CH 3

CHAPTER THREE
3.EFFICIENCY, PROPERTY RIGHTS, MARKET FAILURE

& THE ENVIRONMENT
3.1.Efficiency
What is efficiency? What does it indicate in the
environmental sustainability?
The concept of efficiency which has been used in
social sciences including economics and political
science was developed by Italian economist Vilfredo
Pareto (1848–1923).It is called Pareto efficiency
(Pareto optimal).Pareto optimality states that “a situation
is efficient or a Pareto optimal if it is impossible to make one
person better-off without making someone else worse off”.
04/21/2024 Lati M., Dadu, Department of Economics 1
• An economy is in a Pareto Optimal state when
no further changes in the economy can make
one person better off without at the same time
making another worse off. A state of affairs is
Pareto-optimal (or Pareto-efficient) if and only if
there is no alternative state that would make
some people better off without making anyone
worse off. The concept of Pareto-optimality thus
assumes that anyone would prefer an option that
is cheaper, more efficient, or more reliable or
that otherwise comparatively improves one’s
condition.
04/21/2024 Lati M., Dadu, Department of economics 2
• An efficient economy is one that has
exhausted all means of mutual gains (trade).
On the other hand, a state of affairs x is said
to be Pareto-inefficient or sub-optimal or
improvement if and only if there is some state
of affairs y such that no one strictly prefers x
to y and at least one person strictly prefers y
to x. It is a situation where it is possible to
make at least one individual better-off without
making someone else worse-off.

Why efficiency is needed? Efficiency is needed because;
a)Resources are scares (limited quantity).
b)The complex environmental system that provides
numerous benefit
• Natural resources particularly nonrenewable are found in
limited quantities. Even though, the condition is not
similar for renewable resources, it is real that there is
finite limit that can be harvested in any period of time.
This is the major reason why we bother about efficiency.
In addition, to consider the allocation of environmental
resources, time is an important factor. Let us discuss
resource allocation at some single point in time (static
resource allocation) and allocation over time (inter
temporal
04/21/2024 or dynamic resource
Lati M., allocation).
Dadu, Department of economics 4
Efficiency
04/21/2024 Lati M. Dadu, Department of economics 5

1.Static Economic Efficiency
 In order to understand the concept of static efficiency, let us
consider an economy in which there are two persons (say A and
B); two goods (X and Y) are produced; and the economy uses
two inputs (capital and labor) to produce the products. These
productive resources are available in fixed quantities.
Assumptions of static efficiency
Pareto efficiency (Static Efficiency) requires the fulfillment of the
following three assumptions.
1)Two individuals (A, B), two goods (X, Y), and two inputs (L, K).
2)There is no externality in either consumption or production.
This means the consumption or production activities of one agent
do not affect other agent's utility in an uncompensated way.
3)Both goods are private goods, i.e., there is no public good.
 It is clear that each person's utility depends on the
quantity of goods that he/she consumes in a
particular period of time. Thus, the utility functions
of A and B is as follows.
……………………...
……………………...
Equation (1) states that the utility derived by
individual A, i.e., depends on the quantity of good X
() and good Y() he/she consumes.
The utility derived by individual B
(eq.2), also depends on the quantity of
good X() and good Y() he/she consumes.
In this two-person, two-commodity and
two input economy, static efficiency can
be achieved when the following three
conditions are satisfied simultaneously.
a) Efficiency in consumption
b)Efficiency in production
c) Product-mix efficiency
A)Efficiency in Consumption (Exchange or
Consumption Efficiency)
An allocation of commodities is consumption
efficient if the only way to make one person
better off is to make another person worse
off. All individuals face the same relative
values on margin from all goods consumed
commodities. Consumption efficiency is
achieved when the ratios of marginal utilities
of the two goods (X and Y) are the same for
each consumer. That is;
Thus, the MRS between each pair
of goods must be equal for all
consumers.

What is Utility? What is the contract curve? In
economics, what is good/bad for a human
individual (increases/decreases utility) is self-
decided, determined by that individual’s
preferences. Utility function is an important
concept that measures preferences over a set of
goods and services. Because satisfaction,
happiness or welfare is a highly abstract concept,
economists measure utility in terms of revealed
preferences by observing consumer choices and
creating an ordering of consumption baskets
from least desired to the most preferred.
 Utility
04/21/2024 functions: Lati M., Dadu, Department of economics 11
Consumer sovereignty and economic
outcomes should reflect consumer
preferences. Social welfare is some
aggregation of individuals’ utilities. It states
that any allocation on the contract curve can
be sustained as a competitive equilibrium. The
basic condition that assures this result is that
consumer indifference curves be convex when
viewed from the origin. Edgeworth box is a
graphical tool used to understand what this
definition of efficiency means.
Diagram 3.1: Edge worth Box and contact Curve
NB: Efficiency in consumption lies on the contract curve.

