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POLICY REFORM AND NATURAL RESOURCE MANAGEMENT

WEEK 1: DAY 3

MARKET FAILURE

by Janet EGDELL, University of Aberdeen

CONTENTS

1. INTRODUCTION AND OBJECTIVES2. HOW THE MARKET WORKS2.1. Demand, supply, and the price mechanism2.2. Efficiency of resource allocation3. WHY THE MARKET FAILS3.1. Failure associated with market structure3.2. Failure associated with the market mechanism3.3. Failure associated with non-marketed goods3.3.1. Externalities3.3.2. Public goods4. EXAMPLES OF MARKET FAILURE IN THE MANAGEMENT OF NATURAL

RESOURCES4.1. Negative externalities, e.g., water pollution4.2. Positive externalities, e.g., soil stabilisation4.3. Public goods, e.g., agricultural research4.4. Poorly-defined property rights, e.g., access to land4.5. Short-term thinking, e.g., tree planting5. SUMMARY AND CONCLUSIONS6. REVIEW QUESTIONS7. ANSWERS

REFERENCES

LIST OF TABLES

Table 1. Spectrum of public/private goods

LIST OF FIGURES

Figure A. Economics of pollutionFigure B. Economics of pollutionFigure C. Economics of pollutionFigure D. Economics of pollutionFigure E. Economics of pollutionFigure F. Edgeworth Box illustrating negotiation over a negative externalityFigure G. Optimal provision of a public good

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1. INTRODUCTION AND OBJECTIVES

This section of the course deals with market failures and how they can affect the managementof natural resources. Some natural resources are bought and sold in markets, but many arenot. Here, we explore the reasons for this disparity. This section lays the foundation formuch of the remainder of this module, which will consider how to make markets work moreeffectively, or what alternative mechanisms can be used instead to allocate resources. It isimportant that you understand the reasons why markets work in some situations but not inothers.

In this section of the course you will• be reminded how a market can be an effective means for allocating resources;• consider the role of prices in the allocation of resources;• distinguish between private and social costs and benefits;• consider the situations in which markets fail to allocate resources to the activities that

society as a whole would benefit from;• be able to explain and give examples of different types of externality;• understand which goods and services are public goods; and• be able to apply these concepts to your own experience of natural resource management.

Exercise 1: With your neighbour, spend a few minutes making a list of different natural resources.Which ones are sold in markets, and which ones are not? Can you think of some reasons forthis difference? 2. HOW THE MARKET WORKS 2.1. Demand, supply and the price mechanism Markets are one way to allocate scarce resources. Within a market, many buyers and sellerscan interact to exchange goods and services. The interaction is voluntary and the exchangeprocess is decentralised.

Exercise 2: Can you think of some other ways to allocate scarce resources, other than using a market?

This exchange relies on the price mechanism. In a market, changes in demand cause changesin price, which act as a signal and an incentive to change supply. Similarly, changes insupply cause change in prices, acting as a signal and an incentive to change demand. In thisway, the market moves towards an equilibrium where the quantity demanded equals thequantity supplied. At this point, there is neither a shortage nor a surplus.

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If the market is working, the demand price represents consumer preferences and the supplyprice represents resource use. That is, the full costs and benefits of production andconsumption are reflected in market prices.

Exercise 3: How would you show, using a standard market diagram, the following:• the effect of an increase in consumers willingness to pay for bread, due to a change in

tastes? and• the effect of an increase in the wage rate of farm workers on the willingness of farmers to

supply rice? What is the role of prices in each case? 2.2. Efficiency of resource allocation A competitive market can result in a Pareto-efficient allocation of resources, that is, anallocation whereby it is not possible to make any person better off without making somebodyelse worse off. A competitive market determines how much is produced and who gets it,based on how much people are willing to pay to purchase the good compared to how muchpeople must be paid to supply the good.

