Module 4: How to correct market failures?

Econ 57a, Environmental Economics, Fall 2020

Module 4: How to correct market failures

In this module, we are going to talk about:

Governmental interventions are often necessary when free markets cannot achieve efficient outcomes:

In fact, some of the most important functions for the government are 1) providing public goods 2) establish and protect property right and market institutions; and 3) correcting market failures

Different types of intervention

So, how should the government intervene to “internalize” the externalities?

The mining pollution example (from the last module)

Red Keep LLC can mine the uranium with a marginal private cost (MPC) of: P = Q. It also generates an marginal external cost (MEC) of $10 per unit. The marginal social cost is thus P = Q + 10.

The market demand for uranium is: P = 30 - Q

A socially efficient equilibrium is: \(Q^* = 10\), and \(P^* = 20\)

Private market will arrive at: \(Q' = 15\), and \(P' = 15\)

The tax instrument

One particular way to do so is to put a pollution tax on the firm. The tax is often referred to as the Pigovian tax, named after A.C. Pigou, an English economist, in the 1920s.

The idea is simple:

Tax instrument in the mining example

The producer faces a MPC of P = Q, plus a pollution tax of t=10. Thus the actual cost for the producer becomes

P = Q + 10

Equating the supply with the demand of P = 30 - Q, we get:

\(Q^* = 10\), and \(P^* = 20\)

which is exactly the socially optimal price and quantity.

Real world examples of (proposed) pollution taxes:

Pigouvian policies are in theory efficient, but not without caveats:

Yet still, economic theory is dominated by the Pigovian thought before the 1960s

Wait a minute. Is there another way?

Coase (1959) The Federal Communications Commission

The Mock Trial

Jon Snow vs. Daenerys Targaryen (2020)

Paper I gave Jon

Your name is Lord Jon Snow, a rancher living near the Long Lake, a small lake in the state of Wyoming. The lake is the only freshwater source nearby, and your herd of cattle depends on that lake to survive. Unfortunately, a farmer nearby named Daenerys Targaryen also wants control for the Long Lake to irrigate her field, and there is no way that the lake can be shared between you two. You think you are entitled to the right to use the lake, so you decide to take her to court.

According to the best of your estimate, the lake generates $X worth of value to you. That is, if you lose control of the lake, there will be about $X worth of economic damage to your cattle.

Paper I gave Dany

Your name is Queen Daenerys Targaryen, a farmer/landowner living near the Long Lake, a small lake in the state of Wyoming. The lake is the only freshwater source nearby, and your farmland depends on that lake to remain irrigated. Unfortunately, a rancher nearby named Jon Snow also wants control for the Long Lake to feed his cattle, and there is no way that the lake can be shared between you two. You think you are entitled to the right to use the lake, so you decide to take him to court.

According to the best of your estimate, the lake generates $Y worth of value to you. That is, if you lose control of the lake, there will be about $Y worth of economic damage to your cattle.

The polluter-pays principle

Assigning the “right to clean environment” to the public: polluters have to seek permission from the public (pay) in order to pollute.

The idea is simple: assign the property right to either party, and let them negotiate with each other.

And the government has no need to intervene at all!

The Coase theorem

If property rights are well-defined, and there are no transaction costs, then no matter what the initial allocation of resources, negotiation between parties will reach a pareto-optimal outcome WITHOUT interventions from the government.

How is the Coase theorem useful?

All we need is a “clearly-defined” property right structure, and then we can:

TQs from you

I strongly identify myself with the notions of the Coase Theorem. I believe that when you get to the grassroots level of human welfare, individuals looking to have the best outlooks for other is the foundation of a just society … The elimination of government in matters of environmental economics leaves the solution to be dealt with the parties involved where the two, three or however many don’t lose any benefit from unnecessary government intervention.

President Reagan ran on the notion the government isn’t the solution to problems but itself is the problem. A hands off approach by government would give the proper room for those involved to settle the environmental issue.

TQs from you

It was quite frustrating to read how his theory was weaponized by right-wing groups to provide support for the deregulation movement; the article clearly makes the point that this inaccurate interpretation of Coase’s ideas has severely increased inequities in today’s economy and had a negative effect on the American political environment.

TQs from you

The discussion of people being able to reach a solution without the government intervening is interesting. This does work, but in cases where there is a power or information imbalance this wouldn’t occur many of the times. People would be able to use imbalances to turn things to their favor, taking advantage. Coase discusses this himself, by putting the relevant information disclaimer in his statement. It’s always important to remember power imbalances in any form.

