5. Markets and the Environment

Transcription

1 5. Markets and the Environment 5.1 The First Welfare Theorem Central question of interest: can an unregulated market be relied upon to allocate natural capital efficiently? The first welfare theorem: in an economy in which all agent are there are no there are no information is between buyers and sellers market allocations are Pareto efficient. Such an economy is usually called perfectly competitive. Reflects Adam Smith s notion of the invisible hand of the market bringing about a socially desirable outcome. The 1st welfare theorem is the basis for the faith that liberal democracies place in the market to allocate resources. Market failure: when the market fails to allocate resources efficiently due to one or more of these conditions not being met. Our focus in this course is on market failure due to externalities. 5.2 Externalities An externality (or external effect) is a cost or benefit associated with an action that is external to the agent taking that action. Externalities can be (an external benefit) or (an external cost). The important example of a negative externality is unpriced pollution: an action generates pollution and that pollution has an effect on other agents for which the polluting agent does not have to account. If an action has an associated externality then the privately optimal action may be inefficient from a social perspective, that is, it does not maximize social surplus. 1

2 Private optimum Let PB(z) denote private benefit as a function of some action z (eg. benefit from driving a car z kilometers). Let PC(z) denote the private cost of z (eg. fuel and maintenance costs). An agents will choose a level of z that maximizes her private surplus (or private net benefit): PB(z) - PC(z) Under reasonable assumptions, we can often define the private optimum by z : MPB ( zˆ) = MPC( zˆ) where MPB denotes marginal private benefit and MPC denotes marginal private cost. See Figure 5.1 $ MPC MPB $z z Figure 5.1 Private Optimum 2

3 Social optimum We will use the term Social optimum to describe the surplus maximizing allocation. Suppose action z imposes an external cost D(z) and an external benefit G(z). Define the social cost of z: and the social benefit of z: The social optimum maximizes social surplus: SB(z) - SC(z) Under reasonable assumptions we can often define the social optimum by z* : MSB(z*) = MSC(z*) where MSB denotes marginal social benefit and MSC denotes marginal social cost. A positive externality $ M SB M PC M SC M PB b c a d $z z * Figure 5.2 z A Positive Externality 3

4 Figure 5.2 illustrates a positive externality; that is G(Z)>0 (drawn for the case where D(z)=0). The difference between MSB and MPB is marginal external benefit, MEB; it is the vertical distance between MSB and MPB. Social surplus at z* is. The presence of the external benefit means: z ˆ < z * ie. the privately optimal level of activity is lower than the socially optimal level. Intuition: the agent does not take into account the she bestows on others when she chooses her action, and so her chosen level of the action is too from a social perspective. Note that a forced reallocation from ẑ to z* would make the external agents better off but would make the source agent worse off. Gain to external agents: Loss to source agent: Thus, the reallocation from ẑ to z* would not be a. However, it would be a : the gain to the external agents is greater than the loss to the source agent; the external agents could compensate the source agent for her loss and still be better off. Social surplus would increase by, the shaded area in figure

5 A negative externality $ M PB M SB M SC M PC c b d a z * $z Figure 5.3 A Negative Externality z Figure 5.3 illustrates a negative externality; that is, D(z)>0 (drawn for the case where G(z)=0). The difference between MSC and MPC is marginal external cost, MEC; it is the vertical difference between MSC and MPC in figure 5.3 Social surplus at z* is the area The presence of the external benefit means: z ˆ > z * ie. the privately optimal level of activity exceeds the socially optimal level. Intuition: the agent does not take into account the she imposes on others when she chooses her action, and so her chosen level of the action is too from a social perspective. Note that a forced reallocation from ẑ to z* would make the external agents better off but would make the source agent worse off. 5

6 Gain to external agents (reduced external cost): Loss to source agent (foregone private surplus): Thus, the reallocation would not be a. However, it would be a : the gain to the external agents is greater than the loss to the source agent; the external agents could compensate the source agent for her loss and still be better off. Social surplus would increase by, the shaded area in figure Some Important Examples of Externalities (a) Open Access Resources An open access resource is one to which many agents have free access. Examples: unregulated fisheries or grazing lands; the assimilative capacity of the environment. When one agent exploits the resource (for example, by harvesting fish) and thereby draws down the stock of the resource, she does not take into account the cost she imposes (in terms of reduced fishing productivity) on other agents who are also harvesting the resource. Each agent engages in harvesting effort up to the point where MPC=MPB; but since MSC > MPC, each agent harvests too much from an efficiency perspective. This can lead to the depletion of the resource ( ). Such an outcome is sometimes referred to as the tragedy of the commons ; the tragedy being the depletion of the commons (open access grazing lands). In principle the problem can be solved through the assignment of (as with and ), but transaction costs (and fairness issues ) often call for direct government intervention. 6