In a competitive market, reallocation of resources will occur until all of the gains from tradehave been exhausted. Consumers try to maximise their consumer surplus, whilst producers tryto maximise their producer surplus. They are not seeking to maximise efficiency. However,the price system induces self-interested consumers and producers to make choices that areefficient from society’s point of view. It should be noted that a competitive market may notlead to an equitable allocation, that is, one that is distributionally fair or just. However, it willlead to an efficient allocation. However, markets are not always competitive. Also, the market demand price does notalways reflect consumer preferences and the market supply price does not always reflect thefull resource costs. In these cases, the market fails to allocate resources efficiently. It is thesesituations that are going to be considered in this chapter. The upcoming chapters willconsider how it may be possible for the government to intervene to correct for such marketfailures, either through the legal system by redefining property rights, or through adjusting themarket system with, for example, taxes and subsidies. 3. WHY THE MARKET FAILS There are three main ways in which the market can fail to allocate resources in the way thatwould be desirable for society as a whole. These are

• failure associated with market structure;• failure associated with the market mechanism; and• failure associated with non-marketed goods.

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3.1. Failure associated with market structure Inefficiency may result from the lack of competition in some markets, where the marketstructure is a monopoly or imperfectly competitive. Under imperfect competition, suppliersdo not necessarily respond to consumer preferences. Lesser resources may be allocated to theproduction of certain goods and services so that the firm producing them can obtain higherprofits (supernormal profits). Society as a whole may therefore be worse off. 3.2. Failure associated with the market mechanism The efficient allocation of resources only occurs if the information about consumer preferenceis transmitted to suppliers and the information about resource costs is transmitted toconsumers. If there are high transaction costs involved in buyers interacting with suppliers,then the market may not be able to adjust to changes, or not rapidly. In this case, resourcesmay not be allocated in a socially optimal way. 3.3. Failure associated with non-marketed goods Many environmental goods and services are not marketed at all. This means for such goodswe have no prices at all, or we have prices that do not reflect the full costs or benefits of thegoods and services to society as a whole. The market reflects private costs and benefits,rather than social costs and benefits. Wherever the private and the social costs and benefitsdiverge, the market will allocate resources in the optimal way for private individuals, but notin a socially optimal way.

The following considers, in more detail, this third area of market failure associated withgoods and services for which we do not have the correct price that reflects the social costs andbenefits. 3.3.1. Externalities Often, the person making a decision does not bear all the consequences of his or her action.For example, if somebody decides to smoke a cigarette, the person sitting next to him or herinhales the cigarette smoke too. Similarly, if a firm located upstream puts waste into theriver, another firm located downstream finds they obtain lower quality water. In each of these examples, there is an externality, in the sense that an (external) person bearssome of the consequences of the actions of another person. An externality occurs wheneverthe welfare of some agent, either a firm or household, directly depends not only on his or heractivities, but also on activities under the control of some other agent. The interdependencebetween the two agents is not priced and, therefore, is not taken into account when the latteragent is deciding on how to act. The externality arises from incomplete or non-existentproperty rights. The consequences of an action on the other person may be good or bad, that is, it mayimprove their welfare or reduce it. If welfare is improved, then we have a positiveexternality; if it is reduced, then we have a negative externality. We can also call theseexternal benefits and external costs, respectively.

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In the case of a positive externality, the actions of one firm or household either reduces thecosts of production or increases the utility of people other than the producer or consumer.For example, a beekeeper provides an external benefit to the nearby person who has an appleorchard, which the bees pollinate. By keeping bees, the beekeeper reduces the cost ofproducing apples to the orchard owner. In the case of a negative externality, the actions of one firm or household either increases thecosts of production or decreases the utility of people other than the producer or consumer.For example, a farmer pollutes a river with pesticides and imposes an external cost on thefisherman down the river. By polluting the river, the costs of catching fish are increased forthe fisherman. Externalities occur when the social costs and benefits are different from the private costs andbenefits. The beekeeper will decide whether to keep bees, by comparing the marginal privatecost (i.e. marginal cost to her) of keeping bees with the marginal private benefit (i.e. marginalbenefit to her). This ignores the reduction in costs to the orchard-owner. In this example, themarginal social cost (i.e. the marginal cost to the beekeeper less the saving in costs to theorchard owner) is less than the marginal private cost. Similarly, the farmer will decide how much pesticide to apply, by comparing the marginalprivate cost with the marginal private benefit. This ignores the additional cost imposed onthe fisherman, for whom it is now more difficult to catch fish. The marginal social cost isgreater than the marginal private cost. For a negative externality: MSC > MC or MSB < MB For a positive externality: MSC < MC or MSB > MB Whenever social and private costs and benefits diverge, the result is an inefficient allocationof resources. The result tends to be too much of the negative externalities and insufficient ofthe positive externalities. Exercise 4: Complete the following table with two examples of each of the following types of externality: Negative Positive Consumption

