AGEC 640 – Nov. 7, 2013 Policy: How well can market failures be remedied?

1. AGEC 640 – Nov. 7, 2013Policy: How well can market failures be remedied?

2. Part BPolicy options: How can society move towards Q*? A quick history of thought: • Plato (400 BC): a “benevolent dictator” who knows the level of Q* can impose it through direct regulation. • Pigou (1920s): a government which knows the marginal external cost or benefit can impose it as a marginal tax or subsidy, and let producers/consumers find Q*. • Coase (1960s): a government that can allocate property rights and enforce contracts over the externality can help people make Coasian transactions to find Q*. • The “Coase Theorem”: if transaction costs are zero, then the market equilibrium will be Q* for any initial allocation of property rights, which affect only the distribution of output. ==> it is transaction costs (or entry barriers) that prevent free exchange and create market failure in the first place.

3. S′ = MC + MD MD = marginal external damage to others G S = MC (marginal cost to producers) D E F D = WTP (willingness to pay by consumers) C A B Policy option #1: Welfare-maximizing regulation sets a quota at Q* Q* Qfree quota Effects of Optimal Quota Change in producer surplus -ABC -DEF Change in consumer surplus net gain Change in external costs +C FG +AB DE Change in quota rents

4. S′ = MC + MD MD = marginal external damage to others G S = MC (marginal cost to producers) D E F t D = WTP (willingness to pay by consumers) C A B Policy option #2: An optimal Pigovian tax equals the MEC at Q* Q* Qfree Effects of Optimal Pigovian Tax Change in producer surplus -ABC -DEF Change in consumer surplus net gain Change in external costs +C FG +AB DE Change in government revenue

5. S′ = MC + MD MD = marginal external damage to others G′ S = MC (marginal cost to producers) H D E F Pc D = WTP (willingness to pay by consumers) C A B I J Policy option #3: In ideal “Coasian” transactions, people trade the externality itself, until MD = WTP-MC For example, if victims of the externality paid for reduced production… Q* Qfree Effects of Coasian Bargain paid cut Change in producer surplus +DE –C +FCHI Change in consumer surplus -DEF Change in ext. victims’ surplus +CFG′H -FCHI net gain

6. Part C: From ideal governments to realitywhat would be second-best optimal policy? • Even well-intentioned government leaders often cannot achieve optimal policies • can’t observe Q* or MD (marginal damage) • can’t enforce property rights and regulations • can’t tax or spend without incentive effects • Second-best policy takes account of limitations • constrained second-best policy involves less intervention than unconstrained, ideal policy • clearest example concerns use of trade policy to achieve domestic policy goals

7. With trade, optimal policy must address production or consumption externalities directly A negative production extern. A positive consumption extern. S*=MC+MD D*=WTP+MSB D=WTP S=MC S=MC D=WTP Pw Pw A s A t Pc* Pp* Qc Qc Qc* Qp* Qp Qp optimal prod. tax: t efficiency gain from optimal policy: A optimal cons. subsidy: s efficiency gain from optimal policy: A Note that the optimal policy always offsets the externality directly. Using trade policy would create “by-product distortions” on S or D.

8. If only trade policy can be used, the second-best optimal policy does not reach Q* For example, using import restrictions to capture external benefits from domestic production… a “second-best” policy would restrict only until the external benefit of more production equals efficiency costs of less consumption Price ($/unit) S= MC S – ext. ben. The second-best Qs** is where… Pd** Pw marginal efficiency gain from more production… …just equals marginal efficiency loss from less consumption Qs** Qd** Qs* Qsfree Qdfree Going all the way to Qs* would not be optimal!

9. Part D: What determines real-life policies?Collective action and the political economy • Clearest example is from Garrett Hardin (1968): • “The Tragedy of the Commons” (aka “open access”) • Property rights over common pool resources may be ill-defined, leading to over-exploitation and degradation over time • …but studies of common property management find many nonmarket institutions arise to govern their use: • grazing rules over pasture use in “traditional” societies, • hunting/fishing rules that govern use of wildlife, etc. • social norms and conventions in general • Collective action is unavoidable, and it’s rarely clear how far from Q* we really are! • to tell, we would need careful measurement of the externality… • and also careful assessment of enforcement options; • “better” institutions help societies get closer to Q*… • but institutions may be slow to respond to technological change!

10. Collective action as a Prisoner’s Dilemma In Hillman’s example, two shepherds share a meadow. Their payoffs are mutually dependent: What will each shepherd do? Von Neumann-Morgenstern (1944): cooperative equilibrium …something else is needed to sustain cooperation Nash (1950, 1951): “best response” equilibrium we can predict based only on idea that both optimize.

11. Solving for a Nash Equilibrium • The Nash Program asks what is each one’s best response? • If #1 restricts, • then #2’s best response is to not restrict (gets 20 instead of 14) • If #1 does not restrict, • then #2’s best response is to not restrict (gets 3 instead of 1) • so Nash predicts #2 will not restrict • and by symmetry, the unique “Nash equilibrium” is neither restricts • …unless something else comes along!

12. Can property rights help avoid the prisoner’s dilemma? • Ronald Coase (1960): • society can do better than the Nash equilibrium, by assigning and enforcing property rights. • if property rights were assigned over everything, there would be no more externalities! • so all market failures can be seen as absence of well-defined property rights, as well as the presence of significant transaction costs … • does it matter how the rights are assigned? • does the benefit of enforcement exceed the cost?

13. The Coase Theorem Value per cigarette Any allocation of property rights leads to the same Qe Marginal cost of smoking to non-smokers equilibrium payment “collective action” zone marginal damage Marginal benefit of smoking to smokers foregone benefit Number of cigarettes smoked Qn Qe Qs No smoking Coasian equilibrium Free smoking

14. Under what conditions does the “Coase Theorem” hold? Any allocation of property rights leads to Qe, if: • There are no transaction costs • full information • costless enforcement • There are no income effects • no change in marginal costs/benefits These are extremely STRONG assumptions! • “Coasian” transactions are widespread towards the predictions of the “Coase theorem” • but initial allocations determine how close to the competitive equilibrium the market can reach. Why?

15. Some applications of Coasian logic • Coasian logic says assigning property rights to minimize transaction costs can improve outcomes • e.g. what’s easiest way to pay for a harbor’s lighthouse? • with few ships but many merchants, make the ships pay • with many ships, easier to make the merchants on shore pay • In some cases, can assign property rights to gain other benefits, e.g. for pollution policy: • can choose the “polluter pays” principle • gives a double dividend when payments finance clean-up • or, alternatively, a “cap-and-trade” system • gives polluters Pareto compensation through permit values

16. Some conclusions about collective action • Market outcomes depend on market structure • the easier it is for people to communicate and transact, the closer they can move to the surplus maximizing Q* • Market structure involves non-market institutions: • property rights, • taxes or subsidies, • quantity regulations • …and since externalities persist in equilibrium, • optimal policy is a second-best optimum, taking account of by-product distortions or other unintended consequences