Externalities as a Source of Market Failure Property Rights, Externalities and Environmental Problems Introduction Property Rights: refers to a bundle of entitlement de…ning the owner’s rights,privileges, and limitations for use of the resource. An owner of a resource with a well-de…ned property right has a powerful incentive to use that resource e¢ ciently. WHY? An e¢ cient structure of property rights has 3 main characteristics: 1 2 3 Exclusivity: all bene…ts and costs should accrue to the owner Transferability: PR should be transferable from one owner to another Enforceability: PR should be secure from involuntary seizure by others When well-de…ned property rights are exchanged, as in market economy, this exchange facilitates e¢ ciency. Property Rights, Externalities and Environmental Problems Consumer and Producer Surplus Consumer Surplus The incentives consumers and producers face when a well-de…ned system of property rights is in place. Price Consumer Surplus P* Demand Q* Quantity Property Rights, Externalities and Environmental Problems Consumer and Producer Surplus Producer Surplus The incentives consumers and producers face when a well-de…ned system of property rights is in place. Price Supply P* Producer Surplus Q* Quantity Property Rights, Externalities and Environmental Problems Externalities as a Source of Market Failure Introduction Externality: 1 An activity by one agent causes a loss of welfare to another agent 2 The loss of welfare is uncompensated Property Rights, Externalities and Environmental Problems Externalities as a Source of Market Failure We can draw a number of conclusions about market allocations of commodities causing pollution externalities: 1 The output of the commodity is too large 2 Too much pollution is produced 3 The prices of products responsible for pollution are too low 4 As long as the costs are external, no incentives to search ways to yield less pollution per unit of output are introduced by the market 5 Recycling and reuse of the polluting substances are discouraged since release into the environment is so ine¢ ciently cheap The e¤ects of a market imperfection for one commodity end up a¤ecting the demands for raw materials, labor and so on. Property Rights, Externalities and Environmental Problems Types of Externalities Positive Externality (external economy) Negative Externality (external diseconomy) Pecuniary Externality Property Rights, Externalities and Environmental Problems Externalities as a Source of Market Failure An externality exists whenever the welfare of some agent, either a …rm or household, depends not only on his or her activities, but also on activities under the control of some other agent. Simple Externality Examples The Rat Race Problem Simple Externality Examples The Rat Race Problem It is a contest for relative position. It helps explain: Why students work too hard when …nal marking takes the form of a ranking. The intense competition for a promotion in the workplace when candidates compete with each other and only the best is promoted Assume that performance is judge not in absolute terms but in relative terms Player 2 Player 1 Low effort High effort Low effort (1/2,1/2) (0,1-c) High effort (1-c,0) (1/2-c,1/2-c) Note that 0 < c < 1/2 Simple Externality Examples RIVER POLLUTION River Pollution Simple Externality Examples RIVER POLLUTION River Pollution Assume: 1 Two …rms are located along the same river 2 The upstream …rm u pollutes the river 3 The production of the downstream …rm,d, is a¤ected 4 P=1 5 Both …rms produce the same output 6 Labor and Water are used as inputs 7 Water is free, labor receives w 8 F u (Lu ) and F d (Ld , Lu ) with 9 ∂F d ∂L u <0 Each Firm acts independently and seeks to maximize its own pro…t: π i = F i ( ) wLi Simple Externality Examples RIVER POLLUTION Equilibrium with river pollution Upstream Revenue πu Ou Cost Revenue L*u,L*d Cost Od πd Downstream Simple Externality Examples Improperly Designed Property Rights Systems Other Property Rights Regimes: 1 State Property Regimes: The government owns and control the property 2 Common-property Regimes: The property is jointly owned and managed by a speci…c group of co-owners 3 Open-access Regimes: no one owns or exercise control over the resources 1 Tragedy of the Commons: Nobody is willing to conserve the natural resource Simple Externality Examples Improperly Designed Property Rights Systems Example of Open-access Regimes