CHAPTER THREE

EFFICIENCY, PROPERTY RIGHTS, MARKET

FAILURES AND THE ENVIRONMENT
 EFFICIENCY, DISCOUNTING AND INTERGENERATIONAL EQUITY
Two types of economic analysis can be useful in raising our
understanding of the relationship between the economy and
the environment:
Positive and normative analysis
Normative analysis can be useful in public policy in
several different situations
It might be used, for example, to evaluate the desirability
of a proposed new pollution control regulation
In these cases the analysis helps to provide guidance on
the desirability of the program before that program is put
into place
In other contexts it might be used to evaluate how an
already-implemented program has worked out in practice
10/17/2023 2
…CONT’D
 Here the relevant question is: would this be (or was this) a
wise use of resources?
Evaluating the desirability of a proposed action requires to
identify both the gains and the losses from that action
If gains exceed the losses, then it seems natural support the action
because it is desirable
In benefit-cost analysis:
 benefits are measured as the area under the demand curve
Total costs are measured by the relevant area under the
marginal cost curve
Net benefit is equal to that portion of the area under the
demand curve that lies above the supply curve
Thus, according to the normative choice criterion, desirable
outcomes are those where the benefits exceed the costs.
It is, therefore, a logical next step to suggest that optimal policies
are those that maximize net benefits (benefits-costs).
10/17/2023 3
THE DERIVATION OF NET BENEFIT
Price

Net M
MC

Benefit R
N

Total MB
Cost
0 4 5 6 Q

10/17/2023 4
 STATIC EFFICIENCY
The normative economic criterion typically used to judge resource
allocations at a point in time (static efficiency)
An allocation of resource is said to satisfy the static efficiency criterion if
the net benefit from the use of those resources is maximized by that
allocation
Static efficiency requires us to ask, what is the optimal units of Q?
If resource use in current time period does not affect the amount or the
price of the resource in future time periods, then resource decisions are
time – independent
The normative decision criterion for determining efficient resource use in a
static framework is to maximize consumer surplus plus producer
surplus in each period
The sum of consumer surplus and producer surplus is net social benefit
(NSB) - Optimal amount of Q would maximize net benefits
Is 4 or 6 units are efficient allocations? No…but the fifth unit increases the
net benefit(the
10/17/2023 area) by MNR 5
COMPARING BENEFITS AND COSTS ACROSS TIME
The static efficiency criterion is very useful for comparing resource
allocations when time is not an important factor
Yet many of the decisions made now have consequences that persist
well into the future: time is a factor
Example:
Exhaustible energy resources, once used, are gone
Biological renewable resources can be overharvested, leaving smaller
and possibly weaker populations for future generations
Persistent pollutants can accumulate overtime
How can we make choices when the benefits and costs may occur at
different points in time?
In order to incorporate timing, the decision rule must provide a way to
compare net benefits received in different time periods
10/17/2023 6
…CONT’D
Present value:
Present value explicitly/clearly incorporates the time value of
money
Present value translates everything back to its current worth
A Birr today invested at 10% interest yields Br. 1.10 a year from
now
The present value of Br. 1.10 received one year from now is
therefore Birr 1.00
We can find the present value of any amount of money (X)
received one year from now by computing X/(1+r), where r is the
appropriate interest rate
The amount of birr earned in two years at r percent using
compound interest would be Br. 1(1+r)(1+r) = Br. 1(1+r)2
10/17/2023 7
…CONT’D
It follows then that the present value of X received two
years from now is X/(1+r)2
The net present value of a one time net benefit received n
years from now is
Bn
PV [ Bn ] 
(1  r ) n

The net present value of a stream of net benefits {B0, B1,…,

Bn} received over a period
n
of nByears is computed
n
as t
PV [ B0 ,..., Bn ]   (1  r )
t 0
t
t
 B
t 0
t (1  r )

Where PV (B0,…,Bn) denotes the present value of net

benefits of resource extraction in all n periods, r is the
discount rate, (1+r)-t is the discount factor in period t
10/17/2023 8
…CONT’D
The process of calculating the PV is called discounting, and
the rate r is referred to as the discount rate
It is now possible to show how this analysis can be used to
evaluate actions
How can we think about optimal choices when the
benefits and costs occur at different points in time?
The traditional criterion used to find an optimal allocation
when time is involved is called dynamic efficiency
An allocation of resources across n time periods satisfies the
dynamic efficiency criterion if it maximizes the PV of net
benefits that could be received from all the possible ways of
allocating those resources over the n periods