Production

The following diagrams demonstrate the difference between the private and social optimalallocation of resources. Imagine the case of a paper-mill, which in the process of producing

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paper emits chlorine into a nearby river. The private decision by the paper-mil is shown inFigure A. Assuming the firm aims to maximise its profit, it will continue expanding its paperproduction until Qp, the point where the marginal cost (to the firm) of producing the paperequals the marginal revenue (to the firm). For simplicity, the marginal cost curve is shownhere as a straight, upward-sloping line, though in reality marginal costs might fall at first asfixed costs are spread, before rising as shown here, due to the law of diminishing marginalreturns. Marginal revenue is assumed here, again for simplicity, to be horizontal, implyingthat the papermaking industry is highly competitive. Qp is the optimal amount of paper toproduce from the paper-mill’s private perspective.

[Figures A to E]

Exercise 5: a) Explain to your neighbour why a firm will profit maximise where the private marginal costequals the private marginal benefit. b) How does a firm decide how much to use of an unpriced resource, i.e. with a cost to thefirm of zero? Figure B is simply a transformation of Figure A, indicating the Marginal Net Private Benefit(MNPB), or level of profit, made by the paper-mill. This is calculated as the revenueobtained for selling an extra box of paper less the cost of producing that extra box. Theprofit-maximising level of paper to produce is again shown as Qp, beyond which point nomore is added to the profit level (or MNPB). Figure C now turns to the impact of the chlorine that is emitted during the production process.The nearby river can assimilate a certain level of chlorine. If the paper-mill produces Qaboxes of paper or less, the level of chlorine dumped in the river would be assimilated andthus no pollution problem would arise. Beyond this level, however, pollution is causedwhich imposes a cost on other users of the river (an external cost). Figure D illustrates this external cost, but now in terms of a monetary value, rather than aquantity of pollution, as shown in Figure C. There is an underlying assumption here that wecan put a monetary value on the pollution damage. How this valuation might be done will bediscussed later in this module. The marginal external cost (MEC) is zero up to theassimilative capacity of the river, as up to this point there is no negative impact on other usersof the river. Beyond a level of paper production of Qa, the marginal external cost rises. Thisimplies that there is a cumulative damage effect: as more chlorine is put into the river, it hasan increasingly damaging impact. Figure E combines the Marginal Net Private Benefit curve from Figure B with the MarginalExternal Cost curve from Figure D. We are interested in the socially optimal level of paperproduction, that is, taking into account all externalities. This level of production is indicatedby point Qs where the two curves cross. At this point the benefits in terms of profit to thefirm are balanced by the costs to other river users in terms of pollution. If less paper than Qsis produced, the firm would forego more profit than the cost of the pollution warrants, leavingsociety overall worse off. Similarly, if more paper than Qs is produced, the additional profit

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would be less than the cost of the pollution associated with that production, again leavingsociety worse off.

Exercise 6: What would be the impact on the private and social optimum levels of paper production ofeach of the following: a) an increase in the market demand for paper due to higher incomes? b) new information that indicates chlorine is more damaging than had previously beenthought? Three caveats are suggested to the above model, bearing in mind the Precautionary Principle.If the pollutant is toxic or persistent the environment may have no assimilation capacity.Secondly, the above example considered a single pollutant; it is often the case that cocktailsof pollutants may be more damaging, and less understood. Thirdly, in this model, pollutiondamage only occurs when individuals recognise a loss of welfare. This may not be veryuseful for pollutants that emit low doses over long periods.

Exercise 7: Assume that a firm produces organic waste that has the effect of increasing the fertility ofneighbouring farmland and thus reducing farmers’ costs. It is impractical, however, to sellthe waste to the farmers. The table below shows the firm’s private marginal costs and theseexternal benefits to farmers from the firm’s production.

Output (units)

Price (£)

Marginal (private) cost (£)

Marginal external benefit (£)

1 20 16 6 2 20 15 5 3 20 15 4 4 20 16 3 5 20 17 2 6 20 18 2 7 20 20 2 8 20 22 2 9 20 24 2 10 20 27 1 • How much will the firm produce to maximise profits?• What is the marginal social cost of producing 3 units per day?• What is the socially optimum level of output?

