Ch 10: Market Failures

Chapter 10
Market Failures
Geog 3890: Ecological Economics
Our founding fathers did put this into the Constitution…..
We hold these truths to be self-evident: that all men are created equal; that they
are endowed by their Creator with certain unalienable Rights; that among these
are Life, Liberty, and the pursuit of Happiness. That, to secure these Rights,
Governments are instituted among Men, deriving their just powers from the
consent of the governed, That, whenever any Form of Government becomes
destructive of these ends, it is the Right of the People to alter or to abolish it,
and to institute new Government....
And, these were also put in the Constitution as legitimate functions of government…
"... establish Justice, insure domestic Tranquility, provide for the common defense,
promote the general Welfare, and secure the Blessings of Liberty to ourselves and our
Outline of Topics
Characteristics of Market Goods
Coase Theorem
Congestible Goods
Wealth Effects
Public Goods
Missing Markets
Open Access Regimes
Nonrival, excludable resources
Inalienable Rights
Intertemporal discounting and Net Present Value
Markets only function efficiently for a
narrow class of goods.
• Monopoly is a market failure of a structural nature
• No competition
• Clearly defined and enforced Property Rights
• Open access regimes
• Public Goods
• Common Property
• Externalities
• Big Question: How common and significant are the
market failures outlined here relative to the market
goods that markets work so well for?
• An excludable good is one for
which exclusive ownership is
• It must be possible for the person
or community that owns the
good to use the good or service
and present others from using
the good or service.
• Excludability is virtually
synonymous with property rights.
• Markets forces tend to not
produce nonexcludable goods.
• Why would an entrpreneur
interested in profit build a
Excludability & Institutions
• Or… Why libertarians are such property
rights enforcement fanatics
• Excludability is the result of institutions.
• Excludability is not a property of the
resource per se but rather of the regime
that controls access to the resource.
• Intellectual and Creative property –
patents and copyrights
• Ecosystem services such as bee
pollination, climate regulation, timber
• For markets to operate efficiently the
goods must be excludable
What property rights institutions are better funded:
Copyright enforcement for singer songwriters or patent
enforcement for pharmaceutical companies?
Who paid for the Research & Development?
• Definition: A rival good is a good such that use of a unit of the good
by one person prohibits use of the same unit at the same time by
• Rivalness may be qualitative, quantitative, or spatial in nature.
• Rival goods: Food, Clothing, Cars, and houses
• Nonrival goods: streetlights, information, and sunny days.
• All stock-flow goods are quantitatively rival.
• Fund-service goods may be rival or nonrival.
• Bicycle, car, clothes, house – spatially rival at each point in time.
• All nonrival resources are fund service.
• Market efficiency requires that the marginal cost to society of
producing or using an additional good or service be precisely equal
to the marginal benefit. The marginal cost of nonrival goods to
additional users is zero.
• Goods MUST BE RIVAL in order to be efficiently allocated by the
Excludability and Rivalness
What might make you think this figure was taken from a standard econ textbook?
Congestible Goods
• Some nonrival goods such as UV protection by the ozone layer are not
affected by how many people use them.
• Other nonrival goods can have degraded quality if they are used by large
numbers of people: Bridges, roads, the internet.
• KEY POINT: Goods that are nonrival , nonexcludable, or both will not be
provided or allocated effciently by the market.
A vital concern of
ecological economics is the
development of policies
and institutions that will
lead to the efficient
allocation and production
of nonrival and/or
nonexcludable resources
Don’t say “Tragedy of the commons”
say “Open Access Regimes” (EE PC)
“Rational selfinterest does not
create an invisible
hand that brings
about the greatest
good for the greatest
number, but rather
creates an invisible
foot that kicks the
common good in the
Hardin’s paper is so
very important
because it is a
profound criticism of
economic theory.
Is the Open Access Regime problem
really just a property rights problem?
• Many traditional economists argue that the open access
problem is simply a lack of enforceable property rights.
• Unfortunately for many of the resources o concern to us, the
ability to bestow individual or corporate property rights is
more the exception than the rule and in some cases even if
property rights are granted and enforced it does not lead to
efficient outcomes.
• This idea is the force behind the push for “Privatization”. It
raises some pretty important questions: Should clean air be
sold to the highest bidder? How about potable water? How
about access to a nice day at the seashore?
