Lectures #3 and #4 - Property Rights and Market Failure

Private Property Rights

• Property rights—a bundle of entitlements
  • Describe an owner’s rights, privileges and limitations for use of a resource.
  • Government restricts use of private property
  • Example - land
    • You own land in a neighborhood of one-story houses
    • Zoning laws -
      • You cannot build a factory there
      • You cannot build a 40-story skyscraper
  • Conflict between Government and the Public
    • Endangered Species Act: - A U.S. federal law that protect threatened and endangered species by preserving their environment
    • 5th Amendment to the Constitution - Government cannot take land without compensating the land owners
    • If government finds an endangered species living on your property, then
      • Owner has severe restrictions on their property
      • The government took the property, because it severely limited the owners choices
      • Government does not compensate to protect endangered species
• Private property regimes - individuals hold entitlement
• State-property regimes - governments own and control property.
• Common-property regimes - property is jointly owned and managed by a specific group.
  • They can exclude outsiders
• Open access regimes - no one owns or exercises control over the resources.

Markets

• Markets - bring buyers and sellers together
  • Creates harmony
  • Adam Smith - coined the phrase "The Invisible Hand"
    • Free market of individuals acting in their own self interest leads to a socially-desirable result.
  • Market price communicates information to market participants
    • If price is high, then suppliers could be earning profits
      • if suppliers are earning profits, then they should expand production
    • If price is low, then suppliers could be earning losses
      • if suppliers are earning loses, then they should contract production
    • Profits and market prices direct resources to the most profitable industries
• Market requires many assumptions
  • Large number of buyers and sellers
  • Thus, market has the maximum social welfare
    • Both consumers' and producer's surpluses are maximized
    • Market price is $1.50

• Market failure - something prevents the market to allocate resources efficiently
• Example
  • If a market has one buyer (i.e. monopsonist), then the buyer dictates the market price
    • Walmart - the largest corporation in the United States strong arms its suppliers
  • If a market has one seller (i.e. monopolist), then the seller dictates the market price
• A market failure implies wastefulness or economic inefficiency
  • Graph below shows reduced welfare
    • Consumer surplus shrinks
      • The demand function determines the market price
    • Producer surplus - could expand
      • Firms still in the market are selling for a higher price
    • Black triangle - Deadweight loss to market
    • Trade has been reduced

• Transaction costs - costs involved in making a transaction.
  • High transaction costs could prevent trade
• Include
  • Search and information
  • Bargaining and decision
  • Monitoring and enforcement
  • Transportation and setup
• Example - land transfers in the United States have high transaction costs
  • From 3% to 9% of value
  • A $100,000 house could have transaction costs up to $9,000
• New York Stock Exchange has high setup costs, but once market is operating tends to be low cost.
  • Financial instruments are uniform and many participants

Private goods - goods supplied by producers in private sector

• Characteristics
  • Rivalry - if one person buys and consumes a product, then another cannot buy and consume that product
    • If a person buys and drinks a Coca-cola, then another customer cannot consume that Coca-cola.
  • Excludable - producers can restrict consumption of their product to consumers who paid for it.
    • A store can restrict its sell of Coca-cola to a paying customers.
• Two people are in the market.
  • Each person has their demand function.
  • The quantity denoted by q is for a person, while Q is the total market quantity.
  • Likewise, demand by a consumer is denoted by d, while market demand is D.
  • Market demand - at each market price, horizontally sum the quantity that each consumer buys.

Market Failures

1. Public Goods - the market under supplies public goods and over supplies public bads, like pollution (Knut Wicksell 1896).

• Two conditions
  • Non-rival – one person consuming and enjoying a good does not prevent another person from consuming that good.
    • Marginal Cost = 0
  • Non-excludable – no person can be excluded from consuming that good.
• Free riders will consume public good, but not help pay for it
• Examples:
  • National defense (military)
  • Radio and television broadcast signals (FCC)
  • Clean air (EPA)
  • Stable monetary and financial environment
    • Central bank - influences inflation, interest, and foreign exchange rates
• Examples
  • Air Pollution
    • Non-rival - one person or firm polluting the air does not prevent another from polluting the air
    • Non-excludable - difficult to prevent people from polluting the air
  • Global Warming
    • Substitute greenhouse gases for pollution
• Quasi-public goods - market could supply these goods, but the supply would not be enough
  • Highways
  • Libraries
  • Education
  • Sewage disposal
  • Postal service
• Could be perverse market conditions for public goods if supplied by private market
  • Rome had no fire department around 115 B.C.
  • Marcus Licinus Crassus - started a private fire department in Rome
    • As a person house was burning down, Crassus would be negotiating a price for his services
    • Crassus had market power
    • One of the wealthiest Roman citizens
• Lindahl Price - a way to theoretically correct the market failure for public good
  • If we could ask people the price they would be willing to pay for public good
  • Then government charges each person his price (i.e. tax)
  • However, free riders may not truthfully reveal their preferences or willingness to pay
  • Not practical
  • Example
    • If government supplies 100 units of a public good
    • If people truthfully reveal willingness to pay
    • Person A pays $50 for these units
    • Person B pays $75 for these units
    • Total price is $125 for public good
  • "Vertical summation"