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• What subsidy per unit would the government have to pay the firm to encourage it toproduce this level of output?

• How much would it cost the government?• If a new farming technology doubled the benefit of the waste to the farmer, what will now

be the socially optimum level of the firm’s output? Another way of illustrating a negative externality, is using an Edgeworth Box, indicating thepreferences of two individuals for two goods, for example, money and smoke, as shown inFigure F. This emphasises the point that the socially optimal solution will depend on theproperty rights each person has: do people have a right to pollute, or a right not to put up withother people’s pollution?

Take the example of two people that share an office. One of them smokes but the other doesnot. Smoke is a good for person A, but a bad for person B. This means that unlike the usualEdgeworth Box, smoke is measured vertically from bottom to top for both people. Money ismeasured from left to right for person A and from right to left for person B, as is usual.

[Figure F] Which one of the several equilibria we end up at depends on which endowment we start with.That is, how the money was initially distributed and whether there is a right to smoke, or aright to have clean air. This diagram assumes the money is split evenly between the twopeople. Possible endowment E’ assumes that person A has a right to smoke as much as hewants and B just has to put up with it. In effect, B will pay A not to smoke, moving toequilibrium X’. At this point the marginal rate of substitution of smoke for money is equalfor both of the workers. Endowment E would be the case if B has a right to clean air. In thiscase, A will bribe B to allow him to smoke, moving to equilibrium X. Alternatively the legalright to smoke and clean air could be somewhere between these two extremes, as withsituations where workers are allowed to smoke in some parts of the workplace, but not all. 3.3.2. Public goods Public goods are an example of a particular sort of consumption externality where everyonemust consume the same amount of the good. For example, we must all consume the samelevel of air quality, regardless of whether some of us value high air quality more than othersdo. Once improved air quality has been provided, all will benefit. Public goods have two particular consumptive characteristics:• non-rival: the consumption of a good or service by one person will not prevent others

from enjoying it; and• non-excludable: it is not possible to provide a good or service to one person without it

thereby being available for others to enjoy. As it is impossible to exclude others from consuming the good once it is provided, we havewhat is termed the ‘free-rider’ problem. People can expect to benefit from the provision ofthe public good, even if they do not contribute towards the cost of providing it.

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As public goods have large external benefits relative to the private internal benefits, theywould tend not to be provided by the free market. As we saw earlier, an individual or firmwill decide whether or not to provide a good by weighing the private benefits against theprivate costs. With these public goods, the benefits will tend to be shared with otherindividuals or firms (i.e., MSB>MPB), but the costs will not. This makes them unattractivefor entrepreneurs to provide. The socially optimal provision of a public good will again be where the marginal benefit tosociety equals the marginal cost to society. However, the calculation of marginal benefit inthis case is somewhat different from that associated with private goods, due to the non-rivalcharacteristic of a public good. If you benefit from clean air, that does not take away from mybenefiting from the same clean air. Therefore, to obtain the total marginal benefit from apublic good, we have to sum the private benefits (or individual demand curves) of all theindividuals vertically rather than horizontally. This is illustrated in Figure G. [Figure G] Consider that this public good is the maintenance of a forest, and two people are being askedto contribute to its maintenance. Both people benefit from the forest, which prevents soilerosion and flooding. Person 1 is asked what area of the forest she would like to seemaintained, and would weigh up the marginal benefit to her of maintaining a bit more forestagainst the marginal cost of providing this. If left to a private contribution, this person wouldbe willing to pay for the provision of an area Q1. Similarly Person 2 would consider thebenefit he would receive from maintaining more forest compared to the cost. This personwould be willing to contribute to maintain a maximum area of Q2. Left to the market, thisamount Q2 is the maximum that would be provided. However, the total benefits to society of maintaining the forest are much greater than theprivate benefits to Person 2. We should therefore add to this the benefits that accrue toPerson 1, giving us a total marginal benefit curve equal to MB1 + MB2. The socially optimalamount of forest to be conserved is Qs, where the sum of the two marginal benefit curvescrosses the marginal cost curve. The problem is that we cannot persuade Person 1 to contribute to the maintenance of theforest, as she knows that the amount she would like to see provided (Q1) will already beprovided by Person 2’s contribution. As this is a public good, Person 2 cannot preventPerson 1 from benefiting from the area already conserved by Person 2’s contribution. Person1 can free ride: gain the benefit, whilst not paying the cost. For this reason, the free marketwill conserve too little forest from society’s point of view. In reality, goods may be neither completely public nor completely private but sharecharacteristics of each. Instead, we have a spectrum of goods, as illustrated in Table 1, somebeing closer to public goods and some closer to private goods. For example, fish shoals arequasi-private goods. The fish resource is non-exclusive if it is in the open sea. Anybody hasthe right to take the fish. However, there is rivalry. Once the fish are taken, they are nolonger available to other people who are fishing. A public beach may be a quasi-public good.Again it is non-exclusive, as everybody has the right to use the beach. There may be plenty ofroom on the beach, in which case it is also non-rival. However, there will be a point beyond