On transaction costs

Steven N.S. Cheung (2001)

“I had thought about this for over ten years: private property, efficient market, and zero transaction cost cannot co-exist, because if there’s no transaction cost, there is no need for a market or the delineation of property rights.”

“One night, it occurs to me in my dream, that the purpose for establishing property rights and markets is exactly to lower transaction costs. After that, everything becomes clear.”

Steven N.S. Cheung (2001)

“If transaction costs are zero, then central-planning (and the people’s commune) would be the best economic institution. That is what Mao Zedong missed in his thinking - there are huge information costs and transaction costs that prevent a central-planning economy from efficiently allocating its resources.”

TQ from you:

I do find Coase theorem effective when applying it to household contract responsibility system in China (in the 1980s). Before the household contract system, the Chinese government is controlled for all the property rights and the government assign the rights to each business. After returning the property right to the market , incentives are strengthened and there’s more output.

Coase Theorem and Cap-and-Trade

One of the most important innovations of the Coase Theorem is cap-and-trade program:

Basic Components of a Cap-and-Trade are:

  1. Establish a policy cap, i.e., the optimal quantity of pollution emission/resource extraction for the society
  2. Issue permits to the polluters/extractors with the total amount of quota equal to the cap
  3. Each polluter’s emission cannot exceed the amount of quota they hold
  4. Establish a market for the polluters to trade their quotas with each other

What changed?

  1. The permit (and the pollution at large) is now a private good:
  1. There is now a market to trade these permits:

Caveats about Cap-and-Trade

If tax and cap-and-trade are equivalent, then what is the fuss about choosing carbon tax or carbon trading?

The Role of Uncertainty

Prices vs. Quantities

Are common-pool resources always better governed by governmental regulation?

The Case for Privatization (Enclosure)

Coase theorem also clearly suggests that if property rights are clearly-defined, then the resource allocation will be efficient.

Trophy Hunting

A bit about Mozambique

Coutada 11: the Meat Locker

In year 1994, a South African named Mark Haldane leased Coutada 11 from the Mozambique government

Mark wanted to set up a trophy hunting program in the area to attract wealthy Westerners, so he worked with the locals:

Trophy hunting site opens up:

What happened after a couple of years?

And, financially, the program is completely self-sustainable.

Class Reflections #4

Please reflect on the two following questions:

  1. Why does privatization in Coutada 11 achieve better social and ecological outcomes?
  2. Do you see any problems/concerns with the approach? Is it universally applicable to other parts of the world?

Most modern economic theory describes a world presided over by a government (not, significantly, by governments), and sees this world through the government’s eyes. The government is supposed to have the responsibility, the will and the power to restructure society in whatever way maximizes social welfare; like the US Cavalry in a good Western, the government stands ready to rush to the rescue whenever the market ‘fails’, and the economist’s job is to advise it on when and how to do so. Private individuals, in contrast, are credited with little or no ability to solve collective problems among themselves. This makes for a distorted view of some important economic and political issues. -Sugden(1986)

Coase and Pigou represent two alternate school of thoughts

This is far from reality

Top-down approach may not work well in reality in those situations

The top-down approach will need:

Commons as the prisoner’s dilemma

In the one-shot prisoner’s dilemma game, self-interested individuals end up in a socially non-optimal (Nash) equilibrium.

What if the game is not played “one-shot”, but are played for multiple rounds?

Axelrod’s Tournament

In 1980, Robert Axelrod, professor of political science at the University of Michigan, held a tournament of various strategies for the prisoner’s dilemma.

The Payoff structure is the following:

The basic rule of the tournament is this:

Different strategies emerge

The “Tideman and Chieruzzi”

  1. Every run of defections played by the opponent increases the number of defections that this strategy retaliates with by 1.

  2. The opponent is given a ‘fresh start’ if:

Who wins?

Benchmark:

With a maximum of 600 points, here they are:

The Follow up Tournaments

Implications from Axelrod’s Tournament

How does that help governing the commons

Ostrom’s Observation

Rather than using a pen and a pencil, Ostrom really went into the field:

What does she find?

Ostrom’s principles of designing long-surviving institutions

  1. Define boundaries clearly
  2. Design FAIR rules to use the resource (usually proportional to the benefit)
  3. Involve the participants into the rule-making process
  4. Monitor and enforce these rules locally
  5. Apply gradual sanctions to violators

The power of norms

These principles are usually conveyed through norms

What can threaten these self-governing rules?

Takeaways from this module

There are three schools of thought to correct market failure: