Module V – Market Failure

A market failure occurs when the market does not allocate scarce resources to generate maximum social welfare. A wedge, so as to speak, exists between what a private person does given market prices and what society wants him or her to do to protect the environment. Such a wedge implies wastefulness or economic inefficiency, resources can be reallocated to make at least one person better off without making anyone else worse off.

This module looks at five different cases of market failure, namely: externalities, non-exclusion, non-rival consumption, non-convexities, and asymmetric information. We will then focus on how markets can be expanded to include non-market goods. This draws from the seminal work of Ronald Coase (1960) who argued that government intervention in the form of emission standards, fines, taxes, subsidies, bans and suchlike were unnecessary if transaction costs are zero, i.e. if we remove any institutional constraints that prohibit defining property rights.

Efficient Market Hypothesis

Lodyard (1987) notes that “the best way to understand market failure is to first understand market success.” The First Fundamental Theorem of welfare economics maintains that a competitive equilibrium is always Pareto Efficient, i.e. no one can be made better off by reallocating resources without making someone else worse off.  The following are the conditions that must exist for an efficient, competitive market equilibrium:

  1. A complete set of property rights must exist so that buyers and sellers can exchange assets freely for all potential transactions and contingencies.
  2. Consumers and producers behave competitively by maximising benefits and minimising costs.
  3. Market prices are known by consumers and firms.
  4. Transactions costs are zero so charging prices does not consume resources.

Furthermore, for property rights to be considered well defined (condition 1 from above) they must exhibit the following characteristics:

a)      Comprehensively assigned: All assets or resources must either be privately or collectively owned, and all entitlements must be known and enforced effectively.

b)      Exclusive: All benefits and costs from the use of a resource should accrue to the owner, and only to the owner, either directly or by sale to others.

c)       Transferable: All property rights must be transferable from one owner to another in a voluntary exchange.

d)      Secure: Property rights must be secure from involuntary seizure or encroachment by other people, firms, or the government.

Externalities

Following from Coase’s diagnosis of incomplete markets leading to market failure, Kenneth Arrow (1969) defines market failure as “a situation in which a private economy lacks the incentives to create a potential market in some good, and the non existence of this good results in the loss of efficiency.” This means quite simply, one person imposes a cost or bestows a benefit upon another with neither compensation nor consent.

Non-exclusion and the Commons

A good is said to be excludable when it’s possible to use prices to ration individual use. And it is said to be rival when it is possible to ration the use of the said good. A “common property resource” refers to a property rights regime that allows some collective body to devise schemes to exclude others, thereby allowing the capture of future benefit streams and “open-access” implies there is no ownership in the sense that “everybody’s property is nobody’s property”. A fishing ground would be an example of the latter. Economic theory tells us that for a self interested fisherman fishing on an open access fishery, the dominant strategy is to not cooperate and this outcome is a Nash Equilibrium. A Nash equilibrium exists when neither player has an incentive to unilaterally change his strategy.

Elinor Ostrom and others have documented several real world examples of actual common property resources in which players achieve a cooperative outcome. There groups establish self-governing common property regimes without strict private property rules or government intervention. Research suggests that successful self-coordination of actual common property rights regimes seem to depend, among other things, on information and transaction costs of achieving a credible commitment to the collective, active rules to self-monitor and sanction violators, and the presence of boundary rules that define who can appropriate resources from the commons.

Non-rivalry and Public Goods

Pure Public Goods are by definition, non-rival. That is, one person’s consumption does not reduce another person’s consumption. In addition, since everyone benefits from the services provided by a pure public good and no one can be excluded from these benefits, there is a general concern that people will “free ride”. A free-rider is someone who conceals his or her preferences for the good and enjoys the benefits without paying for them. Using some simple mathematical models it is possible to show that in the case of a public good such as environmental protection, a market will always under-provide, and in the case of a public bad such as pollution, it will over-provide.

Non-convexities

Standard economic theory generally assumes that the marginal benefit and cost functions associated with increased pollution are well behaved- marginal benefits are decreasing, while marginal costs are increasing. Therefore, if a set of complete markets exists for clean water or pollution control, the market sends the correct signal about socially optimal level of pollution.

But for many physical systems the marginal benefit or cost curve need not be so well behaved. The costs of marginal damages, for instance, may initially increase with increased pollution but then may actually decrease or go to zero as the physical system is destroyed and there are no additional marginal costs as pollution continues to increase4. The system is destroyed; nmore pollution cannot make it any more dead. This is a nonconvexity, and implies that more than one optimal level of pollution may exist.

Asymmetric Information: Moral Hazard and Adverse Selection

Market failure due to asymmetric information can occur due to two reasons, when a person in a transaction does not have full information about either the actions or the “type” of the second person. The former is referred to as moral hazard, while the latter is known as adverse selection.

Moral hazard creates two problems for environmental assets. First, when the regulator cannot monitor actions, a person has an incentive to shirk on pollution abatement since he bears all of the costs and receives only a part of the benefit. Second, when a private market cannot monitor actions, an insurer might withdraw from or limit the pollution liability market. The market provides an inefficient allocation of risk.