2. Asymmetric information - either the buyer or seller has more information than the other side

• Market may undersupply goods with severe asymmetric information problems
• Examples:
  • Credit card companies - calculating interest rates
  • Difficult to inspect good or seldom purchases the good from the same producer
  • Some firms will provide:
    • low-quality
    • defective
    • even harmful goods
• Moral hazard - one of the parties to a contract change their behavior that imposes a cost on the other party
  • A person gets car insurance and drives more crazy
  • A person gets theft insurance for his apartment and he leave the door unlock
  • Government insures bank deposits through FDIC
    • Banks may lend to more risky borrowers, because their depositors are protected from deposit insurance.
  • Financial institutions may invest in more risky assets, if they are certain government will bail them out.
• Adverse selection - one of the parties to a transaction withholds critical information
  • Usually people who buy insurance plan to use it
  • Person gets health insurance, knowing he has a medical condition
  • Person hires an arsonist to burn his business down after getting fire insurance
  • A person buys fire insurance, knowing he faulty wiring in his home
  • A person gets a credit card, knowing he will not make payments on it.
• Correcting asymmetric information
  1. Government
     • Some forms may be illegal and prosecuted by government
     • Weights and measures - government has inspectors that make sure gas pumps and supermarket scales are accurate
       • Are you sure you if you pumped one gallon and it is truly one gallon
     • Government sues producers that make false claims
     • Regulations - government approves new products and has inspectors that inspect products
       • Example - USDA has inspectors that frequently inspects meats
     • Licenses - ensures professionals have a high level of competency
       • Professionals like doctors, lawyers, mechanics, etc. need licenses to practice
  2. Private market
     • Purchasing good regularly
     • Brand names
     • Franchises
     • Product warranties
     • Public information - Consumer Reports - magazine that examines consumer products
     • Databases - companies compile information about customers and payment history

3. Open access property - property owned by society or the absence of ownership.

• Also called Tragedy of the Commons (Hardin 1968)
• Property rights are not well defined
  • Open access is nonexcludable but rivalrous
  • Outsiders cannot be excluded from using the property
  • Outsiders can consume the resource, leaving nothing behind
• People have less incentive to develop, improve, or maintain land, if others cannot be excluded from consuming it.
  
• Examples
  
  • Fishermen over fish in public waters.
  • Fishermen catch too many fish, causing fish populations to decrease to such a level that hurts future fish catching.
  • Companies dump wastes onto public lands or waters.
  • Air can be an open access resource. Some firms pollute and send pollution into the air
• Correcting this market failure
  • Allow one firm to control the resource
    • The firm acts like a monopoly and develops the best plan to utilize that resource
      • Monopoly may abuse that resource too
      • Example - monopolist - owns rights to common land with a forest
        • Monopolist cuts down all the trees if lumber prices are high
  • Government create a permit system
    • Anyone harvesting or extracting the resource needs a permit
    • Common property becomes private property
    • Permit holders will monitor the resource against invaders and poachers
    • Government has to monitor the permit holders to ensure they comply with the terms of the license

4. Externalities - The consumption or production of one individual or firm affects another person’s utility or production without their consent. 

• The externality influences profits and utility, but does not impact market prices. 
• Key - choice is not incorporated into the market price
• Therefore, an externality is not efficient (Arrow 1969). 

