Problem Areas for the Market

Problem Areas for the Market Mankiw, Principles of Economics (2004) Chapter 10, "Externalities," pages 203-222. Chapter 11, "Public Goods and Common Resources,“ pages 223-241

Problem Areas for the Market We’ve already discussed how wonderful markets can be. But they don’t always work “optimally.” Less than optimal results are referred to as “market failure” or “market imperfections.” (But don’t let the perfect be the enemy of the good!) Types of Market Failures Externalities Common Pools Public Goods Monopolies (we won’t talk about that here) Information

Market Failure #1: Externalities Property right: bundle of entitlement defining owners' rights, privileges, and limitations for use of a resource A property right is “well defined” if the owner of a resource enjoys all the costs and benefits of using that resource. An Externality exists when the welfare of some agent depends directly not only on his activities, but also on those under the control of another agent. This occurs when a property right is not well defined. The reason we use the word "externality" is that external costs are imposed. If you have garbage rotting in your kitchen, it’s unpleasant, but it’s not an externality. The trick for, say, a steel mill, from a public policy point of view, is to get them to internalize their externality.

Something that is not a Market Failure Let’s be careful about something. Assume the National Polo Hall of Fame moves to State College. As a result, property becomes much more valuable in State College (as people want to be near the Hall.) Rental rates for student housing rises. Students are harmed. But this isn’t a market failure. It is called a pecuniary externality. When market forces cause the price of something to change, some people are harmed. But this isn’t a market failure.

Market Failure #2: Common Property Resources Common Property Resource - Property rights not exclusive (excludable), free access, 1st come, 1st served, exploitation. Examples: Fishing grounds, hunting grounds, endangered species. The basic problem is that animals in the wild are not owned until they are captured, and at that point they are usually dead. People decide to enter these activities if it is profitable for them. But they don't consider the effects they are having on others. If I decide to hunt, and catch deer, it may make it more difficult for you to hunt and catch deer.

What is the Result of a Common Pool Resource? • Over-exploitation, too much usage (no incentive to conserve) • Net benefits dissipated (average benefits equal average costs) In the case of the American bison, an easily available resource gets over-exploited through use of rifles, resulting in scarcity.

Common Property Resources

Practice Question: The Market for Flounder Pet flounder sell for $30. It costs $350 to fish for flounder.

BTW What fraternity was Flounder in? What was Flounder’s big mistake?

Market Failure #3: Public Goods Definition: A public good is non-rivalrous and (generally) non-exclusive. Non-rival: One consumer consuming a good does not affect another consumer's consuming the good. Non-exclusive: People cannot be excluded from consuming the good Examples: National defense. Consumption is non-rivalrous and non-exclusive. We can see a clear example of market failure - private parties cannot be expected to provide the optimal level of national defense. Genetic diversity. Genetic DNA now used for developing food and medicine. But there are arguments that species are disappearing, eliminating this public good.

Can the Market Solve an Externality Problem? Bert and Ernie live together on Sesame Street. Ernie would like to count sheep in order to go to sleep. But that keeps Bert up. They have “payoffs” that look like this (right): What is the best number of sheep counted? How many will Ernie count? If Bert can pay off Ernie, what deal will they make? What if Ernie has to pay off Bert, what deal will they make? Note if Ernie is “left alone” he will count 5 sheep – not the wealth maximizing number.

Let’s Negotiate Now assume that Ernie owns the right to count sheep – but Bert can pay him not to count. How much is Bert willing to pay Ernie not to count the 5th sheep? 10 How much value does Ernie get from counting the 5th sheep? 1 So a deal not to count the 5th sheep is available at some price [1,10].

Let’s Negotiate What about the 4th sheep? Ernie values it at 6, but Bert will be willing to pay 8 not to have it count. So we have a deal at some price [6,8].’ What about the 3rd sheep? Convince yourself there is no deal available. So Bert pays Ernie [1+6=7, 8+10=18], and Ernie only counts 3 sheep, the wealth maximizing amount

Let’s Negotiate Some More Now assume that Bert owns the right to stop sheep from being counted – but Bert can pay Ernie for the right to count them. Ernie is willing to pay 10 for the right to count the 1st sheep, and Bert only needs 1 to be compensated. So Ernie pays some price [1,10] for the 1st sheep. Ernie is willing to pay 8 for the 2nd sheep, Bert needs 2 to be compensated, so we have a deal at a price [2,8].