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which the beach becomes crowded, and some degree of rivalry between different users of thebeach may be found. Generally, public goods will be provided by the government, as otherwise too little of them ornone at all would be provided. Non-pure public goods, that is, those where it is possible toexclude free riders, could be provided by a market, but are often provided collectively by theState. For example, roads may be provided by the government and funded from generaltaxation, but it is possible to charge a toll for those who actually use the road. Table 1. Spectrum of Public/Private Goods

Pure privategoods

Quasi-privategoods

Quasi-publicgoods

Pure publicgoods

Characteristics Exclusive Rival

Non-exclusive Rival

Non-exclusive Only partially rival

Non-exclusive Non-rival

Management Rivalry inconsumption Exclusion easy

Annual orregularpayments madeto providequasi-collectivegood

Congestible goodse.g. exceeding thecarrying capacityof a public beach

Non-rivalry inconsumption Exclusion notpossible orpracticable

Examples Bread Migratory fishshoals Groundwaterreserves

Closed accessnature reserves

Scenic views Clean air Clean water

Source: Adapted from Turner, Pearce, and Bateman (1994). Exercise 8: Can you think of some examples of public goods that are provided by the private sector?Should more of these goods be provided than is being provided at the moment?

Exercise 9: Which of the following features distinguish public goods from other types of goods (Theremay be more than one feature)?• Large external benefits relative to private benefits• Large external costs relative to private costs• A price elasticity of demand only slightly greater than zero• The impossibility of excluding free riders• Ignorance by consumers of the benefits of the good• Goods where the government feels it knows better than consumers about the amount

people ought to consume

4. EXAMPLES OF MARKET FAILURE IN THE MANAGEMENT OFNATURAL RESOURCES

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4.1. Negative externalities, e.g., water pollution

Externalities are often related to resources that are used by many different people. Forexample, a river, throughout its course, is used by a range of people for a variety of purposes.Negative externalities occur whenever one user of the river does not take into account thecost imposed by his or her activities on another user. A factory located upstream may use theriver for waste disposal, and in the process pollute the water for other users locateddownstream.

The factory is making an economically rational decision (from its private perspective) whendeciding to dispose of its toxic waste into the river. It is weighing up the private marginalcosts against the private marginal benefits. Often, water use has a private marginal cost ofzero, which means that a firm will continue to use it right up to the point where its privatemarginal benefit is zero. That is why resources that are free at the point of use have atendency to be overexploited.

The social cost of disposing of harmful waste into the river, however, is not zero. It is thesum of the external costs on all downstream users, which might include the cost of healthproblems caused to those drinking and washing in the water downstream, the loss of incomein terms of damage to livestock or fish populations, and the cost of reduced biodiversity.Some of these external costs are already valued in monetary terms, but others are not. All,however, reduce the utility of downstream users or increase their production costs.

The socially optimal rate of waste disposal into the river is much lower than the rate achievedthrough a free market. Regulations on what discharges are permissible into a river are anattempt to move from the private market outcome to the socially optimal outcome, makingthe factory internalise the externality.

4.2. Positive externalities, e.g., soil stabilisation

Imagine a mountain village that is concerned about its supply of firewood, which has beenrapidly depleting as the village population has grown, therefore necessitating longer journeysto fetch wood and the use of less suitable species, which do not burn as well. To try to tacklethis problem, members of the village become involved in a programme of management of thesurrounding trees and vegetation, developing a tree nursery and planting out the seedlings.