(i) Positive externality - an individual's or firm's actions generate benefits for nonparticipating parties

• The private market may not supply enough
• Supply function understates the true value of output
  • S is regular supply function and D is for demand
  • Society would desire a higher supply
    • Social Marginal Costs (SMC) - the marginal cost function that is beneficial for the whole society

• Example 1 - Inoculation for diseases
  • Each person who gets an inoculation can prevent spread of a disease
• Example 2 - scientific knowledge or technological know-how
• Fixing positive externality
  1. Subsidies - government provides subsidies so producers will supply more
     • Example - government grants subsidies to producers of vaccines
     • Note - government could subsidize the consumer to take advantage of the externality
  2. Government provides the good
     • Health departments give vaccines to the poor and elderly
  3. Government provides legal protection
     • Patent - grants inventors exclusive right to producer their invention for 17 years in the United States
     • Some countries may not honor patents

(ii) Negative externality - an individual's or firm's choice or action negatively harms others without their consent

• Property rights are not defined well
• Not all costs are registered, therefore supply function understates the true cost of production
• Example: A firm emitting pollution will typically not take into account the costs that its pollution imposes on others.   
  • Market price is too low
  • Market quantity is too high
  • The goal is to have firms pay for pollution
  • The goal is not to set the pollution to zero!
  • The pollution is in excess of the 'socially efficient' level.

• Correcting this market failure
  • Have a large list in next section
  • If negative externality is between two firms, gov. could be possible to merge both firms together
    • Not likely
    • Government seizure of property or aiding the growth of a monopoly

Fixing Negative Externalities, like Pollution

Also works for some open-access sources and some types of public goods

1. Prohibit or outlaw the pollution

• Government makes the pollution illegal or shuts down industry
• Problems
  • Creates job losses as industry shuts down.
  • If industry that generates pollution has a strong demand, then black markets could develop.
  • Government spends money to monitor, arrest, and incarcerate violators
  • Industry relocates to another country and exports it back to the original country

2. Lawsuits - U.S. has a variety of laws that allow people to sue to address externalities

• If firms know that they are creating negative externalities, they reduce negative externalities to reduce likelihood of being sued
• Firms compare marginal abatement cost to the marginal damage
  • By avoiding damage, the firm lowers its liability
  • Damage to the environment is very hard to estimate.
• Note that the government does not need to know the marginal costs of the firm in order to achieve the desired level of pollution.
• Problems
  • The burden of proof may be difficult in court.
  • Litigation is costly
    • Large legal fees and damage awards
  • Need to know both who causes the harm and what the damages are.
  • Courts are slow
  • Renting seeking behavior – encourage attorneys to sue for large legal fees and damage awards
  • Leakages – manufacturing firms may flee to developing countries with weak environmental laws
  • Courts usually do not come up with comprehensive plans
    • Rules are developed from a case-to-case basis

3. Command-and-control regulations (CAC) - government uses laws and regulations that dictate the standards and/or technology used to reduce pollution.

• Government fines and penalizes companies that violate the rules.
  
• Government could permanently shut down a company for excessive violations 
• U.S. has historically used command and control (CAC) policies
  • Why, when market-based environmental policies are more efficient?
  • Reasons
    1. Environmental groups - firms shouldn't be able to buy the right to pollute
       • Immoral to hurt the environment
    2. Politicians prefer CAC because:
       • Many are trained as lawyers.
       • Created laws and regulations are their jobs
       • The costs of CAC are less obvious
         • The private firms bear most the costs
    3. All firms are treated fairly

(i) Types of command and control regulations

1. Ambient Standards - Regulates the amount of pollutant present in the surrounding (ambient) environment.
   • Government has sensors the measure pollution levels in an area
   • Examples:
     • Parts per million (ppm) of dissolved oxygen in a river
     • Sulfur dioxide (SO2) in an airshed
   • Measures are often an average over a 24 hour period or per year
     • Concentrations vary by time of day and by season (e.g. due to changes in weather)
   • Note that the level itself cannot be directly enforced
   • Government tracks down the suspects, i.e. the polluting firms
     • The firms have to develop a plan to reduce pollution
2. Emission standards - regulates the level of emissions allowed
   • Environmental Protection Agency (EPA) has links to sensors in electric power plants in the United States
   • The polluter may have freedom to choose the technology used
   • Examples
     • Emissions rates (pounds of SO2 per hour)
3. Technology standards - require polluters to use certain technologies, practices, or techniques.
   • Examples
     • Before 1990, electric utilities were required to install scrubbers with 90% efficiency ratings.
       • Coal has trace amounts of sulfur
       • The scrubbers removed SO2 from the exhaust
   • U.S. gov. requires catalytic converters in automobiles with gasoline
     • Converts have platinum, which is expensive
     • Reduces NOX emissions
     • Oxides of Nitrogen, such as nitrous oxide (N2O) and nitrogen oxide (NO)

(ii) Grandfathering of regulations-  standards and regulations depend on the date the company starting using specific machines and equipment

