Market Failure and Public Policy

1. Market Failure and Public Policy February 7, 2005

2. 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

3. Market Failure: • External costs (S=MPC only)

4. S=MPC + MSC $ S=MPC only P* pm D qm q* Tons of coal mined

5. Market Failure: • External costs (S=MPC only) • External benefits (D=MPB only)

6. $ MC MSB + MPB P* pm MPB qm q* Acres of farmland

7. Market Failure: • 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

8. Market Failure: • External costs (S=MPC only) • External benefits (D=MPB only) • High exclusion costs • Non-rival goods (MC for additional user is 0)

9. 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

10. MB = MC 12 – 4n = 8 n = 1, TB = 10 Rent = TB – TC = 10 – 8 = 2 Case 1 - Privately owned land Commodity produced with labor: Q = 12n – 2n2 Input is labor (n): n = number of laborers P = $1 so TB = $1*Q so TB = 12n – 2n2 MB = 12 – 4n MC = wage rate = 8

11. Rent = ½(4)(1) = 2 $ — MC Number of laborers

12. Labor is added until all potential gains are exhausted (on average, all costs are covered) Case 2 – Open access land Commodity produced with labor: Q = 12n – 2n2 n = number of laborers First laborer earns rent. Second laborer observes this “surplus” and sees an opportunity to benefit. P = $1 so Q = TB AB= TB/n = (12n – 2n2)/n = 12 – 2n

13. $ — MC Number of laborers

14. AB = MC 8 = 12 – 2n n = 2, TB = 16 Case 2 (cont.) AB = 12 – 2n MC = wage rate = 8 Rent = 16 – 16 = 0 Rent is exhausted, or dissipated.

15. Rent dissipated $ — MFC Number of laborers

16. 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

17. 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

18. 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

19. 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

20. Example: Severance tax $t per ton of coal mined $ S=MPC only S=MPC + severance tax P* tax rate = p* - pm pm D qm q* Tons of coal mined

21. Example: Subsidy payment for land retained in farming $ MC Total subsidy paid MSB + MPB P* pm MPB qm q* Acres of farmland

22. Direct public action: • Command and control • Direct regulations or controls

23. Example: Zoning regulations limit development options $ MC MC with regulation MSB P* pm MPB qm q* Acres of farmland

24. 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

25. Why attributes of things matter: Consider the following communication between Canadian authorities and the commander of a U.S. Navy ship off the coast of Newfoundland in October, 1995: Americans: Please divert your course 15 degrees to the North to avoid a collision. Canadians: Recommend you divert your course 15 degrees to the South to avoid a collision. Americans: This is the Captain of a U.S. Navy ship. I say again, divert your course. Canadians: No. I say again, you divert your course. Americans: This is the aircraft carrier U.S.S. Lincoln, the second-largest ship in the United States’ Atlantic Fleet. We are accompanied by three destroyers, three cruisers, and numerous support vessels. I demand that you change your course 15 degrees North, That’s one-five degrees North, or counter measures will be undertaken to ensure the safety of this ship. Canadians: This is a lighthouse. Your call.