Adverse selection is a problem in the market for eco-products. Here the basic problem is that these products may be of perceived higher quality and more ethically desirable to some consumers given the production process, but these very same reasons make these more expensive to produce considering the environment is not subsidizing its production. Unless there exists a very meticulous consumer watchdog groups, any seller may claim greater environmental friendliness and ask for a higher price; the buyer, however, has difficulty or faces too high a cost in determining whether this is actually the case.

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Other causes of inefficiency that causes market failure could be diverging private and social discount rates, which stem from a difference in private and social risk premiums. Political process are yet another source of inefficiency, more specifically rent seeking. Rent seeking is the use of resources in lobbying and others activities directed at securing protective legislation, which increases the net benefits going to a special interest group but frequently lowers the net benefits to society as a whole.

After examining most causes of inefficiency that lead to market failure, in the pursuit of efficiency, we we will now look at Ronald Coase’s conception of how private resolution through negotiation (most effective for a two-party case) and court legislations (in defining property and liability rules) could counter the effects of inefficiency.

Coase Theorem

Assume a world in which some producers or consumers are subject to externalities generated by other producers or consumers. Further, assume (1) everyone has perfect information, (2) consumers and producers are price-takers, 93) there is a costless court system for enforcing agreements, (4) producers maximize profits and consumers maximize utility, (5) there are no income or wealth effects, and (6) there are no transaction costs. In this case, the initial assignment of property rights regarding the externalities does not matter for efficiency. If any of these conditions does not hold, the initial assignment does matter.

With regards to court intervention to solve disputes on externalities, Coase theorem plays an important role is concluding that irrespective of initial assignment of property rights (with the mentioned initial conditions), efficient level of production results. The theorem shows that the very existence of an inefficiency triggers pressures for improvements. Also, Liability rules tend to correct inefficiencies by forcing those who cause damage to bear the cost of that damage.

Twin Market Failures

In the real world, multiple market failures may exist at the same time making the assessment of the contribution of each difficult. An example of twin market failure is that of environmental policy and diffusion of new technologies to address the environmental challenges. The externality of pollution is generally internalized through an environmental policy. However, setting an efficient environmental policy requires a comparison of the marginal costs and benefits associated with the reduction of pollution.  With the introduction of new technologies, marginal costs and benefits of pollution reduction are liable to change typically lowering the marginal cost of pollution reduction.

If we convert the above environmental policy & technological innovation interaction to a dynamic one over time, choosing an efficient environment policy requires keeping in mind the fact that technology will over time lower the cost of pollution abatement. For costs to be lowered, innovation as well as adoption of technology must occur. Both, however, are characterized by externalities. Due to knowledge externalities, it is generally not profitable for a firm to invest in innovation. Too little of innovation is produced due to its positive externality. Further, the cost of new technology to a user may also depend on how many others users have adopted it. Generally, the more other people use the technology the lower will be its cost. Thus, there is an externality in adoption of technology as well.

Both innovation and diffusion of new technology are characterized by additional market failures related to incomplete information. Imperfect information about returns on investment in innovation encourages too little research and development. In the context of environmental problems such as climate change, the huge uncertainties surrounding the future impacts of climate change and thus the likely return on R&D exacerbates the problem. With respect to technology adoption, imperfect information about the impact of the technology can slow the diffusion of technology.

The fact that markets might underinvest in technology when dealing with the market failure relating to pollution control strengthens the case for making sure that environmental policy is designed to foster, rather than inhibit innovation. The twin market failures here are thus related: pollution represents a negative externality, and new technology generates positive externalities. Hence, in the absence of appropriate public policy new technology for pollution shall be doubly underprovided by markets.

Due to these twin market failures, there is a case for explicit technology policy to address environmental problems in relation to the environmental policy. There are several reasons why a mix of technology and environment policy might work better than mere environmental policy. Firstly, there are practical limitations of environment policy. Though most scientists would argue that the pricing greenhouse emissions is the most efficient method for addressing global climate change, most of the countries have largely put off significant environmental policy intervention. Hence, a policy directed at fostering greenhouse reducing technology may prove better policy. Secondly, policies directed at technology rather than environment is generally politically more feasible.

The governments can foster technology policy for environment by focusing on innovation and adoption policies.

  1. Innovation Policies: The government could either use the demand or supply side measures to incentivize innovation. The demand side approach increases the return to developing such technologies. The supply side approach would involve making it less expensive for firms to undertake research in environment, or by performing the research in public institutions.
  2. Adoption Policies: The most important problem associated with adoption is that of technology lock in. If the government encourages the diffusion of a particular technology, it is possible that it could become so entrenched that it might stifle the development of a superior technology. To avoid this, focus should be on making sure that specified environmental objectives are achieved without focusing on a particular technological approach. Technology diffusion could be encouraged by subsidies and tax credits. It can also be improved by encouraging information provision.

In conclusion, when dealing with twin market failures, normal approaches mentioned in the first two sections of this article may not work in entirety. There is a need to supplement the policies with non-market based interventions as well by identifying the linkages between the failures in environment and technology markets.

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Module Leaders: Abhishek Kannur, Neeraj Singh and Nikhil Joseph

Readings Covered: Tietenberg Chapter 4; Kolstad Chapter 5-6; Jaffe et al (2005); HSW Chapter 3.

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