• The date a electric power plant started operating
• Newer units face more restrictive regulations.
• Older units are often exempt, i.e. grandfathered.
  • Grandfathering reduces resistance to the new regulations
  • Easier to pass regulations if they do not harm existing firms
• Could lead to more emissions in the short run
  • Companies use the older, less efficient equipment longer
  • New technology may be expensive
• Firms may reduce investment in new technologies or renovated an old plant or factory
  • If a firm upgrade or renovates its facilities, then the new regulations apply
• Potential for economic rent for existing firms
  • rent - unfair, long-run profits
  • firms with old equipment may have a cost advantage
• New firms may not enter the market
  • Creates a barrier to entry
    • This protects monopolies
  • Higher investment costs to implement that regulations

(iii) Problems with command and control regulations

• Not efficient
• Freezes technology and limits firm’s flexibility
• U.S. government uses self-monitoring
  • Firms keep their own records on emissions, and are subject to surprise audits.
• Although regulations are set by the federal level, the local governments enforce the regulations.
  • Local government may be more concerned about creating jobs and expanding the tax base

4. Coase Theorem - disputing parties will work out a private agreement that is efficient

• Named after Noble laureate Ronald Coase (1960)
• Externalities are reciprocal in nature
  • Not only does the pollution cause an externality, but also the presence of the victims harms the polluter
  • Pollution is not a problem if no one were harmed
• Polluting firms and the people that are harmed by the pollution can negotiate to reduce pollution.
  • Does not depend which party holds the property right.
  • Example - a firm dumps pollution into a lake that kills the fish.
    1. If the right to use the lake is given to the fishermen, then the polluting firm has to negotiate and compensate fisherman in order to pollute the lake
    2. If the right is given to the polluting firm, then the fishermen will pay the firm not to pollute the lake.
• Benefits
  • Could work for small group of people
  • Private parties solve a pollution problem without the government’s help
• Assumptions and Problems
  • Property rights are well defined
    • Someone owns the resource
  • Need to be able to clearly establish who causes the harm.
    • Some victims aren't well defined (e.g. endangered species)
  • Zero transaction costs
    • Search and information
    • Bargaining and decision
    • Monitoring and enforcing
      
  • Perfect information
    
  • A court system enforces contracts without any costs.
    
  • Two parties (it is more difficult for large groups of people to agree about something).
    
  • No wealth effects.
    
    • If ownership of the resource makes one party wealthier, then that party may be more resistant to bargaining.
  • More people will come to the problem if they are likely to be compensated.

5. Market incentives - government uses price or quantity mechanisms to internalize the externalities.

• Price incentives
  • Pollution taxes - government puts a price on pollution
  • Subsidies - government helps firms pay for pollution equipment
• Quantity rationing
  • Market permits - government requires firms to have a permit in order to pollute
    • Government creates permits
    • Firms may purchase or sell permits in a market

(i) Pigouvian Taxes - government places a tax directly on pollution.

• Government imposes a tax for each unit of pollution that is emitted
  • Firms are supply too many units to the market
    • Creating pollution
  • Government places a tax on pollution
    • Taxes increase a firm's costs and reduces profits
    • The Pigouvian tax works by internalizing the cost of the externality.
    • Polluter incorporates the social cost of pollution.
  • Firms also have an incentive to develop new pollution control technology in order to avoid paying taxes
  • Government implements a tax on pollution, which puts a price on pollution
    • Equilibrium price increases while quantity supplied decreases
    • This is efficient because firm pays all costs including pollution
    • Firms still pollute, but less
    • Firms can pay the tax on pollution or avoid the tax by reducing pollution

• Welfare effects
• Usually taxes cause a deadweight loss on society
• However, firms are polluting, which is harming the environment
• It is like the environment is subsidizing the production
• Shown in graph below
  • Red triangle - shows up as consumer and producer surpluses, but represents damage to the environment
    • Price is too low and quantity is too high
  • Yellow triangle - damage to environment; nobody benefits from this
    • Quantity should be less than Q*
    • It is not the price that damages the environment, but the quantity

• Alternative method to show tax
  • Be careful of the scale
  • MB - as firms invest in more abatement equipment, the marginal benefits to the environment decreases
  • MC - as firms invest in more abatement equipment, its marginal costs increase
  • Gov. places a tax on pollution
    • If there were no tax, firms would not invest in abatement equipment

• Have to be careful how tax is placed
  • If tax is place on any else other than pollution, then perverse incentives could exist.
  • Example 1 - Gov. places tax on coal to reduce sulfur emissions.
    • Utilities may use dirtier, cheaper coal to avoid tax and increase emissions.
  • Example 2 - Difficult to measure the actual emissions from cars
    • Gov. taxes gasoline, then drivers reduce their mileage
    • Gasoline consumption and emission are directly related
• Advantages
  • Gives firms more flexibility.
    
