Market Inefficiencies & Externalities

• Inefficiencies in markets can arise from externalities and the nature of public goods.

Externalities Defined

• Externalities involve costs or benefits from a market activity affecting a third party, who is neither the buyer nor the seller .
• Pollution and vaccinations are examples of externalities.
• Market failure occurs if externalities results in an inefficient allocation of resources.
• Internal costs or benefits are those participants in a market activity receive or pay directly.
• External costs or benefits are those imposed on individuals not involved in the market.
• Social costs or benefits are the sum of internal and external costs or benefits.
• Externalities exist when internal costs or benefits do not equal social costs or benefits.
• Third-party problems arise when those not involved in a market activity experience positive or negative externalities.
• Negative externalities lead to "too much" consumption or production of a good.
• Examples of negative externalities: excess cologne, reclining airplane seats, and going to school sick.
• Positive externalities result in "not enough" consumption or production of a good.
• Examples of positive externalities: vaccines, gardening, and hybrid vehicles.

Correcting for Externalities

• Internalizing externalities involves individuals accounting for the social costs or benefits of their actions, positively or negatively.
• For negative externalities, the goal is to make firms recognize external costs like taxing the product (carbon tax, bottle tax, plastic bag tax)
• Regulation of production (emission limits, banning red dye 3, fuel efficiency standards)
• Encouraging research and development of alternative substitutes (grants, subsidies, biodegradable plastics) can all help correct for externalities.
• When firms recognize the external costs, a company's costs equal the social cost, shifting the supply curve to the left.
• Subsidizing production is not appropriate for correcting negative externalities.
• For positive externalities, help individuals realize external benefits through finance/subsidies (college education, tax credits)
• Laws that require consumption (vaccines, K-12 school), and encouraging research (pharmaceutical research, public transport).

Property Rights

• Clearly defined property rights prevent externalities
• Property rights give owners power over a resource, such as deeds, patents, and fishing licenses.
• Private property grants exclusive ownership for use and exchange, such as a phone, stock certificate, and laptop.
• Property rights create the incentive to maintain, protect, conserve, and enable trade with others.

Coase Theorem

• The Coase Theorem states that in the absence of negotiation barriers and with fully specified property rights, interested parties will bargain to correct externalities,
• The assignment of property rights is irrelevant, as bargaining will lead to an efficient outcome.
• Consider the example of two adjacent farmers, one raising cattle and one growing wheat, without fences
• Scenario 1: When the cattle rancher is liable for damages, they can either erect a fence or pay for damages.
• The rancher will choose the cheapest option, internalizing the costs.
• If a fence costs $25,000 and the damages are $30,000, the rancher builds the fence.
• If the damages are $20,000, the rancher pays for the damages without building the fence.
• Scenario 2: If the wheat farmer lacks legal rights to cattle-free fields, the farmer may erect a fence to prevent cattle damage instead,
• If a fence costs $25,000 but damages are $30,000, then the farmer will build the fence
• Where damages are $20,000, than the farmer must accept occasional cattle damage.

Public and Private Goods

• Economists classify goods based on two characteristics: excludability and rivalry.
• Excludability refers to the possibility of preventing consumption by those who have not paid.
• Rivalry means that one person's consumption of the good prevents simultaneous consumption by others.
• Private goods are excludable and rival in consumption (cups of coffee, phones, clothes, cars)
• Public goods are non-excludable and non-rival (national defense, street lights, public parks, lighthouses)
• Public goods can be consumed by many, and it is difficult to exclude non-payers.
• The free-rider problem occurs when individuals receive the benefit of a good without paying for it.

Club and Common Goods

• Club goods are non-rival but excludable, such as Netflix, toll roads, and country clubs.
• Common resource goods are rival but non-excludable such as fishing, forests, and community gardens.

Cost Benefit Analysis

• Cost-benefit analysis helps determine if the benefits of providing a public good outweigh the costs.
• Costs easier to compute than benefits.
• Individuals might misrepresent the value they place on a public good (national defense).

Tragedy of the Commons

• Tragedy of the commons happens when a rival but non-excludable good is depleted or ruined i.e. cattle grazing on common ground.
• The commons can be sustained with a limited capacity but if everyone acts in their own intrest the commons is destroyed.
• Real-world examples: Haiti deforestation, bluefin tuna, traffic jams, public restrooms or shared spaces.

Possible solutions

• Proactive management is used to solve the tragedy of the commons which include taxes and regulations.
• Other solutions include taxes (carbon tax, license tax), regulations (fishing limits/seasons, water restrictions),
• Cap and trade system can be used like a pollution "permits" that can be traded on an open market.
• Firms that can control emissions cheaply sell their permits, but the firms that face very high costs to reduce emissions will purchase permits,
• This creates property rights for pollution to internalizes the externality.

Summary

-Occur because of poor incentives -Externalities: arise from diverging social and private costs and can be corrected by internalizing them -Efficient level of pollution?: Must use cost-benefit analysis