Let’s Negotiate Some More Ernie is willing to pay 6 for the 3rd sheep, Bert needs 4 to be compensated, so we have a deal at [4,6]. Ernie is willing to pay 4 for the 4th sheep, but Bert requires 6, no deal. So, Ernie will pay Bert: [1+2+4=7, 10+8+6=24] Ernie counts 3 sheep, the wealth maximizing amount.

Solving the Externality You might think Bert and Ernie are a silly example But let’s say I changed the table above to “Tons of Hideous Guck Emitted into Stream,” “Payoff to Steel Mill”, “Payoff to Downstream Laundry.” The Coase Theorem: If transactions costs are not “too high,” the market will find the optimal (best, wealth maximizing) solution. But what constitutes “transactions costs?”

Transactions Costs What could be a transactions costs? • Spite. Not so much in business, but often in divorce (“The War of the Roses”) • Government Regulation and taxes; say a tax on trading • Public goods problem Instead of having 1 laundry being affected by the toxins in the stream, let us have 1000 residents of Port Matilda being affected. Now fighting pollution becomes a public goods problem. (So the problem with externalities is that they create public good problems.) Here the government could come in and impose a solution. The government could say: Don’t pollute so much; or Pay us $X every time you pollute. What is the difference?

Market Failure #4: Information Our market model assumes that all parties to a transaction have access to the relevant information. But this is not always the case. For instance, when you buy a personnel computer, it may be difficult to know the radiation danger you are exposing yourself to. In such cases, you may wish the government to impose standards for the product. The basic idea before imperfect information is that buyers know less than sellers about the product. The market, however, may generate some solutions to this problem. In addition, firms will invest in generating reputations for themselves, in ways we will discuss later.

When Do People Get Cheated? When it pays. It pays when either: • You can't find out that they have cheated you; or • Once you find that they have cheated you, you can't punish them. How could you punish someone? By not buying from them again. So repeat business is important to deter fraud or deception. When could fraud occur? Let's say my car breaks down in a small town. I can't judge cars, and I'm not coming back. Then mechanic has real incentives to cheat you. But I don't think this occurs in tourist areas. There, the local chamber of commerce doesn't want the town to get a bad reputation, so they may find ways of punishing cheating mechanics. Deception has become very important lately in the area of "green claims". Many products now claim that they are environmentally friendly. But how can you tell? What does “green power” mean?

More on Trade Creates Wealth From Final Exam, Spring 2008: Joe and Graham are locked in the locker room at Beaver Stadium for the next five hours. Joe has 6 “mini-Mac” burgers in a bag. Graham has money. Each of them has total value of mini-Macs consumed (in shekels, of course) as outlined below. A: (14 points) Assume that neither party acts out of spite, and all trades are voluntary, explain what trades will be made.

How much are Mac’s worth?

1st Step: Reorganize remembering that total macs must = 6

2nd step: Calculate Joe’s MC for giving up Macs and Graham’s MV for gaining Macs

What trades will take place? To trade 1, Joe has MC of 9, G. MV of 90. So they will trade in the range [9,90]. To trade a 2nd mac, Joe has MC of 19, G. MV of 70. So they will trade in the range [15,70]. To trade a 3rd mac, Joe has MC of 21, G. MV of 55. So they will trade in the range [21, 55]. To trade a 4th mac, Joe has MC of 25, G. MV of 50. So they will trade in the range [25, 50]

What trades will take place? To trade a 5th mac, Joe has MC of 30, G. has MV of 36. So they will trade in the range [30,36] But for the 6th mac, Joe has MC of 40, Graham MV of 32. No Trade! So Joe will trade 5 macs to G for a price in the range [15+21+25+30=81, 70+55+50+36=211] They will reach the maximum net happiness of 301 – all by themselves, using the “invisible hand.” Here, trade creates wealth by moving assets to higher valued uses.

Why taxes are bad – because they reduce trade! B: (6 points) Let us make this a little harder. Assume that every time Joe sells a mini-Mac to Graham, Joe has to pay 50 shekels to the government authority. How many shekels will the government collect from Joe, and why? Answer: Add 50 to Joe’s margins. Now only 2 trades make sense, where the net gain>50. So the government collects 2*50=100 shekels. But instead of trading 4 unit, Joe and G. trade only 2. Taxes reduces trading in goods – which is bad! But later, we’ll see how to use taxes to reduce production of bads – which is good!

Problem Areas for the Market