Chapter 14
Examining Market Failure: Pollution and Parks
In This Chapter
Identifying why the market fails to produce what people want
Figuring out how to get the market to produce what people like
The well-known economist Nicholas Stern wrote in 2007 in a report commissioned by the U.K. government that climate change “is the greatest market failure the world has ever seen.” He estimated that the costs of climate change if not addressed would be equivalent to losing between 5 and 20 percent of global gross domestic product each year, now and forever. Those are more than stern (no pun intended) words. Environmental damage is a market failure and we need to understand how the market is failing us.
On a cheerier environmental note, Grand Teton National Park is a pristine ecosystem enjoyed by people from across the United States and beyond. However, such a natural treasure owes its heritage not to the marketplace but to the intervention of the Rockefeller family (who did well in the market). In the 1920s, John D. Rockefeller established a blind trust and spent $1.5 million secretly buying ranches in the valley with the intention of creating a park to be enjoyed by everyone. The Rockefeller family has a long tradition of supporting national parks through philanthropy. They’ve established or enhanced more than 20 national parks from Maine to Wyoming, including Grand Teton, Acadia, Virgin Islands, Shenandoah, and Great Smoky Mountains. Why is it philanthropy and not the market that creates parks?
To economists, these two cases are linked by the concept of market failure, which comes in two types:
- Where a market provides in equilibrium something in excess of what society wants: Pollution.
- When a market fails to provide in equilibrium the quantity of something that society does want: In the case of public parks, a bias exists against producing goods for which the market has difficulty charging.
Economists spent a lot of time looking at these two types of market failure and came up with a library of ways to categorize the problems and find methods of solving them. In this chapter, we lead you through some of the simpler cases, so that you can see how economists approach the issue of market failure and what steps policy makers can take to solve it.
Coming to Grips with Externality: Too Much of a Bad Thing
Sometimes, as a result of trading, markets produce byproducts that society doesn’t want or like, such as pollution from industrial processes. While looking at the specific problem of pollution, economists came up with a definition of the problem that makes sense more generally about the use of markets.
When two people make a trade and some part of the costs (or benefits) of that trade falls on a third party, that third party experiences an external cost (benefit). The general existence of external costs (benefits) is called an externality.
Here’s an illustration. In a market, two people — Molly, homeowner, and Nick, a fence builder — make a contract. In this contract, Molly decides that she wants Nick to build a fence that faces the front of a neighboring house. Molly hands over her money, and Nick builds a fence.
On the surface, all appears fine. But suppose Molly’s and Nick’s trade places a cost (or benefit) on the third party — the neighbor Olivia — who wasn’t part of that trade. The cost (benefit) that falls on Olivia is the external cost (benefit).
Externalities can be one of two types:
- Positive externalities: Benefits conferred on a third party.
- Negative externalities: Costs that a third party incurs.
When economists look at externalities, they try to be careful about remedying them. For instance, Molly’s and Nick’s trade creates value and benefits to both Molly and Nick. A cost falls upon Olivia if the fence is undesirable from her perspective because it blocks her view — that’s the bit economists want to remedy. However, they don’t want to impose a ban on Molly and Nick trading if they can avoid doing so.
Instead they want to find mechanisms that reduce the degree to which an external cost falls upon Olivia without using legal prohibitions. This section discusses two of the approaches that economists advocate: one involving taxes and the other negotiation and contracts.
Both these solutions, however, depend on feasibility. For example, imagine an airline trying to negotiate with every single person affected by its landing noise. Ultimately, if you can’t negotiate or work out a social-cost calculation (that is, a tax), your last resort may be legal prohibition.
Reducing externalities with taxes
Pigovian taxes, so named after Arthur Pigou, an early 20th century economist, are one method for tackling the issue of externalities. The idea is quite simple and is based on identifying the following two sets of benefits and costs:
- Private: Benefits and costs gained or incurred by the two main parties in a trade.
- Social: Benefits and costs from the trade that fall upon everyone.
The key is to align the private cost to the social cost, which a government can do by taxing the private transaction.
Pigovian taxes in action
Here’s how Pigou’s method works. When a person is trying to get the maximum benefit from doing something, he does so up to the point where marginal benefit equals marginal cost (see Chapter 3 for a refresher). Thus, without a tax, the equilibrium in a perfectly competitive market is where marginal benefit is equal to price is equal to marginal cost. If you measure the marginal benefit by marginal revenue equal to price — which works for a private transaction — you can derive a simple model (see Figure 14-1).