B)Efficiency in Input or Production
Efficiency in the production requires the
equalization of marginal productivity of inputs in
similar products. An allocation is input or
production efficient if the only way to increase the
output of one commodity is by decreasing the
output of another commodity. This, in turn,
requires the marginal rate of substitution between
factors to be the same in all industries, and the
slope of IC needs to be equal with the slope of
Isoquant (Marginal Rate of Technical
Substitution).
Now, let us see the production side of the
economy. Consider an economy which
uses only two factors of production,
labor and capital, to make the two goods
X and Y. Production efficiency is
achieved when the ratio of the marginal
product of each resource is the same in
the production of both goods. It is
mathematically expressed as;

Or

Figure 3.2: Efficiency in Production or Input
NB:Efficiency in the production or input efficiency lies on the contract curve.

C.Efficiency in Production Mix
Product Mix efficiency condition is realized
when both the exchange or consumption
efficiency and product or input efficiency are
achieved together. Suppose we add a productive
sector to our exchange economy. It consists of 2
firms each of them using capital K and labor L.
To show the efficient production mix, it is
useful to translate the contract curve from the
Edge worth consumption box to production
possibilities frontier.
Production mix is the set of all possible
output combinations that can be produced
with given quantities of capital and labor.
A mix of product/commodities is allocation
efficient if the MRT between any two goods
is equal to consumers’ between the two
commodities (the ratio in which goods are
being produced is the same as people want
to consume), i.e., subjective values of X in
terms of Y should be equal to its marginal
cost.
Figure 3.3: Efficiency in Product

Marginal rate of transformation (MRT)
represents the slope of the production
possibilities frontier at any point on the line.
It is the rate at which the amount of second
commodity is given up or released in order to
produce more one additional unit of the first
commodity. It measures the opportunity cost
of producing one additional unit of the first
commodity, let say clothing in terms of food.
The (negative of the) slope of the production
possibilities curve.
So, an economy in competitive general equilibrium is
efficient (i.e. Pareto optimal) if it simultaneously
produce efficiency in consumption, production and
choice of product mix. To summarize, the three
conditions for efficiency in the resource allocation;
i) Exchange (Consumption) Efficiency
 “Maximum” utility for individual consumers.
ii) Input (Production) Efficiency
 “Maximum” output from combinations of inputs
used.
iii)Product-Mix (Substitution) Efficiency
 Optimum mix of commodities and consumption

2.Dynamic Efficiency or Inter-temporal Efficiency
When time is not an important factor, static efficiency
criteria is very important for comparing resource
allocations. However, time is an important factor in a
dynamic efficiency. Almost all of the decisions made at
this moment affect the benefits that the resource
provides for the coming generation. Especially, for
non-renewable energy resources, once they are used
by the present generation, they will not be available
for future generation. So, dynamic efficiency method
considers not only the magnitude of benefits and costs
but also timing.

To incorporate the concept of timing, we
have to provide away of comparing the net
benefits derived at different period. The
idea of present value enables us to compare
net benefit from one period to another
period. Present value includes time value
of money.
For example, a one hundred birr invested at
10% interest rate today will generate 110 birr
after one year, because 100 + 100*10%= 110.
 The total amount (value) of one birr saved today at r%
interest rate after three years is;
1
 The present value of x birr earned after three years
is given by;
, Where r is the interest rate.

 The present value of a one-time net benefit earned
after one year is;

;
Where,
PV ( ) Present value of net benefit
=net benefit,
n = No of years, and
r = interest rate.
The process of determining the present
value is said to be discounting; and the
interest rate r is called discount rate.