Provocative Question for
Kenneth Boulding’s market solution to the population problem
Kenneth Boulding actually proposed a
solution to the overpopulation problem
based on awarding all women the
“Property Right” to 2.1 children
(replacement fertility level) in the
form of tradable permits. Needless
to say, many people object to such a
system. Or, you could give each man
and woman 1.05 tradable permits for
procreation. Can you suggest a better
• What do you think of this idea?
Excludable & Nonrival Goods
• “Trade Secrets” as a type of Monopoly
• Patents, Copyrights, and Information
• Patents are a mechanism to make trade secrets legally
excludable with institutional support paid for by the
• The rationale being essentially this: Without excludable
property rights, people would not profit from inventing
new things. Inventors would have no incentives, and the
rate of advance of technology would slow, to the
detriment of society.
• Once a patent expires the knowledge embodied in it
becomes a pure public good.
“The efficiency of the commons”
• Programmer’s adage: The grass grows greener when grazed on.
• Intellectual progress is invariably a collective process.
• In academia, people have freely shared and built upon each other’s
ideas for centuries. (Issac Newton quote)
• The internet and much of its associated software were primarily the
result of freely shared knowledge.
• In many ways the free flow of information and ideas creates an
efficiency of the commons. (and is vital for ‘information’ assumption)
• Keeping existing knowledge artificially expensive during the life of a
patent can make the production of new knowledge more expensive.
• There was a Supreme Court case involving the argument that extention
of patent rights to 95 years for a corporation and life plus 70 years for an
individual actually deters the progress of science. (the argument failed)
• Conspiracy Theory: What would happen to a patent on a motor that
could allow cars to get 200 mpg?
Open Source Software
Tough row to hoe in a purely capitalist world
Profits, Patents, & Pharma
Market Failure or Moral Failure?
• Medical Patents can also generate serious
• Imagine an AIDS drug that mitigates symptoms and
significantly reduces risk of transmission of the
• The ‘reduced transmission rates’ benefit of this
drug are a nonexcludable positive externality.
• Currently drug companies hold patents on these
medicines, making them prohibitively expensive
for 3rd World Countries, decreasing their ability to
control the disease, and increasing the risk of
everyone contracting the disease.
• From the drug company perspective – total
elimination of the disease would be a very
• The irony is that patent rights are protected in the
name of the free market, yet patents simply create a
type of monopoly – the total antithesis of a free
Excludable Congestible Goods
• Congestible goods are nonrival at low levels of use and rival at high
levels of use (e.g. Beaches, Roads, Parks, Broadband, etc.)
• A solution: Treat congestible goods as market goods during peak
usage and nonmarket goods otherwise.
• Is it ‘fair’ to do this with National Parks?
• Is it ‘fair’ to do this with roads and public swimming pools?
Pure Public Goods
Pure public goods are both nonrival and nonexcludable.
The Public Park Example
Assume $100 Million for a nice public park.
Society is willing to pay $150 million for the park.
Would market forces (i.e. the private sector) build the park?
$150 for a Lifetime pass would not generate enough revenue (why?)
$ 1 for each use would not generate enough revenue (why?)
If the park were free, more people would use it, increasing the total
welfare of society while imposing no additional costs on society.
• The market will not provide the park even as a private good, and if it
did, id would not be efficiently allocated.
• Despite the fact that Benefits are $50 Million greater than Costs, this
Public Good would not be built without a social contract to make it
happen – e.g. A Government.
Free Riders & Prisoner’s Dilemma
Subsistence Farmers and Ecosystem Services
A small sharecropper in Southern Brazil is kicked off
his land share so that the landowner can grow
soybeans under a heavily mechanized system
requiring little labor. The soybeans are exported to
Europe as cattle feed for higher profits than the
landowner could make using sharecroppers to
produce rice and beans for local markets. The
sharecropper heads to the Amazon and colonizes a
piece of land. He whacks down way more ecosystem
services provided by that rainforest than he reaps in
timber sales and subsistence farming.
Why not just pay the farmer
for the ecosystem services?
Many obstacles prevent this sort of exchange from
Most people are ignorant of the value of
ecosystem services.
Free-rider effects means many beneficiaries of
public goods will not pay for their provision.
We lack the institutions suitable for transferring
resources from beneficiaries of ecosystem
services to the farmer who suffers the
opportunity cost of of not deforesting.
Public Goods and Scarcity
• “Anyone who accepts the premise that global ecosystems
create life sustaining ecosystem services must believe that
public goods are critically important. Yet market economic
theory offers little advice concerning the production and
allocation of public goods.”