In the foothills of the mountains, there is another village that also benefits from the tree-planting programme. As vegetation cover was reduced in the mountains, this village hadsuffered from more frequent flooding of the river that runs close to the village, causingconsiderable soil erosion. The planting programme in the mountains will stabilise the soiland reduce the risk of flooding in the foothills.

The mountain village is making its decision to undertake a planting programme by weighingup the costs and benefits to its own members. These private costs involve establishing thenursery and the management of trees that would be planted; the private benefits involve thesavings in the amount of time spent in collecting firewood and the better quality of wood thatwould be available. It does not, however, include the additional (external) benefits to the

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foothill village. The socially efficient outcome would take this into account, leading to moretree-planting than the private market outcome.

4.3. Public goods, e.g., agricultural research

Many governments support programmes of agricultural research. For example, research mayinvestigate which crops are most suitable for which situation, what the response of crops is todifferent levels of inputs, what the impact of different rotations is, how to improve animalhealth, eradicate pests and diseases, and how to breed animals that are more productive.

Is agricultural research an example of a public good? How do the benefits to societycompare with the benefits to private individuals? If one farmer benefits from the research,does that mean other farmers must benefit too? That is, is agricultural research non-excludable? If one farmer benefits, does this reduce the benefit to another farmer? That is, isagricultural research rival or non-rival?

As you will have realised, it depends on the exact nature of the research. Using a higheryielding seed can bring private benefits that outweigh the private cost of buying it. However,these private benefits may not be sufficient to cover the costs of actually developing the newvariety, if it is not already available. In these circumstances, a private firm might develop anew variety if it can patent it and then recoup the costs of developing it by selling it to anumber of farmers. Thus, some farmers can be excluded from gaining the benefits of the newseed.

Alternatively, there may be research into the impacts of obtaining two crops from one area ofland. The effects in terms of higher yields may be obvious, so that all farmers can see andbenefit from this new knowledge. It would not be possible to exclude some. Therefore, thiswill discourage private companies from undertaking such research, as they will not be able toprofit from selling this knowledge. Such research is still worthwhile, however. The benefitsto society in terms of higher yields may easily outweigh the costs of undertaking the research.Without government intervention to provide such research, though, it may never be started.

4.4. Poorly-defined property rights, e.g., access to land

Externalities can be seen to result from situations within which property rights are notcomplete. They are often related to cases where property rights are poorly-defined, where itis not clear who has and who does not have the right to the benefits from a resource and whatthe limits on the use of that resource are and who is responsible for any associated costs. Forexample, in the previous example on water pollution, the problem lies with the factoryassuming the right to pollute the river with its waste, without taking into account the right ofthe people located downstream to have unpolluted water. The mountain village ignores therights of the foothill village not to suffer from soil erosion and flooding. If in each case theexternal party had a clearly defined property right, they could ensure by legal or socialsanction that their rights are taken into account. It remains an externality, because such rightsare not clearly defined or easily enforced.

Market failure is particularly prevalent, therefore, whenever property rights are poorlydefined. Some resources, that are open to access by all, have no property rights defined at all.

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An example is a piece of land used for grazing by anyone: all can use it and no one person hasthe right to prevent anyone else from using the land. Each grazier who puts cattle on the landmakes a decision about his or her private returns compared to the private costs. For anindividual, increasing the number of grazing animals brings the benefits of more meat to sell.It also, however, adds to greater grazing pressure, leading to more soil erosion and lowerquality feed. Much of the cost of overgrazing is an external cost, borne by the other graziers,not by the grazier who put on the extra cattle. The benefits accrue to the individual, but thecosts are shared among all the graziers. This means that in an open access situation, allgraziers have an incentive to keep more animals than is socially optimal, as the decision ismade without taking into account the external cost on the other graziers.

One solution to externalities such as this is to define some property rights. In this case, itmight be necessary to develop mechanisms for excluding some people from access to theresource, or to limit their use of it. This will be discussed in greater detail in Week 3.