By now, it is possible to discuss about dynamic
efficiency. According to Tietenberg T., resources
allocation over n-periods of time is referred to as
inter temporally efficient if it maximizes the present
value of net benefits that could be achieved from all
the possible means of distributing these resources
over the n-periods because dynamic efficiency
considers the main objective of the society as to
balance the use of resources at this moment and the
coming period by maximizing the present value of
net benefit earned from the use of resources, mainly
of non-renewable resources.
Dynamic Efficiency of Marginal Analysis:
Marginal analysis of static efficiency states
that certain allocation is efficient if the
marginal benefit and marginal costs are
equal. But, in dynamic efficiency, we need to
think not only about the marginal trade of
benefits and costs but also about timing. An
allocation of resource across n time period is
dynamically efficient if it maximizes the
present values of net benefits that could be
received from all the possible ways of
allocating those resources over the n periods.
According to the dynamic efficiency criteria, efficient
allocation is the one that maximizes the present value
of the net benefit for the n years (simply the sum of
present value in each of the n year).
In dynamic efficiency we should consider costs and
benefits of the present and future generation.
 Net benefit = Total benefit - Total cost
 Total benefit is the total willingness of the consumer
to buy different level of output with their respective
prices. And total benefit is measured by the area
below the demand curve or it is the integration of the
demand function whereas the total cost is the cost of
production.
 Net present value of a stream of net
benefits received over a period n years is
computed as:
Where r is the appropriate interest rate and

is the amount of net benefits received
immediately.

 The process of calculating present value is called
Discounting and the rate r is referred to as discount rate.
 Example: If the time period is say two years (i=2).
 Assumptions of Dynamic Efficiency

1.The resource can be used in n time period.
2.The marginal cost of extracting the resource is constant
and it is C per year.
3.There is a fixed supply of the resource to allocate between
the n periods. Given total supply (amount of resource
extracted at time t).
4.Total demand for the resource is linear and constant
overtime
 Consider the following simple model to define an efficient
allocating
04/21/2024 of non-renewable resources
Lati M., Dadu, Department of economics 32
Suppose, there is a given inverse demand function:
Step 1: Find the Total Benefit and Total Cost
Total benefit of using the resource or from
extracting an amount in year t is the integral of
the demand function or curve. Thus, total benefit
is calculated simply by integrating the demand
(total benefit function). Given inverse demand:
;

 Further it is assumed that the marginal cost of
extracting the resource is constant (C),and therefore,
the total cost of extracting any amount of is an
integration of ;
Step 2: Total quantity supply of the resource is limited.

where
Step 3: Compute the Net Benefit

Step 4: Find the Present Value of the above Net
Benefit
……

 Now, we will maximize the Present Value of Net Benefit
with the given quantity constraint (Q).
Step 5: Maximize the Present Value of the Net Benefit
Maximize:
Subject to: Resource quantity constraint;
where
 To maximize the present value of the net benefit, given
its limited quantity, we need to use the Lagrange
function.
 Lagrange function is a composite function that combines
the objective function with the constraining function.

It is used in solving optimization problems. Now, our objective is to
maximize the present value of the net benefit but there is a
constraint that is limited quantity.
……….
Where; = the undefined Lagrange multiplier
After combining the two functions the next thing that we
should do is to find the first order condition.
First order condition: Find the partial derivation of the
Lagrange function with respect to the each period quantity
and the Lagrange multiplier.

Numerical Example:
1.Consider a non-renewable resource and the inverse
demand function given below:
which is constant. Marginal cost of extraction which
is constant and given by birr 2 per unit (MC=2).
The resource can be used in only two time period t=2 (Y1 &
Y2). There is a fixed supply of resource to allocate between
two years and Q=20 Units and r=10%.

A)Find and , and , to make an allocation between
the two periods is efficient.
Solution:
The inverse demand function is given by;
; Where t stand for time period.
Net benefit is the difference between total benefit and
total cost. If the total available amount of this
resource is ,then the dynamic allocation of a resource
over n years is the one which satisfies the
maximization problem, i.e.

Maximize
s.t. Q
From the objective function and the constraint
form the composite function using the
Lagrangian multiplier, i.e.;
At the maximum the first order conditions must be satisfied.

That is the partial derivative of the composite function with q i
and λ must be zero.

……………
Equation (7) and (8) are called necessary conditions.
If the reserve is greater than what is demanded by
every generation, there is no need for maximization.

Illustration
Let the inverse demand function for the
depletable resource is and the marginal cost of
supplying it is $2.
If 20 units are to be allocated between two
periods, in a dynamic efficient allocation how
much would be allocated to the first period and
how much to the second period when the
discount rate is 0.1.
Given inverse demand function;
dq
,
Using equation (7), we obtain

