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 price-takers there are no externalities there are no scale economies information is symmetric 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 in 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 positive (an external benefit) or negative (an external cost). The archetypal 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. Private optimum Let PB(z) denote private benefit as a function of some action z (eg. benefit from

2 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 ẑ : MPB ( zˆ) = MPC( zˆ) where MPB denotes marginal private benefit and MPC denotes marginal private cost. See Figure 5.1 Social optimum Social optimum : surplus maximizing allocation. Suppose action z imposes an external cost D(z) and an external benefit G(z). Define the social cost of z: SC(z) = PC(z) + DG(z) and the social benefit of z: SB(z) = PB(z) + G(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 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. The presence of the external benefit means: z ˆ < z * ie. the privately optimal level of activity is lower than the socially optimal level.

3 Intuition: the agent does not take into account the external benefit she bestows on others when she chooses her action, and so her chosen level of the action is too low 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: area(abcd) Loss to source agent: area(acd) Thus, the reallocation would not be a Pareto improvement. However, it would be a potential Pareto improvement: 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 area(abc), the shaded area in figure 5.2. A negative externality 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. 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 external cost she imposes on others when she chooses her action, and so her chosen level of the action is too high 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 (reduced external cost): area(abcd)

4 Loss to source agent (foregone private surplus): area(abd) Thus, the reallocation would not be a Pareto improvement. However, it would be a potential Pareto improvement: 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 area(bcd), 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. In principle the problem can be solved through the assignment of property rights (as with fishing licenses and timber licenses), but transaction costs (and fairness issues ) often call for direct government intervention. (b) Public Goods Public goods are characterized by two features: joint consumption possibilities high exclusion costs

5 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). 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. Public goods are categorized by the degree to which they are non-rivalrous and/or nonexcludable: pure public goods are perfectly non-rivalrous (eg. radio signals, a lighthouse beam, knowledge). impure (or congestible) public goods are subject to congestion; the benefits of consumption decline as more agents consume the good (eg. roads, radio spectrum, a wilderness area). club goods are congestible public goods with relatively low exclusion costs (eg. a swimming pool, a restaurant). The market provision of public goods (or more generally, the provision of public goods in private equilibria) tends to be inefficient. Why? MSB>MPB, and the external benefit cannot be priced because the good is nonexcludable. Each agent has the possibility of free-riding (that is, not paying ) once the good has been provided. 5.4 Externalities and the Environment Pollution is the archetypal 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:

6 MAC=0 since marginal damage is not taken into account. Marginal damage is the external cost of the pollution. See Figure 5.4 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; degradation of natural areas and biodiversity loss; protection of natural areas or habitat as a public good. 5.5 Externalities and Future Generations An unregulated market outcome may be inefficient with respect to intergenerational resource allocation. 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 If the current generation values 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 a free-rider problem that can lead to an efficiently low level of provision for future generations. In equilibrium there is likely to be too much current consumption and not enough saving. (b) Open access to natural capital Much natural capital is characterized by open access (eg. assimilative capacity) and

7 open access can lead to inefficiency in intergenerational resource allocation. Open access means that current agents cannot protect the legacy they leave for future generations from consumption by other current agents. This creates a disincentive to leave that legacy even when current agents are intergenerationally altruistic. 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 property rights. 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; that is, the process of moving from one allocation to another is itself costly. The role for government intervention on efficiency grounds rests on the possibility - in some circumstances - of institutional advantage 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: can the government do better than the market? In many aspects of environmental policy, the case for intervention is compelling.

8 $ MPC MPB $z z Figure 5.1 Private Optimum

9 $ MSB MPC MSC MPB b c a d $z z * z Figure 5.2 A Positive Externality

10 $ MPB MSB MSC MPC c b d a z * $z z Figure 5.3 A Negative Externality

11 $ MAC MD e A e * $e e Figure 5.4