4.5. Short-term thinking, e.g., tree planting

An important trade-off in the management of our natural resources is the decision about theamount of resources that we should use now and how much we should save for futuregenerations. This can be seen as a particular type of externality, where the effect on the thirdparty of a private economic decision is not felt simultaneously, but in the future. As with allexternalities, the market will encourage us to weigh up the private benefit against the privatecost. We will take into account future costs and benefits through discounting, which isdiscussed elsewhere in this course. However, future costs and benefits will only be includedas far as they impact on the agent involved in the management decision. The cost or benefitto, for example, somebody else’s children (i.e. external cost or benefit) may well be ignored,.

An example of this type of externality would be where a decision needs to be made about theamount of resources that has to be put into planting trees. A private owner of land wouldweigh up the private discounted costs of planting the trees against the private discountedbenefits of selling timber at some later date. As it will take a number of years for the trees togrow and mature, the benefits may appear relatively small in present value terms compared tothe costs.

Thus, this might lead to no new planting at all, giving rise to a considerable external cost onfuture generations, who will find it difficult to find sufficient timber for their needs. Theprivate market solution may be a result of a short-term perspective, and therefore would notput sufficient weight on future costs and benefits. Society as a whole may put more weighton the future and so the efficient allocation of resources would take into account a long-termperspective. What weights to put on the potential preferences of future generations and howto implement this in practice is not clear, and this is a major concern within the sustainabilitydebate.

5. SUMMARY AND CONCLUSIONS

In this chapter we have learnt that markets can be an efficient way of allocating resources.This depends on there being prices for the goods or services, an effective mechanism fortransmitting those prices and sufficient competition within the market. However, markets

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may fail to allocate resources for the benefit of society as a whole in a number of situations.If there is a lack of competition, firms may not respond to the preferences of consumers. Ifthere are high transaction costs, the information may not be available for suppliers to respondto changes in demand, or for consumers to respond to changes in supply.

In relation to the management of natural resources, the most important market failure is whenthere are unmarketed and unpriced goods and services. This is the case when there areexternalities and public goods. Individuals and firms would make management decisions inresponse to the private costs and benefits they face, rather than take into account the totalsocial costs and benefits.

Much of the remainder of this course will deal with ways to correct for the failure of themarket to allocate non-priced goods. A range of techniques can be used to estimate the valueof non-marketed goods and services. The government can then intervene in the marketthrough, for example, taxes and subsidies to alter the price signals to which producers andconsumers respond, which would make the producers and consumers ‘internalise’ theirexternalities.

6. REVIEW QUESTIONS

Exercise 10:The following are problems that cause market failures:i. Externalitiesii. Monopoly / oligopoly poweriii. Monopsony / oligopsony poweriv. Ignorance and uncertaintyv. Public goods and servicesvi. Persistent disequilibriavii. Dependantsviii. Merit goods

Match each of the above problems to the following examples of failures of the free market.In each case assume that everything has to be provided by private enterprise: that there is nogovernment provision or intervention whatsoever. Note that there may be more than oneexample of each problem. Also each case may be an example of more that one marketproblem.

Which Market Failure?

There is an inadequate provision of street lighting because it isimpossible for companies to charge all people benefiting fromitAdvertising allows firms to sell people goods that they do notreally wantA firm tips toxic waste into a river because it can do so at nocost to itself

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Firms pay workers less than their marginal revenue product

Prices take some time to adjust to changes in consumer demand

People may not know what is in their best interest and thus mayunderconsume certain goods or services, such as educationFirms’ marginal revenue is not equal to the price of the goodand thus they do not equate MC and priceFirms provide an inadequate amount of training because theyare afraid that other firms will simply come along and ‘poach’the labour they have trainedIn families one person may do the shopping for everyone andmay buy things that other family members do not likeFarmers cannot predict the weather

Minimum efficient scale is at 58% of current industry output

Exercise 11:Would it be desirable for all pollution to be prevented? Explain your answer using anexample and a diagram.

Exercise 12:Consider your activities during a day.• What external costs and benefits resulted from your activities? Try and identify all

externalities you created.• Were there any pressures on you to avoid generating external costs? If so, were these

pressures social, moral or what?• How could you best be encouraged / persuaded / forced to take the externalities fully into

account? Are there any costs in such methods?

Exercise 13:Go back to your examples of natural resources that are not marketed, from Exercise 1.Discuss with your neighbour whether these resources are being managed in a sociallyefficient way and whether there is any evidence of market failure.