© John Wiley & Sons, Inc.
Figure 14-1: How a Pigovian tax makes revenue equal to social cost.
Note the presence in the figure of two possible equilibria:
- Market equilibrium: Marginal private cost is equal to marginal revenue equal to price.
- Social equilibrium: Marginal social cost equals marginal revenue equal to price.
Assuming that the transactions themselves are costless, the government can add the Pigovian tax to each unit of the good whose private cost is less than the social cost. For example, think of coal-powered electricity that causes pollution. Taxing the production of coal-powered electricity reduces the quantity traded and therefore reduces the quantity of the “bad” — that is, pollution — produced.
The difficulty of taxing
Economists often study what they call wicked problems, meaning that they tend to have no solutions or have solutions that themselves are subject to widespread disagreement. The case of taxing production to reduce a “bad” is just one of many such problems.
In particular, a number of problems exist with Pigou’s approach:
- Measurement: Measuring and determining the social cost of something isn’t easy and therefore neither is determining the right level of tax. Even Pigou found this to be a wicked problem in and of itself. For instance, some part of the cost may not be easily measurable because it’s borne psychologically by the people subject to the external cost, and so doesn’t readily show up in any data you can use for calculating the cost.
- Gaming: The level of the tax can be influenced by lobbying on behalf of the industry whose output production produces the externality, such as pollution. Lobbying is a form of gaming that consumes resources and can lead to losses for society.
- Reciprocity: In a society, all people are interconnected to a varying degree. Where do you draw the line of when one person’s trade is another’s external cost? If you move into an area knowing that, for instance, an extremely loud nightclub is nearby that could be a nuisance, to what extent can you hold the nightclub owner responsible? After all, you chose to live there.
Compensating the affected party through contracts
The problems mentioned in the preceding section don’t invalidate the Pigovian approach, but they do indicate some problems with using it in practice. Therefore, economists have considered other ways for reducing negative externalities.
One such approach is based on people contracting with each other, instead of getting the government involved via taxes. This method is a contrasting way of looking at the problem compared to Pigou’s and is often used as a basis for developing policy on big societal problems such as climate change.
Coase theorem
Ronald Coase looked at the problem of the divergence of social cost from private cost in a famous paper in 1960. His analysis became a famous result called the Coase theorem.
The Coase theorem is based on the following two related points:
- When property rights are completely assigned and parties can negotiate costlessly, the parties can always negotiate an efficient outcome; the legal framework just determines the payer of the cost.
- Negotiation is sufficient to solve the problem unless property rights are incomplete or negotiating is too costly.
The first point about property rights is a key observation. In many of the most challenging environmental problems that economics has been asked to solve, the issue is that no one has a property right over the resource. For example, consider who owns the air: either no one does, in which case the first problem exists of not being able to assign the property rights completely; or everyone does, in which case negotiation between every citizen is unfeasible and costly.
Whereas Pigou’s model implies that social cost can be known and measured, Coase’s focus is on cases of unremedied externalities in situations where property rights aren’t fully assigned.
He uses a thought experiment about a doctor and a baker who work next door to each other. The doctor needs quiet to treat patients, but the baker’s kneading and pounding of dough makes a noise that’s essential to the baker’s work. The prevailing logic was that the baker should therefore have to compensate the doctor.
Coase begins by pointing out the reciprocal problem. You can equally well frame the doctor as moving to a place where a bakery exists and then demanding that the baker bake in silence. Now suppose that the wise town mayor is fed up with being harangued over the argument of who’s responsible for the noise. He points out that the baker could install quieter machinery for $500 and the doctor install soundproofing for $1,000. The cheapest or most efficient solution is therefore that the baker installs quieter machinery.
So that solves that, right? Well, not quite. In fact, two different possibilities exist depending on who has a property right over the ability to make — or be free from — noise:
- If the doctor has the “sound rights” over the building: The baker has to pay the $500 for quieter machinery.
- If the baker has the “sound rights” over the building: The doctor has to pay to reduce the noise. He could soundproof his own office for $1,000, although paying $500 to the baker for quieter machinery makes more sense because it’s a far cheaper option.
Therefore, you can arrive at the best or efficient solution through negotiation, regardless of who’s responsible for the noise, as long as property rights are completely assigned and people can negotiate. Here, the cost of remedying the externality is $500, the most efficient outcome regardless of who has the “sound rights” — the only difference is who ultimately pays the $500.