7 (b) Public Goods Public goods are characterized by two features: joint consumption possibilities high exclusion costs Joint consumption possibilities means that the benefits of the good can be enjoyed by more than one agent simultaneously; (eg. a park, a lighthouse beam, a radio signal, etc). That is, consumption of public goods is non-rivalrous (in contrast to private goods like bread). High exclusion costs means that it is very costly to prevent agents from consuming the good once it is provided (eg. it is costly to build a fence around a national park or to prevent a ship from seeing a lighthouse beam). Public goods are a kind of positive externality: the provision of the good by one agent bestows a positive benefit on other agents.(who can enjoy the public good without paying for it). Public goods are categorized by the degree to which they are non-rivalrous and/or nonexcludable: pure public goods are perfectly non-rivalrous (eg. ). impure (or congestible) public goods are subject to congestion; that is, the benefits of consumption decline as more agents consume the good (eg. ). club goods are congestible public goods with relatively low exclusion costs (eg. ). The market provision of public goods (or more generally, the provision of public goods in private equilibria) tends to be inefficient. Why?, and the external benefit cannot be priced because the good is non-excludable. Each agent has the possibility of free-riding (that is, not paying ) once the good has been provided. If the good is continuous (can be provided at varying levels), then the market tends to provide too little of the good (eg. Environmental clean-up, the creation of knowledge, care of children, infectious disease immunization) If the good is discrete (that is, it is either provided or not provided) then the market may not provide it even though it is socially desirable to provide it. 7

8 5.4 Externalities and the Environment Pollution is the important example of a negative externality. The pollution generated by one agent impacts negatively on other agents but the agent generating the pollution has no incentive to take account of that negative impact because the cost is external to her. The unregulated market outcome occurs where: MAC=0 since marginal damage is not taken into account. Marginal damage is the external cost of the pollution. See Figure 5.4 $ MAC MD e A e * $e Figure 5.4 e 8

9 Figure 5.4 illustrates the private optimum ê and the social optimum e*. There is too much pollution in the unregulated outcome; that is, ê >e*. Many other aspects of natural capital use are also characterized by externalities. Important examples include: open access to a depletable resource such as fish: when one agent harvests they reduce the of fish and thereby reduce the of other agents fishing effort; hence, each agent takes too many fish relative to the social optimum because they do not take account of this negative externality. degradation of natural areas and biodiversity loss; each user fails to take account of the cost imposed on other users by the degrading effort of their use. This leads to over-utilization. protection of natural areas or habitat as a public good. An agent who contributes to protection bestows a benefit on other agents who value the protection (a positive externality) but has no incentive to take account of this benefit. This implies too little protection. Viewed differently, each agent who values the protection has an incentive to on the contributions of others. 9

10 5.5 Externalities and Future Generations An unregulated market outcome may be inefficient with respect to intergenerational resource allocation. We now wish to examine why that inefficiency may occur. We will focus on two possible sources of inefficiency: future generation welfare as a public good open access to natural capital (a) Future generation welfare as a public good This idea originated with Marglin (1963). The basic idea is the following. If each current generation individual derives some benefit from the well-being of some future generation then the well-being of that future generation is a public good from the perspective of current individuals. Thus, there arises that can lead to an efficiently low level of provision for future generations. In equilibrium there is likely to be too much and not enough. (b) Open access to natural capital Much natural capital is characterized by open access (eg. assimilative capacity) and open access can lead to inefficiency in intergenerational resource allocation. This inefficiency is due to the open access to natural capital. Each individual in period t recognizes that the natural capital that she leaves intact for her descendants will also be available for consumption by the descendants of her fellow citizens. She cannot protect the legacy that she leaves. Recognition of this fact leads her to leave less than she otherwise would. This creates a disincentive to leave that legacy even when current agents are intergenerationally altruistic. This inefficiency due to open access to natural capital indicates a role for policy intervention restore efficiency. 10

11 5.6 Market failure and Transaction Costs If two agents can potentially be better-off at some allocation than at the existing allocation, why don t the agents themselves agree to a reallocation? Where is the need for government intervention? The so-called Chicago view is that there is no role for government intervention except to assign and enforce. If this is done, then agents can solve problem themselves. We have seen that underlying any government-imposed reallocation is an implicit assignment of property rights; any such implicit assignment of property rights could in principle be made explicit (for example, by assigning ownership rights to a fishing ground, park, etc.) and let market transactions realize any potential efficiency gains. Transaction costs Why might the market not realize such gains even if property rights are assigned? The problem is transaction costs (Coase 1960). The cost of negotiating an agreement can more than offset the gains from the agreement; i.e., the process of moving from one allocation to another is itself costly. For example, the enforcement of private property rights over the atmosphere would be prohibitively costly (if not impossible). A separate bargaining arrangement between the thousands of people affected by air pollution and every individual car driver, for example, would involve astronomical transaction costs, surely higher than a government brokered arrangement. Thus, the role for government intervention with respect to the environment for efficiency reasons must be argued on the grounds of over the market. That is, in some cases government intervention may be able to achieve an efficiencyenhancing reallocation at lower transaction costs than the market (eg. global climate change agreements). The mere existence of externalities, and their adverse implications for the environment, is not enough to justify government intervention. Any proposed government intervention on efficiency grounds should be subject to the question: In many aspects of environmental policy, the case for intervention is compelling. 11