From the above equation (10)
,solving for we get = 20 – .Moreover rearranging equation (9)
and (10) we get;
8 – 0.4 2 = λ
(1.1)
1.1(8 -0.4q1 - 2) = 8 -0.4q2 – 2
 8.8 – 0.44q1 – 2.2 = 6 -0.4q2
 6.6 – 0.44q1 = 6 – 0.4q2
 6.6 – 0.44q1 = 6 – 0.4(20 –q1)
 6.6 – 0.44q1 =6 -8 + 0.4q1
 8.6 = 0.84q1
 q1 = 8.6 = 10.238
0.84
q2 = 20-q1  q2 = 20 -10.238 = 9.762
λ= 6 – 0.4(q1) = 6 – 0.4 (10.238) = 1.905
B)What would the efficient price be in the two periods?
Solution
Pt = 8 – 0.4qt , thus
P1= 8 – 0.4 (10.238) = 3.9
P2 = 8 – 0.4(9.762) = 4.1
C)What would the marginal user cost be in each period?
The value of λ obtained from equation (9) and (10) is the
present value of marginal user cost. That is λ = 1.905. In the
case of natural resource (depletable) price is equal to the MC
plus marginal user cost.
D)Check that PVMNB1= PVMNB2
PVMNB1 = 8 – 0.4(10.238) – 2 = 1.905
PVMNB2 = 8 - 0.4(9.762) – 2 = 1.905
1.1
PVNB in each periods are equal to each other.
What does marginal user cost measures?
Marginal user cost measures the opportunity cost
of producing an extra unit of the resource against
the future generation.
MUC = PVMNB = λ

Social marginal cost is the sum of
marginal extraction cost and marginal
user cost.
SMC = MEC + MUC
E)From the above equation compute MBs
and MCs of each generation
MB1 = 8 – 0.4(10.238) = 3.905
MB2 = 8 – 0.4(9.762) = 4.095
MC1 = $2 + $1.905 = 3.905
MC2 = $2 + $2.095 = 4.095
To compute the present value, divide for
the discount rate
3.2.Public Gods, Environmental Externalities
and Market Failures
3.2.1.Public Gods
What is a public Good?
 What is the main difference between private
goods and public goods?
 Pure public goods have two basic
characteristics.
1.Non-Rivalry in Consumption: Non-rivalry in
consumption indicates the fact that one person
uses the good does not reduce the amount of good
that can be used by another person. A good is
referred to as non-rival in consumption when the
marginal cost of providing the good to another
individual to consume the good is zero. This
means there is no opportunity cost of consumption
of such a good. A broad cast radio or television
signal is an example of non- rival consumption
good because consumption of it by one person
does not decrease the consumption by others.
So, users of public goods do not compete to get
the service. Example: Radio or TV programs,
national defence, public road, road light, public
school, etc.
2.Non-Excludability in Consumption:
Non-excludability indicates that it is impossible
to exclude somebody who does not pay from
using the good. Example: TV programs before
cable TV, radio programs, national defence, etc.
For thèse good, there is no reason to presume
that private markets will supply optimal
quantities of pure public goods.
It is possible to exclude people from
watching programs they do not pay for but,
even they are likely to be inefficiencies.
Once a TV program has been produced, it
costs society nothing to let an extra person
see it. In general public goods have
different feature from private goods.
According to Samuelson, pure public good
is defined as "Each individual of
consumption of such a good leads to no
subtraction from any other individuals
consumption of that good."
 From this definition one can understand that the
consumption of private good by one individual leads
to a reduction in the availability of this good for
another consumer. According to Samuelson;
 Peace and Security of a nation
 National defense
 The law
 Air pollution control
 Street light
 Fire protection
 Weather forecast
 And public television

 Infrastructure, such as roads, bridge, public school
 Knowledge from education and public research
 Environmental amenities, such as clean air, water
etc.; are examples of public goods.
In contrast to public goods, private goods are
divisible in consumption where as pure public
goods are not. As far as 'pure private goods are
concerned, a set of property rights defines the
ownership of the good. Thus, the legal proprietor
can exclude others from enjoying the
consumption of that good. However, the exclusion
principle cannot be applied on pure public goods
due to two main reasons;
a)It might be technically difficult to exclude beneficiaries.
Take the case of national defense. It is difficult to exclude
any body there from being defended once the country has
provided national defense. Public goods are also non-reject
able. The citizen is defending whether she/he likes it or not.
Defense can be rejected by moving to another place where it
is not provided. However, one cannot reject it by selling
his/her share of defense. The same is also true for street
lighting and lighthouse.
b)Even if it is technically feasible, it becomes expensive to
exclude others, i.e., the cost of exclusion overrides the
benefit earned from its application. Therefore, public good is
a good for which exclusion is either technically not feasible
or too expensive to apply even if technically feasible.

