Part II: “Missing Markets”: Externalities, Public Goods, and Property Rights

Part II: “Missing Markets”: Externalities, Public Goods, and Property Rights The previous three chapters have described how a perfectly functioning market system works and why it results in quantities of ordinary goods that make human beings as well off as possible, both at a point in time and over time. This desirable outcome assumes that human tastes, production technology, and equilibrium prices are known. Moreover, it was seen in these chapters that producing public goods at levels where (aggregate) marginal social benefits equal marginal social provision costs yields an outcome that shares the desirable efficiency properties of perfect markets for private goods. It would seem that all we have to do is add up individual marginal benefits and merely compare them to marginal costs and do all activities with MB $ MC. To decide what long-term investments–public or private–to pursue it would seem that the same decision-making rules that apply to private goods also apply to public goods, namely, invest if net present value, NPV, is greater than zero. There are many reasons, however, to suspect that performing these calculations will be far more difficult for public goods than for private goods. For private goods you must reveal your true marginal willingness-to-pay (paying the market price) for otherwise you are unable to obtain the good. Similarly, a seller has an incentive to supply any good that has a marginal cost lower than the marginal revenue obtained by a sale. In Part II, we discuss the role of “missing markets,” situations where markets do not exist or where the equilibrium marginal price is not related to either marginal social benefits or marginal social costs. In such cases, incentives become distorted, and buyers and sellers exchange quantities that end up making us collectively worse off. I prefer to call the problems discussed in this part “missing markets,” rather than the more traditional “market failures” because the problems really represent a failure to have markets, not a failure associated with markets per se. It is just that certain markets are unable to exist. Chapter 4 considers the implications of situations where either buyers or sellers do not receive all the marginal benefits or pay all the marginal costs of their actions. We shall see, not surprisingly, that if buyers do not receive all of the benefits from buying a good they will buy an amount that is non-optimally small from society’s perspective. A simple environmental example would be the purchase of lady bugs to eliminate aphids from rose bushes. Many lady bugs will go to other households’ backyards and eat their aphids yielding benefits to society that might not be considered by the purchaser, particularly if they are not fond of their neighbors. Goods giving rise to positive externalities, such as this lady bug case (or more important cases such as years of education), will be under-purchased and under-consumed from society’s perspective relative to the greater optimal purchase quantities. Similarly, if consumers damage other households (e.g. noise damage from loud music or pollution from a fireplace) they will tend to over-purchase and over-consume. This follows from the fact that their private benefits overstate full social benefits because their actions lower benefits others receive, by the so-called negative externalities. Usually, when people think about environmental problems, however, they are thinking about firm behavior. When sellers do not pay all of the marginal costs associated with producing their good (e.g. a steel producer not considering its air pollution damage), they will tend to over-produce goods relative to the socially optimal amount of production. The true marginal costs will exceed the marginal costs paid by the seller, so a profit-maximizing seller will end up selling goods that have marginal social costs greater than marginal social benefits. Chapter 4 discusses in detail the problems caused by externalities of every kind and the natural policy response to dealing with these problems. That policy response is to “internalize the externality” (introduce taxes or subsidies that result in buyers and sellers seeing the true costs of their actions, eliminating the missing market), or to directly regulate behavior. But, as will be clear in later chapters it is very difficult to know how big externalities actually are in real-world cases. In Chapter 5, we return to discussion of public goods, recognizing that such goods result in another sort of “missing market” problem. Here the problem is the inability to sell a product to someone if they cannot be prevented from consuming that product without paying. Illustrating, if you were to install a large and costly filter to clean up the air in a community, you cannot earn any revenue from your efforts because others can consume the clean air whether they pay you or not. In fact, it would be irrational for people to pay in such situations (though perhaps some public-spirited individuals might pay), hence you would abandon your project. The air would go uncleaned, even in cases in which the true marginal benefits were vastly in excess of the true marginal costs, because the supplier cannot force households to pay for the benefits they receive. Externalities and public goods are related because externalities tend to occur in public good media (e.g. air or noise pollution, CO2 buildup). One is much more likely to find graffiti in a public restroom than in the bathroom of a private home, because private owners have an incentive to take care of the assets that they own. The Coase Theorem,1 as a potential means of solving problems of externalities and public goods provision, is discussed in Chapter 6. In this chapter it is seen that under certain circumstances voluntary transactions between those damaged and those doing the damage would be expected to automatically solve “missing market” problems. The circumstances under which the Coase Theorem is operable, however, are somewhat limited. Ronald Coase’s argument may best be thought of as providing a reason why there are not more environmental problems than there are. Illustrating, a neighbor might burn firewood in their fireplace, damaging you, but they are much less likely to dump their trash over the fence separating your properties. This is because “property rights” are very clear in the case of land (deeds of ownership exist) and compensatory and punitive damages can be awarded at low cost by courts to the damaged party. It is much more difficult to know whose air is whose or how much damage is due to any one polluter. 1Ronald Coase "The Problem of Social Cost." Journal of Law and Economics 3 (October 1960): 1-44. Chapter 4. Externalities As “Missing Markets.” Recall from earlier chapters that suppliers will supply goods as long as their marginal cost is less than or equal to the price they receive and that demanders will demand goods as long as their marginal benefit is greater than or equal to the price. This individual self-interest was seen to lead to equilibrium market price and output levels at which marginal cost equals marginal benefit–moreover, given tastes and technology, government cannot improve on these output levels. But suppose a buyer, in consuming a good, has a negative impact on other people (e.g. trips leading to congestion, noise pollution from stereos, or smoke from a fireplace). This case is depicted in Figure 4.1, where beginning at a fairly low output level others begin to be harmed by increasing consumption of the goods generating the negative externalities . The negative benefits that others receive–the congestion, the air pollution, or the noise pollution–subtract from the private benefits to arrive at the full marginal social benefits of consuming goods with negative consumption externalities. Hence, the true social benefits of consuming such goods lies below the private benefits as shown by the dashed line in Figure 4.1. In the uncontrolled case, consumers would take too many trips, light too many fires, and play stereos too loud. The equilibrium quantities of activities giving rise to negative externalities is too large, at QE, relative to the socially optimal quantities, shown as Q* in the figure. The welfare loss from too much of the offending activity is the (generally growing) sum of the amounts by which marginal cost exceeds marginal benefits for output between Q* and QE. This welfare loss is shown by the shaded area in Figure 4.1. It should be noted that the external damages to those harmed actually fall by a larger amount than the shaded area, when moving from QE to Q*. The external harm is reduced by the entire area above the MSBSociety curve but below the DPrivate curve between Q* and QE. The environmental gain, in excess of the shaded area, is a transfer from those who consume the good that gives rise to the negative external effects to those experiencing them. Where is the “missing market” here? The missing market stems from the fact that the negative impacts on those harmed do not register with those engaging in activities giving rise to those negative impacts. An obvious way to correct this situation, first advanced by Arthur Pigou in 1920,12 is to increase the price (by a “tax” or “fine” ) on those consuming the good in an 1A.C. Pigou, The Economics of Welfare. Macmillan and Co. London, 1934 4th edition. 2Fines are usually more popular with environmentalists, since they convey disapproval of the activity under consideration. However, if the fine is set higher than marginal damages, society collectively will be made worse off since a smaller than optimal amount of the offending activity will occur.

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