Coase is interested in why parties don’t negotiate when they can and in what to do when property rights aren’t assigned.
One thing that the Coase theorem absolutely does not do is say that the market can solve all externalities; that’s an incorrect interpretation of the argument. Instead, the Coase theorem says that if you can completely assign property rights and you can negotiate, then the market may solve the externality. However, there may be cases where the solution may be unfeasible to implement.
Coase theorem in practice
Economists use Coase’s reasoning when thinking about emissions — particularly of carbon — on a global scale; the idea spawned the approach that led to cap and trade policies for climate change. Regarding a carbon tax, no doubt you can envisage all kinds of difficulties with implementing the tax on very different nations — should a rich nation like Norway have the same taxes as a poorer one like Burkina Faso?
Instead, the carbon-market approach assigns each nation a tradable property right over its own emissions. If one country or region emits less than its property right allows, it can sell its spare capacity to a country or region that is less able to reduce its emissions. If it can’t (or won’t) reduce its emissions, instead of paying a tax the country or region, can buy “emission certificates” from regions that are not using their full allocation. The hope is that after trading, everyone is made as happy as possible.
Making the Market Produce What Otherwise It Would Not: Public Goods
The market is not able to produce every good that society wants.
Earlier we mentioned the Grand Teton National Park. What’s remarkable about much of America’s national park lands is that they are gifts to local, state, and federal governments by wealthy industrialists.
Public parks are almost never provided by a market system because they are what we call public goods, which are a type of goods with the following features:
- Non-rival: One person’s consumption of a public good doesn’t affect another person also enjoying the good, which means that the marginal cost (see Chapter 3) of supplying the good to one additional person is zero.
- Non-excludable: It is not feasible to prevent people from enjoying the good, even if they haven’t paid for it.
This special set of economic circumstances means that the market doesn’t provide these goods. If the marginal cost is zero and the good is non-excludable, price tends to fall to the marginal cost, which is zero. Market systems therefore have incredible difficulty pricing a public good and covering the costs of its provision.
We discuss some suggested ways of remedying the situation in this section. As you read what follows, though, bear in mind that not everything that looks like a public good up front turns out to be one, and some things that you’d think aren’t turn out to be very similar to public goods.
Defining goods by rivalry and excludability
You can categorize goods in all sorts of ways, but here we’re interested in thinking through whether the good is rival (the marginal cost is higher than zero) or excludable (you can keep out someone who hasn’t paid from consuming the good), or both.
Four options exist:
- Normal good: One that’s rival and excludable, which constitutes most things the market provides.
- Public good: One that’s non-rival and non-excludable, such as street lighting or radio broadcasts.
- Club good: One that’s non-rival but excludable. Some pay TV services fall into this category, though you can argue that technology has eroded some of the excludability of the services by enabling people to get them by illegal means.
- Common good: One that’s rival but non-excludable. Think about grazing rights on common land: no one owns the land and so it’s non-excludable, but because grazing affects the amount of grass available to another cow or sheep, it’s definitely rival. We discuss a special economic problem that affects these goods in the later section “Considering a common (goods) tragedy.”
A few really tough cases are tricky to place in one category. One of the most difficult is the case of pure information, such as TV, software, music, ebooks and audiobooks, and other digitally transmitted material, which is non-rival — when you’ve written a song it doesn’t matter whether one person or a billion hear it, the cost was the fixed cost of writing the song, not the transmission cost — but partially excludable and often charged for.
Seeing spillovers, considering public benefits, and providing public goods
When you get down to the simplest definitions, a market makes the marginal cost of something equal to its marginal benefit. A trade gets made when someone agrees to pay a cost for a given benefit. In the case of goods with public benefits, though, a difficulty exists in equating the price with the marginal benefit. This problem is similar to the difficulty of setting Pigovian taxes — social costs and social benefits are difficult to calculate (check out the earlier section “Reducing externalities with taxes”).
A public benefit is actually another kind of externality, one that gives a benefit to a party not involved in the transaction. In this case, the person gaining the benefit can be seen as a free rider — which, perhaps slightly unfairly, compares him to a person riding a train without paying.
A challenging problem is that almost no one exactly knows what the public benefit is and, because the marginal benefit can’t be easily measured, no one really knows how to price it in a market through negotiation. The practical result is that a market almost never provides goods that fall into the public good categorization.