However, still some goods are exclusive but non rival.
For instance, in low traffic period, travel on the bridge
is non rival but it is exclusive because bridge authorities
can exclude people from using it. Some goods are
exclusive but non rival. For example, air is non
exclusive but can be-rival if the byproduct of one firm
negatively affect the quality of the air and the ability
other firms to use it. In addition to this fishing in an
ocean is non exclusive but rival because as more fish
caught, fewer fish will be available for others which
increase the marginal cost of fishing. Therefore, all
goods provided by the government do not necessarily
fulfill the above two characteristics.
3.2.2. Common property Resources
(Open Access or Unrestricted Resource)
Pure public goods are different from common
property resources in that the consumption of
common property resources, for example grazing
land, by a single individual leads to a reduction of
the total by equivalent amount. However, common
property resources are rival in consumption. One
person's cattle on the grazing land are in competition
with the cattle of other persons. Property rights
cannot be assigned to any individual for some
commodities, e.g. common property.

For these resources an individual cannot sell his/
her right to the benefits of the property to another
member of the group because the benefits of the
property are made equally available to all
members of the group. David Hume in the 18th
century tried to analyze the problem which is arise
from the use of common property resources, i.e.,
the tragedy of commons. Hume considered a
number of neighbors who have access to a
meadow (a field of grass) which becomes
common property, in the sense that every member
has the right to graze his/her cattle on it but a
single member does not have the right to sell the
grazing land.
For example, as the grazing land is free for
each member, individual will tend to over-
graze the meadow. The result is the
property rapidly deteriorates and this
unregulated self-interest behavior of each
individual produces a less-than-optimal
solution for the group as a whole. The
problem is resulted from;
The indivisibility of common property
resources.
The size of the beneficiary group.
 Two characteristics of open access allocation of
resource
i.In the presence of sufficient demand, open
(unrestricted) access causes resource to be
overexploited.
ii.The scarcity rent is dissipated; no one appropriates
the rent, so it is lost. Unlimited access destroys the
incentive to conserve. An individual exploiting an
open-access resource would not have any incentive to
conserve because benefits derived from restrain
(conservation) would, to some extent, is exploited by
others. Thus, open (unrestricted) resource promotes an
inefficient allocation.
 Tragedy of the Commons
Open access leads to the most serious problem in
natural resource use. Open access resources have
given rise to what has become known popularly
the ‘tragedy of the commons’. Each agent
harvesting an open-access resource does not take
in to account the cost he imposes (in terms of
reduced productivity of the resource) on the
other agents who are also harvesting the
resource. Each of the agents harvests too much
from an efficiency perspective thereby drawing
down (reducing) the stock of the resources.
This can lead to the exhaustion (depletion)
of the resource. Such an outcome is referred
to as the ‘tragedy of the commons’. Thus,
everybody’s property in nobody’s property.
What solutions are suggested for such
problem?
The solutions to ‘tragedy of the commons’
are;
Privatization (recognizing private property
rights);

 Central government management (state property);
 Effective local self-governance (common
property).
For instance, in common property rights, the rights
to the resource are well defined, but owned by a
number of individuals over the same area. These
rights are fully defined and enforced either by local
courts or tradition and customs.
They determine the overall level of use and how the
benefits and costs are shared among the users. This
situation need not constitute a cause of market
failure.
But, open access resource is quite different. It is
completely nonexclusive. No one can be
prevented from using or exploiting an open
access resource. It can be considered as
nobody’s property sand is likely to be over
exploited. 3.2.3.Environmental Externalities
Definition:
Externality occurs when an action taken by the
firm or individual which don’t have a direct
relation or link with the given firm. Or any cost
or benefit to a firm made unconsciously by other
external factor.
In the case of perfectly competitive market, the
costs and benefits of producing and consuming is
reflected by demand and supply. An externality
occurs whenever welfare of an individual depends
not only on his/her activity but also on the activity
of some other individuals. The implication is that
the utility of an individual depends not only on his
or her but also on the activity of others.It occurs
when the utility of one individuals affects the
utility of some other individuals and hence do not
compensate. Externality occurs when market price
do not reflect the social value.
 When does Externality Occurs?
Major source of inefficiency occurs when production or
consumption activities involve benefits or costs for people
not directly involved in them. Such benefits and costs are
called externalities. Example of negative externality:
Pollution and positive externality: flowers. Externality
occurs when the production or consumption decisions of
one agent affect the utility or production possibilities of
another agent in unintended manner and when no
compensation is made by the producer of external effects to
the affected body. This is when one of the characteristics of
efficient property right is exclusivity fail to function
properly. This means if the cost or benefit of owning or
using the resource belongs to other party which doesn’t have
the property right.
Externalities create a problem very similar to
taxes: They cause producers and consumers to
react to a different set of relative prices.
Measures/solution;
 Tax negative externalities
 Subsidies positive externalities
The existence of externalities is a good example
of market failure
 It is a case in which the outcome generated by the
working of the market is no optimal.
 This sets the ground for public intervention in the
economy.
 Distinction between Social and Private Value
Private costs: The cost that is born in undertaking an activity
by the individual (agent) who undertakes the activity.
 Social costs: All other costs related to the production of
some activity. It includes private costs and other
associated costs. It is costs born to undertake the activity
plus costs imposed on all other economic agents.
 Private benefits: Benefits obtained from production or
realization of an activity by agents undertaking the
activity.
 Social benefits: Are benefits obtained from production of
an activity by economic agents undertaking the activity
plus benefits to all other economic agents.
Thus externality will exist only if: SC > PC or SB > PB

