Market Failure & Environmental Protection
Economic efficiency rule – produce the quantity of output where marginal social benefit equals marginal social cost.

Market failure – occurs when the market does not produce the optimal quantity of output.

One cause of market failure is a lack of perfect competition.

Externality – a benefit or a cost of an activity that affects third parties.
  • When an externality is generated, the private market will fail to produce the optimal quantity. 
  • Private market equilibrium will occur where the private market demand curve intersects the private market supply curve (where marginal private benefit equals marginal private cost).
  • If there are no externalities, the private market equilibrium is also the optimal quantity.
  • If a market generates an external benefit, the private market will underproduce compared to the optimal quantity.  The private market equilibrium (where MPB = MPC) will be less than the optimal quantity (where MSB = MSC).
  • If a market generates an external cost, the private market will overproduce compared to the optimal quantity.  The private market equilibrium (where MPB = MPC) will be greater than the optimal quantity (where MSB = MSC).
Internalizing externalities:
  1. Persuasion
  2. <>Establishing private property rights and reaching voluntary agreements.  Whichever party is assigned the property rights, a more efficient solution can be worked out.
  3. Taxes and subsidies.  The tax (subsidy) needs to be equal to the external cost (benefit).
Externalities can also be controlled through government regulation of the externality producing activity.

Government regulation of externalities may result in costs that exceed benefits:
  • Regulations are generally imposed on a blanket basis (or “one size fits all”).
  • Regulations are sometimes imposed without careful comparison of costs and benefits.
  • Regulations are costly.
Pollution – any undesired byproduct of production.
  • The ideal level of pollution is usually not zero.  The cost of reducing pollution to zero is usually greater than the benefit of achieving zero pollution.
  • Pollution control should be pursued up to the point where the MSB of control equals the MSC.
Methods of pollution control:
  1. Regulatory standards.  May result in costs that exceed benefits<>
  2. <>Market environmentalism.  Achieve environmental goals through the use of the market.  Allows for pollution control at the lowest possible cost.
Public goods – nonrivalrous in consumption and nonexcludable.
A good is rivalrous in consumption if consumption by one person prevents or interferes with consumption by another person.
A good is nonrivalrous in consumption if consumption by one person does not hinder consumption by others.

A good is excludable if nonpayers can be excluded from consumption.
A good in nonexcludable if nonpayers cannot be excluded from consumption.

Because a public good is nonexcludable, consumers can obtain the benefit of the good without paying for it.  This is the free rider problem.  Thus, public goods must be produced by government.
Market failure can also be caused by:
    <>Adverse Selection - a party is confronted with a different selection than expected
    Asymmetric information – when a party to an exchange has information that the other party doesn’t have.
    <>Moral hazard – one party to an exchange changes their behavior in a way unexpected by and detrimental to the other party.
The Environmental Threat
  • We have come to recognize that pollution impairs health, reduces life expectancy, and thus reduces labor-force activity and output.
  • People in the nation’s most polluted cities are 15 to 17 percent more likely to die prematurely than those in cities with the cleanest air.  Pollution entails real costs, as measured by impaired health, reduced life spans, and other damages.
  • Air Pollution
    1. Acid Rain
      • Sulfur dioxide (SO2) is an acrid, corrosive, and poisonous gas created when high-sulfur fuels are burned.
      • Sulfur dioxide emissions contribute to the formation of acid rain that destroys vegetation and forests.
      • Coal burning alone accounts for about 60 percent of all emissions of sulfur oxides.
    2. Smog
      • Nitrogen oxides (NOX), another ingredient in the formation of acid rain, are also a principal ingredient in the formation of smog.
      • Automobile emissions account for 40 percent of urban smog.
      • Bakeries, dry cleaners, and production of other consumer goods account for an equal amount of smog.
    3. The Greenhouse Effect
      • Excess buildup of carbon dioxide is creating a gaseous blanket around the earth.
      • The potential effects of this blanket are intensely debated.
      • Everyone agrees that the burning of fossil fuels is a significant source of CO2.
      • The destruction of rain forests, which absorb CO2, also contributes to the greenhouse effect.
  • Water Pollution
    1. Organic Pollution
      • The most common form comes from the disposal of organic wastes from toilets and garbage disposals.
      • Sophisticated waste-treatment plants can reduce organic pollution up to 99 percent.
      • Inadequate treatment systems often result in the closure of waterways and beaches.
      • The 7.5 billion chickens and 161 million cows and hogs raised each year generate 1.4 billion tons of manure.  If improperly managed, that organic waste can contaminate water supplies and trigger algae blooms that choke waterways and kill fish.
    2. Thermal Pollution is an increase in the temperature of waterways brought about by the discharge of steam or heated water.
  • Solid-Waste Pollution
    1. According to EPA estimates, we generate over 5 billion tons of solid waste each year.
    2. Most solid wastes originate in agriculture and mining.
    3. The smaller amount of solid waste originating in residential and commercial use is considered more dangerous, however, simply because it accumulates where people live.
The Cost of Pollution
  • Some monetary measure of environmental damage is important to our decision making.
  • We won’t get clean air unless we spend resources to get it.
  • Assigning Prices.
    1. In some cases it is fairly easy to put a price on environmental damage.
      • Scientists can measure increases in cancer, heart attacks, and other disorders.
      • Economists can estimate the dollar value of damage by assessing the economic value of lives, forests, lakes, and other resources.
    2. In other cases, measuring the cost is difficult at best.  For example, it is difficult to measure the value of lost
      • Views of sunsets.
      • Wildlife.
      • Recreation opportunities.
  • Cleanup possibilities.
    1. One of the most frustrating things about all of this environmental damage is that it could be avoided.
    2. The EPA estimates that 95 percent of current air and water pollution could be eliminated by known and available technology.
    3. Pollution control measures include: auto-emission controls, smokestack cleaners, improved sewage and waste-treatment facilities and cooling towers for electric power plants.
    4. Solid waste can be reduced by less packaging, recycling more materials or transforming garbage into a useful energy source.
Market Incentives
  • Market incentives play a major role in pollution behavior.
  • The Production Decision  
    • Business managers seek to make a profit-maximizing production decision.
    • Production Decision – The selection of the short-run rate of output (with existing plant and equipment).
    • The rate of output which maximizes profits is where MR = MC.
  • The Efficiency Decision
    • Efficiency Decision – The choice of a production process for any given rate of output.
    • The efficiency decision requires a producer to choose that production process that minimizes costs for any particular rate of output.
    • Unfortunately, this efficiency decision does not lead to a low production of pollution.
    • Pollution abatement can be achieved, but only at significant cost to the plant.
    • The behavior of profit-maximizers is guided by comparisons of revenues and costs, not by philanthropy, aesthetic concerns, or the welfare of the environment.
Market Failure: Externalities
  • Pollution does not generally appear on the profit-and-loss statement for a firm.
  • These external costs (pollution) are called externalities.
    • Externalities – Costs (or benefits) of a market activity borne by a third party: the difference between the social and private costs (benefits) of a market activity.
  • Whenever external costs exist, a private firm will not allocate its resources and operate its plant in such a way as to maximize social welfare.
    • Social Costs – The full resource costs of an economic activity, including externalities.
    • Private Costs  - The costs of an economic activity directly borne by the immediate producer or consumer (excluding externalities).
  • When social costs differ from private costs, external costs exist.  In fact, external costs are equal to the difference between the social and private costs.
  • When external costs are present, the market mechanism will not allocate resources efficiently.  This is a case of market failure.
  • If pollution costs are external, firms will produce too much of a polluting good.


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this page is maintained by Reed Fisher
last updated January 15, 2011