Market Failure and Public Policy

February 6, 2005

An efficient market allocation:

Maximizes net benefits MB = MC MNB0=PV MNB1=PV MNB2=…=PV MNBn

Cannot make anyone better off without making someone else worse off

Market Failure:

External costs (S=MPC only)

Tons of coal mined

$

D

S=MPC only

S=MPC + MSC

qm

pm

q*

P*

Market Failure:

External costs (S=MPC only) External benefits (D=MPB only)

Acres of farmland

$MC

qm

pm

q*

P*

MPB

MSB + MPB

External costs (S=MPC only) External benefits (D=MPB only) High exclusion costs

High exclusion costs limit incentive for private production of good or service

Market Failure:

Market Failure:

External costs (S=MPC only) External benefits (D=MPB only) High exclusion costs Non-rival goods (MC for additional user is 0)

Market Failure:

External costs (S=MPC only) External benefits (D=MPB only) High exclusion costs Non-rival goods (MC for additional user is 0) Open access

Individual users benefit but do not bear all costs of their use

Case 1 - Privately owned land

Commodity produced with labor: Q = 12n – 2n2

Input is labor (n): n = number of laborers

MB = 12 – 4n

MC = wage rate = 8

P = $1 so TB = $1*Q so TB = 12n – 2n2

MB = MC

12 – 4n = 8

n = 1, TB = 10

Rent = TB – TC

= 10 – 8 = 2

0

2

4

6

8

10

12

0 1 2 3

MB

Number of laborers

$

— MC

Rent = ½(4)(1) = 2

Case 2 – Open access land

Commodity produced with labor: Q = 12n – 2n2

n = number of laborers

Labor is added until all potential gains are exhausted(on average, all costs are

covered)

P = $1 so Q = TB

AB = TB/n = (12n – 2n2)/n = 12 – 2n

First laborer earns rent. Second laborer observes this “surplus” and sees an opportunity to benefit.

0

2

4

6

8

10

12

0 1 2 3 4 5 6

MBAB

Number of laborers

$

— MC

AB = 12 – 2n

MC = wage rate = 8

AB = MC

8 = 12 – 2n

n = 2, TB = 16

Rent = 16 – 16 = 0

Case 2 (cont.)

Rent is exhausted, or dissipated.

0

2

4

6

8

10

12

0 1 2 3 4 5 6

MBAB

Number of laborers

$

— MFC

Rent dissipated

Market Failure:

External costs (S=MPC only) External benefits (D=MPB only) High exclusion costs Non-rival goods Open access Planning horizon

Private vs. social discount rate

Reasons for public policy:

Correct market failure Internalize externalities Provide public goods Change/create property rights

Change outcome if we don’t like the efficient market outcome Change/create property rights

Correct government failure

Incentive-based policies:

Property rights changes Market failure: Open access shellfish flats on

Cape Cod resulted in decreased quantity and quality of shellfish

Property rights change: Shellfish flats divided into individual parcels, sold or leased, and owners or lessees manage for the long run

Incentive-based policies:

Property rights changes Public (government) incentives

Taxes (increase cost of undesired activity) Subsidies (increase benefits of desired activity) These imply underlying property rights

preferences

Tons of coal mined

$

D

S=MPC onlyS=MPC + severance tax

qm

pm

q*

P*

tax

rate

= p

* -

pmExample: Severance tax $t per ton of coal mined

Example: Subsidy payment for land retained in farming

Acres of farmland

$MC

qm

pm

q*

P*

MPB

MSB + MPB

Total subsidy paid

Direct public action:

Command and control Direct regulations or controls

Example: Zoning regulations limit development options

Acres of farmland

$MC

qm

pm

q*

P*

MPB

MSB

MC with regulation

Direct public action:

Command and control Direct regulations or controls

Public goods production Where no private incentive for production exists High exclusion costs Non-rival goods