Types of Externalities
1.Negative Externality: It is the cost that the
producer and consumer of that commodity do not
take in to account. It is a cost of resource not
reflected in price of the resource. If the utility the
third parry decreases, then an external diseconomy
(external cost) is said to exist. An external cost
represents negative externality. It causes additional
costs to other members of the society that the
consumer and producers of a good will not take in to
account. In case of negative externality, social cost
exceeds the private.

The smoke produced by a particular technology which
is involuntary consumed by the people in the nearby
village is an example of negative externality (external
cost). Pollution, noise, etc. are examples of negative
externality. Like public goods, externalities are non-
rival and non-excludable in consumption.
SC = PC + EC.
2.Positive Externality: If the utility of the third party
increases, then an external economy (external benefit)
is said to occur. External benefit means positive
externality. All benefits are not reflected in the price.
Additional benefit to the society that the producers do
not take in to account. E.g.: Education:
if the individual educated, it has benefit
to him/herself, the society will be
beneficial to the benefit. The benefit
that the beekeeper generates from the
nearby flower gardening is also positive
externality. The same is also true for
pollination of flowers arising from
proximity to apiary. SB > PB.

Example of Negative Externality
River
Still factory
Hotel
Pollution
Example of Positive Externality
Flower Benefits Beekeeper

cultivation
Pollination

3.Pecuniary externality (pseudo externality): We cannot
call it purely externality (no market failure). When one
individual’s activity level affect the financial
circumstance of other but which need not produce a miss
allocation of resource in a world of pure competition. For
example, if farmers migrate to certain farmland, the
financial capacity of the existing farmers is affected but
this is reflected in the increasing in rent of land which
shows scarcity of land.
4.Unidirectional externality: Occurs when externality are
in one direction/unilateral. The case where the activity the
activity of individual A affects B but that of B do not
affect A.

5)Reciprocal externality: It occurs when
externalities are bilateral. The case when the activity
of individual A affects that of individual B and vice
versa. Example: Acid rain in industrialized countries
affects both DCs and LDCs.
6)Technological externality: This type of externality
exists when at least one of the variables in the
production or utility function of one agent falls under
the control of an external economic agent.
i.e. U1 = U(X, Y)
U2 = U(X, Y2, Y)

 Externalities and Economic Efficiency:
When externalities are existed, the price of products
does not reflect its social value. Consequently, firms
may produce too much or too little, in order that the
market outcome is inefficient. This means
externalities, either positive or negative, can be a
source of economic inefficiency.
 For Negative Externality:
When there are negative externalities, marginal
social costs (MSC) are higher than marginal private
costs (MPC).
 The difference is marginal external cost (MEC). This means,
MSC = MPC + MEC. As a result, the efficient level of output will be
lower than the profit maximizing level of output as shown in the
graph below.
Negative externalities and inefficiency