So how are these goods provided, and what can the public do to get more of them? Well, several mechanisms have been used over the centuries:
- Patronage: In the past, many composers of music — which has public-good aspects — benefitted from patrons. These rich supporters of the arts decided what to give based on their estimation of how valuable a composer’s work and how their funding of it added to their social standing.
- Philanthropy: In this approach, wealthy individuals or groups bequeath items to society as a social good that fits with their view of their roles as “good” people. This is a bit like Blanche Dubois in A Streetcar Named Desire depending “on the kindness of strangers.” Economists are reluctant to depend on it.
- Public provision: Of course, the government can also be the patron or philanthropist from general public spending. This is one of the ways that cities and counties get essentials such as parks and street lights. The disadvantage is that it takes provision into the political realm, and things get a little murky — too murky for some economists.
- Crowdfunding: This modern approach is a grass-roots variant of the philanthropy or patronage models. Here, the Internet makes it cheap enough to allow a large number of people to be patrons, each contributing a small slice of revenue. The research into the effectiveness of this solution is still new, but it has already brought products that the market system was unwilling to develop to the public. Many enjoyed the movie Veronica Mars, a result of the Kickstarter mechanism.
None of these systems is perfect. Crowdfunding can fail, patronage can result in too much control over the thing funded, and public provision can make everything a political battle. With a little help — for example, a tax break to induce philanthropists to part with their money — you can get more of the provision, but all these mechanisms can still fail to produce what society wants.
Considering a common (goods) tragedy
Common goods create contention wherever you go, because although they’re rival, they’re also non-excludable.
This specific issue, called the Tragedy of the Commons, is contentious because when a good is common, every user has an incentive to overuse the resource.
To see why, think about cod stocks. No one owns the sea, and so it’s non-excludable. But because the stocks of cod in the sea are rival, overusing the resource leads to depletion. Overuse is exactly what happened in reality, leading to the collapse of cod populations such as those on the Grand Banks in the North Atlantic (people used to say that they were so full of cod that you could walk straight over them — though you’d need to watch your step).
Over the years, the Tragedy of the Commons has been refined, mainly in thinking about it in terms of poor management of a common resource. In particular, Elinor Ostrom, the first woman Nobel Prize winner in Economics, did a lot of research into how indigenous people, such as the Masai in Kenya, managed common land. She found that the dimensions of the Tragedy of the Commons were overstated and relied on people not using a common framework.
Ostrom’s main point is that when people can agree upon a common framework for managing the commons, they can eliminate or at least lessen the tragedy. She describes four conditions that can achieve this goal:
- Resources with definable boundaries are easier to preserve: International waters, for example, are one of the harder cases, because the boundary definition is imprecise.
- Communities find managing the resource easier with the threat of resource depletion and a lack of substitutes: The fear of resource depletion is an incentive to preserve the resource.
- The presence of a community helps manage the resource: In particular, a strong, stable economy has a collective interest in preserving the resource.
- The community needs a set of rules and procedures: These can include dealing with individual overuse and agreeing on common use.
In essence, when you put these four conditions together, you end up with a community treating the common good as if the community holds a property right over the resource, which means that people in the community are willing to invest time and effort into maintaining it.
Preventing good things: Anti-commons
The flipside of the Tragedy of the Commons is the anti-commons, which reflects situations where too many private property rights prevent the development of a common benefit.
Think about the difficulties of negotiating with all the people affected by building a new road in town. At some point, because all property owners want to be compensated up to their estimation of their value of their property, the required buyouts can be prohibitively expensive, and necessary common projects fail to take place.
One answer is the power conferred to the government called eminent domain. Essentially, this power can force landowners to sell their property, typically for public projects like highways, when a “fair” price is met.
That way, society gets its product, and property owners get compensation — though not so much that it imperils the project. This system isn’t perfect by any stretch of the imagination — court cases can go on for years — but it does at least prevent holdouts from stopping projects going ahead.
Another serious problem of the anti-commons effect is in the area of pharmaceuticals. Many medicines depend on prior discoveries for at least part of their formulas, and patents still cover some of them. If the patent holders demand the best possible fee, and you can’t negotiate it down, investing in developing the new medicine can become unprofitable In these cases, society loses through the excessive ability of owners of the properties to extract the highest possible price for their work.
The general remedy to this situation is compulsory or pooled licensing. In these situations, the government negotiates a standard fee with patent holders to prevent them from stopping the new product.