7. ANSWERS TO EXERCISE 10

Which Market Failure?There is an inadequate provision of street lighting because it isimpossible for companies to charge all people benefiting from it

v

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Advertising allows firms to sell people goods that they do notreally want

iv, ii

A firm tips toxic waste into a river because it can do so at no costto itself

i

Firms pay workers less than their marginal revenue product iii, iv

Prices take some time to adjust to changes in consumer demand vi

People may not know what is in their best interest and thus mayunderconsume certain goods or services, such as education

viii, iv

Firms’ marginal revenue is not equal to the price of the good andthus they do not equate MC and price

ii

Firms provide an inadequate amount of training because they areafraid that other firms will simply come along and ‘poach’ thelabour they have trained

i

In families one person may do the shopping for everyone andmay buy things that other family members do not like

vii, ii

Farmers cannot predict the weather iv

Minimum efficient scale is at 58% of current industry output ii

REFERENCES

Two very useful general collections of environmental economics are:

Daly, H.E. and Townsend, K.N. (eds.). (1993). Valuing the Earth: Economics, Ecology andEthics. MIT Press.

Markandya, A. and Richardson, J. (eds.). (1992). The Earthscan Reader in EnvironmentalEconomics. Earthscan, London.

Further reading on Market structures and imperfect competition can be found in mosteconomics textbooks.

Transaction costs can be found in:

Williamson, O.E. (1996). The Mechanisms of Governance. Oxford University Press, Oxford.

Externalities and public goods can be found in all environmental economics texts, such as:

Field, B.C. (1994). Environmental Economics: An Introduction. McGraw-Hill, New York.

Hanley, N., Shogren, J.F. and White, B. (1997). Environmental Economics in Theory andPractice. Macmillan, Basingstoke.

Pearce, D.W. and Turner, R.K. (1990). Economics of Natural Resources and theEnvironment. Harvester Wheatsheaf, Hemel Hempstead.

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Perman, R., Ma, Y. and McGilvray, J. (1996). Natural Resource and EnvironmentalEconomics. Longman, London.

Tietenberg, T.H. (1994). Environmental Economics and Policy. Harper Collins.

Tietenberg, T.H. (1992). Environmental and Natural Resource Economics. Harper Collins,New York.

Tisdell, C.A. (1993). Environmental Economics: Policies for Environmental Managementand Sustainable Development. Edward Elgar, Aldershot.

Turner, R.K. (1993). Sustainable Environmental Economics and Management: Principles andPractice. Wiley, Chichester.

Turner, R.K., Pearce, D.W. and Bateman, I. (1994). Environmental Economics: AnElementary Introduction. Harvester Wheatsheaf, Hemel Hempstead.

Methods for correcting for market failure are discussed in:

Hanley, N. and Spash, C.L. (1993). Cost Benefit Analysis and the Environment. EdwardElgar, Aldershot.

Pearce, D.W., Markandya, A. and Barbier, E.B. (1989). Blueprint for a Green Economy.Earthscan, London.

Pearce, D.W. (1993). Blueprint 3: Measuring Sustainable Development. Earthscan, London.

Pearce, D.W. (1995). Blueprint 4: Capturing Global Environmental Value. Earthscan,London.

Organisation for Economic Co-operation and Development (1994). Managing theEnvironment: the role of economic instruments. OECD, Paris.

Taylor, R. (1992). The Market in Environment: Market Failure or Market Solutions? ASIResearch Ltd, London.

Property rights can be found in:

Anderson, T.L. and Leal, D.R. (1991). Free Market Environmentalism. Pacific ResearchInstitute for Public Policy, San Francisco.

Bromley, D.W. (1991). Environment and Economy: Property Rights and Public Policy. BasilBlackwell, Oxford.

Bromley, D.W. (1997). Property regimes in environmental economics. In H. Folmer and T.Tietenberg (eds.). The International Yearbook of Environmental and Resource Economics1997/98. Edward Elgar, Cheltenham. 1-27.

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Hardin, G. (1968). The Tragedy of the commons. Science 162(13):

by Janet EgdellDepartment of AgricultureUniversity of Aberdeen581 King StreetAberdeen, United KingdomAB24 5UAE-mail: j.egdell@abdn.ac.uk

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Figure F. Edgeworth Box Illustrating Negotiation over a Negative Externality

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Figure G. Optimal Provision of a Public Good

Q1 Q2