It is clear that in competitive market, the demand
curve is negatively sloped and the marginal cost
curve is U - shaped as shown above. In a
competitive market, the industry maximizes
profit when the marginal benefit and additional
unit of output is equal to the marginal private
cost, i.e. at point E. Thus, the equilibrium level of
output and price of the industry are Qe and Pe
respectively. However, efficiency is achieved
when marginal benefit is equal to marginal social
cost, i.e.,
MB = MSC.
Because, the demand curve measures the
marginal benefit of the consumer, the efficient
level of output is Qb rather than Qe and the price
level which results in efficiency is P b. Point B is
the point of efficiency. The industry which
maximizes its profit is producing excess
production which results in economic in
efficiently. The market Price P e is too low which
does not reflect the marginal social cost rather
MPC. Therefore efficiency is achieved when the
price of the product increases from P e to Pb.
• For any output level greater than Q b the
social cost is given by the difference
between social marginal cost (SMC) and
marginal benefit (the demand curve). The
social cost is shown by the shaded region in
the above figure.
• Externalities generate long run as well as
short run inefficiency. It is clear that a firm
enters in to a competitive industry when the
price of the product is above the average cost
of production, and leave when the price is
below average cost.
 In long run equilibrium price is equal to average cost
(rough run). When there is negative externality, the
average social cost is greater than the average private
cost of production. Consequently, some firms may
remain in the industry even if it is efficient to leave it.
Therefore, external costs encourage firms to remain in
the industry.
 For Positive Externality
When there are positive externalities, marginal social
benefits (MSB) are higher than marginal private benefits
(MPB). This difference is the marginal external benefit
(MEB). This means, MSB = MPB + MEB.

Similar to the above analysis, the efficient level of output
and the profit maximizing level output are quite different,
in a situation of positive externalities. The efficient level
of output is higher than the profit maximizing level of
output as indicated below.
Positive externality and inefficiency

The above graph indicates that the industry
can maximize profit when Marginal private
benefit (demand curve) is equal to the
marginal cost. This means, Qe and Pe are the
profit maximizing level of output and price
respectively. However, this output level does
not reflect economic efficiency because
efficiency is achieved when marginal social
benefit (MPB+MEB) is equal to marginal
cost, i.e. at point b, Thus, the efficient level of
output and price are Qb and Pb respectively.
It indicates that the industry can achieve economic
efficiently by decreasing the market price from Pe to Pb.
So the external benefit of the individual firm but the cost to
the society is shown in the shaded are of the above figure.
3.2.4.Market Failures
Definition
Market failure refers to the situations in which the
conditions necessary to achieve the market efficient
solution fail to exist. When properties of a perfectly-
competitive equilibrium do not hold, its resulting
equilibrium is not efficient market failure exists. It is a
condition where the market systems do not reflect the true
social values.
It is the condition in which the prices do not reflect
the true costs and benefits. A market failure occurs
whenever the individuals in a group end up worse
off than if they had not acted in perfectly rational
self-interest. Such a group either incurs too many
costs or receives too few benefits.
The primary cause of market failure involving
public goods is non-excludability. Non-
excludability means that producers of a public good
cannot prevent individuals from consuming it.
Because of this, market cannot produce efficient
level of public good.
The market provision of public goods tends to be
inefficient. Markets often undersupply public
goods. Inefficient level of production
(undersupply) of public goods results because
individuals have the incentive to free ride. Because
of the consumption indivisibility (non-rival) and
non-excludability properties of public goods,
individuals benefit from consuming a public good
without paying for it. Those who benefit without
any payment are called free riders. Free riding is
obtaining benefits without paying an appropriate
share of the costs of obtaining those benefits.
With a free-riding problem, private firms cannot earn sufficient
revenue from selling a public good. Hence they lack the incentive to
produce the socially optimal level of the public good. It would
therefore be undersupplied.
Market failure exists basically because of the following four factors;
 Monopoly power: Exists when one or a number of agents
(suppliers or demanders of a commodity) exert some market
power in determining prices.
 Externalities: An interaction among agents that are not adequately
reflected in market prices—effects on agents are external to
market. Air pollution is classic example of an externality.
 Public goods: One individual’s consumption of a commodity does
not decrease ability of another individual to consume it. Examples
are national defense, income distribution, and street lights.

 Asymmetric information: When perfectly competitive
assumption of all agents having complete information about
commodities offered in market does not hold. Incomplete
information can exist when cost of verifying information about
a commodity may not be universal across all buyers and
sellers. For example, sellers of used automobiles may have
information about quality of various automobiles that may be
difficult (costly) for potential buyers to acquire. When there is
asymmetry in information buyers may purchase a product in
excess of a given quality
 Market failure exists because of;
 The existence of public goods and externalities
 Imperfect information/ Uncertainty/asymmetry
 Imperfect competition/existence of monopoly power
 Existence of common property
 Correcting Market Failures: Given the presence of
market failure, there are four measures/ solutions
which are considered to correct it. The following are
important measures of correcting market failures.
1.Assignment of Property Rights
Some economists have argued that government should
re-arrange property rights.Coas’s theorem states that
markets can reduce the problem of externalities without
direct government involvement in the production
process using property designed property rights. For
instance, let us take a small take in which anybody can
harvest fish without payment. As a result, each person
does not care about over fishing.
If the government were rearranging property right and give to one
person the right to fish, he would fish efficiently. There would be no
externality. He would realize that if he fished too much today, he
would have fewer fish in the coming period. He would take the long
run and short run interest in to account. The main point here is that
the problem of over exploitation of resources can be solved, with
only limited government intervention, through properly assigned
properly right.
2.Regulation
Although assigning property rights can tackle some externality
problems, there is a general consensus that there are some problems
particularly those concerning the environment which needs more
government interventions. Some forms of them are regulatory
measures.