• “One of the underlying assumptions of ecological economics
is that many of the scarcest and most essential resources are
public goods (services provided by natural resource funds),
yet the existing economic system only addresses market
Do we have the incentives right?
• If new inventions are driven primarily by
the pursuit of profits, then we have a
serious bias against the invention of public
goods or technologies that preserve or
restore public goods.
• When we spend more money on elective
breast augmentation surgeries than we do
on the prevention of Tuberculosis we have
perhaps crossed a threshold of insanity –
driven by market forces.
• If the market is extremely effective at
producting market goods but very poor at
producing or preserving public goods, then
over time, public goods inevitably become
scarce relative to private goods, giving rise
to a problem called macro-allocation.
32,000 Barbies, equal to the
number of elective breast
augmentation surgeries performed
monthly in the US in 2006.
Public Goods and Substitution
• NCEs posit that manmade capital and
natural capital are infinitely
• NCEs posit that price signals spur
invention and innovation of substitutes
for scarce goods.
• What happens when the resources
becoming increasingly scarce are public
• Public goods have no price, and there
will therefore be no price signal telling
our entrepreneurs that we need
substitutes, nor is there any profit to
be made by creating such substitutes.
• Conventional market economics does
not address this question.
Distribution of Public Goods in Space
• Local, Regional, national, and
global provision of public goods
in the form of ecosystem
• These spatial effects complicate
who benefits from what services.
• This complicates how and who
should be compensated for the
preservation of ecosystem
• Examples: Storm protection, soil
erosion prevention, urban
cooling by transpiration, carbon
sequestration, etc.
Market Failure: Externalities
• An externality occurs when an
activity or transaction by some
parties causes an unintended loss or
gain in welfare to another party, and
no compensation for the change in
welfare occurs. If the externality
results in a loss of welfare, it is a
negative externality, and if it results
in a gain, it is positive. The Marginal
External Cost is the cost to society
of the negative externality that
results from one more ‘unit’ of
activity by the agent.
• Examples: Water polluting widge
manufacturing, Sprucing up the
neighborhood, air pollution, water
pollution, etc.
The Coase Theorem & Externalities
1) Ignorance of outcomes
2) Transaction costs
3) Multiple actors and
Free riders
Internalizing costs will make the externalities problem go away. Who you give the
‘rights to pollute’ or ‘rights to clean air/water’ are is the ‘Wealth Effect’ problem.
The problem is well behaved with one power plant and one laundry. However when
More players enter the game the solutions get way more complicated.
Missing Markets
• Everyone who might want to produce or consume a good must be
able to participate in order to insure efficient allocation of
resources. (This is problematic for future generations)
• Auctioning the Mona Lisa in Waco Texas. Will it get best price?
• How can we provide future generations with property rights to
• How we handle intergenerational gambles with unknown reward
structures is an ethical issue, but it would certainly seem that most
ethical systems would demand at the very least that we do not risk
catastrophic outcomes for the future in exchange for nonessential
benefits today.
• What have future generations ever done for us?
Intertemporal discounting
• Most conventional economists assume
that money is an adequate substitute
for anything, and therefore anything in
the future is worth less than the same
thing today. In general, the present
value (PV) of a sum of money t years in
the future, Xt, when the interest rate is
‘r’, will be given by:
PV = Xt / (1 + r)t
• What would I pay you a
year from now for a $2
hamburger today?
Cost Benefit Analysis (CBA)
• The farther off in time that a
cost or benefit occurs, the
more we discount its
present value. The basic
equation for this is on the
• ‘r’ is called the discount
• Question: Do you think the
convention of estimating
net present value ignores
the rights of future
generations? Why or why
Uluru (aka ‘Ayer’s Rock’) is a national treasure
of the Australian NP system. Suppose it costs $3
million a year to operate this park and brings in
$4 million of revenue each year. What is the
value of the rock for a year 100 years in the
future? Assume a 3% discount rate.
Big Concept of this chapter
• “We must recognize that the ‘optimal’ production of pure
public goods cannot be based on the criterion of Pareto
efficiency. The public good problem appears to be beyond the
scope of market allocation. You might think about policies
and institutions that could be effective mechanisms for
allocating public goods and the ecological fund-services the
provide many of them. One possibility worth considering is a
participatory demoncratic forum that captures a broader
spectrum of human values than self-interest, and does not
weight participant values solely by the purchasing power at
their disposal.”
• Pg 183 Ch 10 Market Failures
What is Nature Worth?
Video from University of Minnesota

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