concept of
deadweight loss
Deadweight loss is the fall in total surplus that results from a market
distortion, such as tax or tariff.
 Economic welfare
At market equilibrium, welfare is equal to the total surplus
Producer surplus is measured as amount received by the sellers-
social cost to the society
At optimal quantity of production, consumer surplus is reduced but
producer surplus increases
The dead weight loss of producing at market equilibrium level rather
than at optimal level is equal to the area of the triangle formed by the
social-cost curve and demand curve
The dead weight loss is associated with the negative production
externality
Pigovian taxes:
The government can internalize the externality by imposing a tax on
the producer. The tax shifts private cost supply up to social cost
supply and eliminates the deadweight loss.
Internalize an externality means to alter incentives so that people
take account of the external effects of their actions
Contd.
Pigovian taxes are enacted to correct the effects of the negative
externalities.
Positive Externalities in Production
Social cost of production = Private cost - technology spillover
The optimal quantity is larger than the equilibrium market quantity
The positive externality can be internalized by imposing a Pigovian
subsidy
Patents are an example of internalizing positive externalities
 Externalities in Consumption
The analysis of consumption externalities is similar to that of
production externalities
The demand curve does not reflect the value of the good from
society’s point of view
•Negative consumption externality (tax)
•Positive consumption externality (subsidy)
Externalities : Conclusion
Negative externalities in production or consumption lead markets to
produce a larger quantity than is socially desirable.
Positive externalities in production or consumption lead markets to
produce a smaller quantity than is socially desirable.
Government can internalize externalities by
•Levying a tax on goods with negative externalities
•Imposing a subsidy on goods with positive externalities
Contd.
Private Solutions to Externalities
Is it possible for private actors to allocate resources at the social
optimum level?
Types of private solutions:
•Moral codes and social sanctions
•Charities
•Self-interest of involved/relevant parties
•Integration of different types of business
•Contracts
The Coase theorem proposes that if private parties can bargain
without cost over the allocation of resources, they can solve the
problems of externalities on their own.
The Coase theorem says that whatever the initial distribution of
rights, the interested parties can always reach a bargain in which
everyone is better off and the outcome is efficient.
Contd.
Why private solutions do not always work?
•Transaction costs are costs that parties incur in the process of
agreeing and following through on a bargain
•Coordination costs increase as the number of interested parties
increase
Government is an institution designed for collective action
Public Policies Toward Externalities
Regulation- dictating maximum level/ adopting a particular
technology
Pigovian taxes and subsidies
Pigovian taxes and subsidies are more efficient than regulation as
they achieve the same result by conferring a lower cost on the society
Tradable pollution permits- limits the supply of pollution permits
and the demand curve sets the price for pollution
Pigovian Tax- sets a price on pollution and the demand curve
determines the quantity of pollution
 Discounting the Future with Net Present Value (NPV)
NPV = x/(1+.10)n
X =your present money value
.10 = the discount rate
N(yrs) = the power of how many years down the future you are looking
at
NPV of 100 dollars in five years with a discount rate of 10% is
100/(1+.10)5 or $62.09
From Market Failure to Government Failure
Limited information of how to deal with specific environmental
problems (of area or industry) and of firms’ capability to deal with or
hide environmental impact
Limited resources to regulate, monitor and enforce
Command and Control regulations: uniform standards and
technologies
 Policy Guidelines from Environmental Economics:
I. Benefits of Using the Market
1. Cost effectiveness: example, emission trading credits
2. Substitution and technological advance: example, green taxes
3.Other institution/market based schemes: deposit refund schemes,
environmental bonds, transferable quotas, transfer of development
rights.
II. Better Valuation of Non-market Valued Assets
1. Financial Costs
2. Averting Behavior
3. Travel Cost Method
4. Hedonic Pricing
5. Contingent Evaluation
For: Better Cost-Benefit Analysis, regulations, fines
 Environmental Economics and Ecological Economics
Weak vs. Strong Sustainability
Efficiency standard vs. ecological standard
Discount rate (growth) driven vs. discount rate (growth) limiting
Resources as inputs & outputs of unlimited economic system vs.
economic system as limited subsystem of ecosystem
Substitutability vs. complementairty
The Environmental Economics Trade-off
Contd.
Contd.
 Substitutability vs. Complementarity
• Manufactured and • Manufactured capital
knowledge capital for depends on natural
natural capital capital
• Land, labor and capital • Uniqueness,uncertaint
substitutability y and irreversibility
• Same service by • Ecosystem services
different product • Growth outpaces
• Technological fixes substitution
• Ecosystem resilience • Ecosystem fragility
 Policy Influences from Ecological Economics
Strict demands for environmental protection reflected in:
Environmental impact assessment
Natural preservation areas (parks, reserves)
Absolute limitations on chemicals
Policy Guidelines from Ecological Economics
1. Daly Rule
2. Index of Sustainable Economic Welfare (ISEW)
3. Ecological tariffs on free trade
4.Community based sustainability through self-sufficiency and
diversification

Daly Rule: "Never reduce the stock of natural capital below a level
that generates a sustained yield unless good substitutes are available for
the services generated."
Contd.
Index of Sustainable Economic Welfare
ISEW=total output + unpaid work - environmental destruction and
degradation- environmental improvement measures - depreciation of
human-made capital+/- welfare distribution effect
Free Trade Limitations
Regional specialization obscures view of resource exploitation,
depresses ecological and social laws, weakens terms of trade and
impoverishes landholders
Externalities from the shipping of goods around the world
Therefore, tariffs to compensate or reduce free trade
Community Based Development
Community rather than corporations or government creates social
conditions (wants and needs) that limit impacts
Greater self-sufficiency through decentralized control
Local synergies for recycling and energy reduction
Ethical bonds amongst business community
Contd.
Summing up:
Market success in exchange efficiency
Market failures in: valuation, common access, externalities, and
discount rate
Environmental economics guidelines: cost effectiveness and market-
based incentives
Ecological economics guidelines: limiting growth to within global
and local ecosystems
*therefore reducing throughput of economy within ecological
carrying capacity
 Assignment one
1. Answer the following questions
What company did you buy your air from?
How much did you pay for your air? How was that price set?
How clean was the air you bought? How do you know?
How can a company stop other companies from dirtying its air?
What can you do if someone makes your air dirty after you bought
it?
What rate of return should a company expect to get from investing
in air quality?
Should economics be used in the analysis of pollution?
Hint: People face tradeoffs and if clean environment is treated as a
commodity ???
Does Ethiopia have any mechanisms for valuing its environment?
2.Write a lecture note on
 Environment and sustainable development
What is sustainomics?
Linking climate change and sustainable development