For example, are electric utilities that
burnt high Sulphur coal might not be
allowed to emit Sulphur Dioxide in to
the atmosphere. They might be required
to install devices that remove the
sulphur from fumes. This approach is
sometimes referred to as command
control approach.

3.Taxes and Subsidies
Most economists believe that taxes and subsidies reduce
environmental problems better than regulation does.
Taxes are the stick and subsidies are the carrot. Taxes
imposed on pollution are costs and thereby can
discourage pollution. In this case, taxes and regulation
are similar. However they are different in such a way
that regulations penalize firms which pollute the
environment over a specified level, but pollute as who
are below these level are free. It is clear that taxes add
the pollution cost on the cost that a company has to
incur to continue in a market. This condition decreases
the profit of the company.
Consequently, companies will be encouraged
to create new method of production which
minimizes pollution rather than keeping it as it
is. This is the efficient way of reducing
pollution in which the producer who pollutes
less will be rewarded in lower costs. Subsidies
are another way of giving incentives for the
producer to reduce pollution, may be in the
form of credits for pollution abatement
devices. However, subsides are not as such
economically efficient.
4.Marketable permits
It is another way of reducing pollution. In this
case, companies buy a permit from the
government that allows them to discharge a certain
amount of pollution. The government issues the
amount of permits so that the company produces
the same level of pollution that there would be
under the command and control approach.
However, companies can sell their permit. This
means, if a company reduces it's pollution by half,
it can sell some of its permit to another company
which needs to increase production.
The incentive effect of marketable permit is
similar to those of taxes on pollution. A
market pollution permits encourage the
development of the best possible antipollution
method rather than keeping the pollution just
under some limit by government.
Property Rights
Definition
Property right is a bundle of entitlement that
defines the right, privileges and limitations for
owner's of the rights to use a resource.
The manner in which producers and consumers
use environmental resources is decided by the
existing property rights in a society which direct
the use of resources. In a free market structure a
property right brings efficiency in production,
distribution and consumption of goods and
services. Through observing the ways how these
entitlements affect the behavior of human being,
one can easily be aware of how environmental
problems arise from government as well as
market allocation.
These property rights can be vested either
with individuals in a free market economy
or with state in a command economy. The
structure of property rights which can
result in efficient allocation of resources in
a well-functioning market economy has
four main characteristics. These are.
1. Universality - refers to all resources
are privately owned and all entitlements
are completely specified.
2.Exclusivity- refers to all benefits and costs
created as a result of owning and using the
resources should accrue to the owner and only
to the owner, either directly or indirectly by
sale to others.
3.Transferability-refers to all property rights
should be transferable from one owner to
another in a voluntary exchange.
4.Enforceability- refers to property rights
should be secured from involuntary seizure or
encroachment by others.
The owner of a resource has the right to
practice the above characteristics of well-
defined property right. For example, a
farmer who privately owns the farm has an
incentive to fertilize and irrigate it because
the resulting increase in production
increases his income level. In addition to
this, he has an initiation to rotate crops to
increase the productivity of his farm.
Exchange of a well defined property rights
facilitates efficiency.
One can explain this fact by observing
the incentives consumers and producers
face when there is a well-defined
property right. Since the seller has the
right to prevent the consumer from
consuming the product without making
payment, the consumer must pay to
receive the product.

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CHAPTER THREE

3.EFFICIENCY, PROPERTY RIGHTS, MARKET FAILURE

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NB: Efficiency in consumption lies on the contract curve.

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NB:Efficiency in the production or input efficiency lies on the contract curve.

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, Where r is the interest rate.

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Where r is the appropriate interest rate and

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 Assumptions of Dynamic Efficiency

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Step 2: Total quantity supply of the resource is limited.

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At the maximum the first order conditions must be satisfied.

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Using equation (7), we obtain

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Example of Positive Externality

Flower Benefits Beekeeper

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Negative externalities and inefficiency

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Positive externality and inefficiency

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