  • Firms may meet pollution objective with lower costs
• Problems
  • Piguovian taxes require massive amount of information to implement the tax correctly
  • Regressive taxes - placing a tax on an industry makes products more expensive
    • The higher price may impact low-income families, because they spend more of their income on it.
  • Government may be more interested in the tax revenue than setting the correct tax rate
• Double-dividend debate
  • The Pigovian tax causes two things.
    1. The externality is corrected.
    2. The tax gives the government revenue, so it could reduce other distortionary taxes.
       
  • Taxes distort markets, because market prices are higher and market quantities are lower.
  • Empirical research indicates Pigovian taxes may also be distortionary

(ii) Government can implement a subsidy

• The opportunity cost of polluting is losing the subsidy.
• Government grants a subsidy to help a firm pay for a specific abatement technology.
  • The technology helps reduce pollution.
• Problems with subsidies
  • The polluter receives money from the government, rather than paying
  • New firms may enter market, so that total pollution increases
  • Need to raise taxes to pay for subsidies
    • Taxes create distortions in the market
    • Market price is higher and market quantity is lower.
  • Ethics - should we have to pay to avoid pollution?
  • Subsidies are often politically motivated, and can be difficult to remove when no longer needed.

(iii) Market Permits - A transferable discharge permit places the maximum limit of pollution or concentration level that any firm is allowed to discharge into the environment.

• Examples
  • Some electric generation plants use coal to generate electricity
    • Some coal has sulfur that turns into sulfur dioxide when burned
    • Sulfur dioxide leads to acid rain
    • They have to buy sulfur dioxide permits
  • Proposing a permit system for mercury emission and greenhouse gases
• Government places the maximum amount of pollution that can be emitted
  • Also called cap and trade system
  • Each polluter has to buy a permit
    • One permit allows firm to emit 10 metric tonnes of sulfur dioxide into atmosphere
  • Government creates enough permits, where
    • Sum pollution levels in permits = maximum pollution level
    • Quantity rationing
      • Pigouvian tax - is price rationing
• The permit creates a market price of pollution.
  • Firms with high marginal abatement costs buy permits, so that they could pollute more
  • Firms with low marginal abatement costs sell permits, and pollute less.
  • Firms with low abatement costs may be investing in new technology
• Government sets the max. pollution level
  • Firm 1 buys permits and pollutes more
  • Firm 2 abates pollution and can sell its permits
  • Marginal Social Costs (MSC) of pollution
  • Q bar is max. pollution level

• Thus, the permit market is efficient, because 
  • Producers have to keep their pollution level at or below the amount specified in the permits.
    • Used in sulfur dioxide emissions, quotas on fish harvesting, etc.
    • Theoretically, you get the same result as a Pigouvian tax
      
• How are permits allocated
  • Government auctions permits - government sells permits to the highest bidder
    • Auctioning permits gives government gets revenue from the permits.
    • Plan appears as a "tax"
  • Grandfathering - government give permits to the firms
    • Firms are less likely to resist the implementation of a permit system.
    • How are permits distributed?
    • Some firms are bigger than others, etc.
    • Distribute permits relatively to their pollution levels
  • Hybrid - government could give some of the permits freely and hold some back to auction off at the market
• Permits require the following to have low transaction costs
  • Homogeneous - all permits are identical
  • Perfectly divisible
  • Exchangeable -producers can buy and sell their permits without interference
• Market participants - can anyone buy the permits?
  • Environmental groups or private individuals could buy permits and retire them
  • Pollution is not released into atmosphere
• Benefits
  1. The permit is a right that can be sold or bought in a market.
  2. The permit creates a market price for pollution
  3. Gives firms more flexibility
  4. Firm may meet objective with lower costs
• Problems
  1. Regulators must have sufficient knowledge to design the market.
  2. Government has to monitor pollution levels
     • Prevent illegal emissions or illegal dumping.
     • Government may have higher enforcement costs
  3. Market-based policies may lead to localized "hot spots."
     • Hot spots - a group of neighboring polluters buy permits to pollute more
     • Concentrated area of pollution
  4. Does government set a maximum pollution level that applies forever
     • Example - no more than 10 trillion tons of sulfur dioxide can be emitted into atmosphere
     • Does government create new permits each year
     • The price of market permits can "shoot" up quickly if government establishes a maximum pollution level forever.
       • Hotelling's Rule - Covered in non-renewable resources
  5. Permit market may have few participants, because it is a specialized market
     • A firm may have market power