Market Failures - Washington State University

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Market FailuresMarket failure occurs when the market outcome does not maximize netbenefits of an economic activity.Due to the nature of environmental resources, the market often fail indealing with environmental resources.There are three main environmental market failures. a. Externality b. Public Goods C. Tragedy of the Commons

Externality An Externality results when the actions of an individual/firm havedirect, unintentional, and uncompensated effect on the well-being ofother individuals or profits of other firms. The key words are: Direct: There has to be a direct effect on well-being of an identifiableindividual(s) or profits of firms. Unintentional: The effect rather than the action has to beunintentional. This rules out acts of spite or malice. Uncompensated: The responsible actor is not compensated for theiractions.

Examples of Externalities Second hand cigarette smoking. Air pollution from factories and power plants. In the Pacific Northwest, logging in forested headwaters degradesspawning habitat for salmon- adversely affect commercial fishing Hydroelectric dams hinder the fish on their way upstream- adverselyaffect commercial fishing. Firms R &D often produces knowledge that its rivals can use. If a neighbor keep their houses and flower gardens well maintained,the value of the houses in that neighborhood is likely to rise.

How do Externalities Cause Market Failure?Lets take the example of a steel industry: Steel furnaces typically burn coal, emitting sulfur dioxide, nitrousoxides and particulate matter. Lets assume there is a fixed relationship between the amount ofsteel produced and the amount of pollution emitted.E.g, say for every one thousand tons of steel produced, one ton ofsulphur dioxide is emitted.The amount of the pollution causes damage to downwind residents.There is a marginal damage of pollution function which is dependenton amount of steel produced


Externality In the absence of regulation, steel producers will ignore thedamages caused by pollution. The supply curve here corresponds to only the private marginalcosts of steel (PMC) The producers of steel ignore another cost of production; damagesfrom pollution-externality! With this externality, the social marginal cost (SMC) is not equal tothe supply curve ( which only reflects the MPC).SMC MPC MD. In a free market without regulation, QM would be produced. When regulation forces the steel industry to internalize the marginaldamage as part of their cost, the supply curve will now be SMC.Now the equilibrium output of steel is Q*.

Consequences of Market Failure in this Case. Sub-optimal Output: After regulation help internalize the damagingcost, output falls (QM Q*). Sub-optimal Pricing: Price increases after externality isinternalized. As a consequence of the above, the sum of consumer and producersurplus decreases after internalizing the externality in this case. What makes internalizing the externality welfare enhancing? Social surplus from steel production is not just the sum of producerand consumer surplus but also the damages from pollution- socialwelfare deadweight loss. Although the reduction in output and the corresponding increase inprice hurt both consumers and producers of steel, it benefits peoplewho are harmed by pollution resulting from the steel production.

Public Goods Goods that are shared by all but owned by no one.There are two fundamental characteristics of public goods that lead tomarket failure. Non-rivalry: A good is non rival in consumption if more than oneperson can consume the same unit of good at the same time. Theconsumption from individual does not diminish the amount availablefor others. Non-excludability: A good is non-excludable if the supplier cannotprevent consumption by people who do not pay. If the person doesnot contribute to the provision of that good, they cannot beprevented from enjoying that good. Public good is

Market Failures Market failure occurs when the market outcome does not maximize net-benefits of an economic activity. Due to the nature of environmental resources, the market often fail in dealing with environmental resources. There are three main environmental market failures. a.

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