10/17/2023 9
DYNAMIC EFFICIENCY: A TWO-PERIOD MODEL
It provides intergenerational equity (justice) or fairness in the
distribution of the wealth of nation
To what degree is dynamic efficiency compatible with
intergenerational fairness?
Dynamic efficiency balances present and future uses of a
depletable resource by maximizing the PV of the net
benefits derived from its use
We can investigate the properties of this allocation and
influence of such key parameters as the discount rate with
the aid of a simple numerical example
We begin with the simplest of models - deriving the dynamic
efficient allocation across two time periods: current period
and future period
10/17/2023 10
MATHEMATICAL DERIVATION OF DYNAMIC EFFICIENCY
Assume that the demand curve for a degradable resource is linear
and stable over time.
Thus, the inverse demand curve in year t can be written as:
Pt  a  bqt
The total benefits [TBs] from extracting an amount qt in year t are
then the integral of the demand function (area under the inverse
demand curve)
qt
b 2
(TBs) t   (a  bq)dq  aqt 
0
2
qt

Further assume that the marginal cost of extracting that resource is a

constant c, thus total cost of extracting qt of the resource in year t is
given by:
(TC) t  cqt
…CONT’D
If the total available amount of the resource is Q , then the
dynamic allocation of a resource over n years is the one that
satisfies the maximization problem:
bqt2
n aqt   cqt
Maxq  2
t 1 (1  r ) t 1
S .t
n
Q  q
t 1
t

The Lagrange equation is given by :

aqt  bq / 2  cq t
n 2 n
Maxq  t 1
 [Q   qt ]
t

t 1
10/17/2023
(1  r ) t 1 12
 …CONT’D
Assuming that Q is less than would normally be
demanded, the dynamic efficient allocation must satisfy
a  bqt  c
t 1
   0, where t=1, 2, …, n ----------(1)
(1  r )

n
Q  q
t 1
t
---------------------------------(2)
Here the implication of equation 1 is that (P-MC) increases
over time at rate r
This difference, which is known as the marginal user cost, will
play a key role in our thinking about allocating degradable
resources over time
10/17/2023 13
 …CONT’D
Both the size of the MUC and the allocation of the resource
between the two periods is affected by the discount rate
The size of the discount rate is a major determinant of the
allocation of resources among generations
The amount allocated to future period would be necessarily
smaller with larger discount rates
Higher discount rates tend to skew resource extraction
toward the present
B/C they give the future less weight in balancing the relative
value of present and future resource use
The choice of what discount rate to use, then, become a very
important consideration for decision makers
10/17/2023 14
 PROPERTY RIGHTS (PRS)
Producers and consumers use of environmental resources depends on the
property rights governing those resources
In economics, property right refers to a bundle of entitlements defining
the owner's rights, privileges, and limitations for use of the resource
These property rights can be vested either with individuals, as in the
capitalist economy, or with the state, as in a centrally planned socialist
economy
Property rights are institutional rules that govern and facilitate the use
and exchange of resources and commodities
Efficient property rights are a prerequisite for transactions
Market equilibrium prices and quantities are influenced by the
specification of property rights
Purely competitive markets automatically achieve efficient resource use
through the independent profit maximizing behavior of firms and utility-
maximizing behavior of households, provided there exists an efficient set
of property
10/17/2023
rights 15
 EFFICIENT PROPERTY RIGHTS
Property rights are efficient if they satisfy four basic properties:
Ownership, Specificity, transferability, and enforceability
Ownership is the legal mechanism for conveying property
rights to a resource
It determines who has the legal right to use a resource
In cases where resources are privately owned, ownership is
secured by payment in an amount that mutually agreeable to
buyer and seller
Five important property rights that make up together ownership:
»Access - the right to enjoy benefits of the property that do not
subtract from benefits that others can enjoy: authorized
entrants have access rights, such as those that are purchased
with entry fees at national parks

10/17/2023 16
…CONT’D
»Withdrawal: the right to withdraw the product of the property,
such as harvesting fish from a fishery, a firewood gathering
permit from a national forest
»Management: the right to regulate use and improvements:
farmers who participate in the management of government -
owned irrigation systems
»Exclusion: the right to determine who has access and who can
be excluded from using the property. It is the most restrictive
form of ownership; it allows the resource owner to let another
party use or not the resource. e.g. villages that possess and
govern their own common property pastures and forests
»Alienation: the right to sell or lease. "Owners" possess all the
rights of proprietors along with the right of alienation e.g.
private property falls under this category, though owners can
also be governments or communities
10/17/2023 17
…CONT’D
Specificity: of property rights refers to the bundle of rights
that apply to a particular property
It determines what can and can not be done with the
resource. e.g. Cattle owned by a rancher graze on a
neighbor's land, causing damages to the land
The neighbor's property rights are being violated if the
rancher does not have permission to graze cattle on the
neighbor's land
If the neighbor's land is designated as open range, however,
then the rancher has a right to graze cattle on the neighbor's
land
If cattle grazing is not covered by a property right, then a
conflict is likely to arise between the rancher and the
neighbor
10/17/2023 18
…CONT’D
Resource conflicts can be resolved when the rights of the
rancher and the neighbor are completely specified
Four different classes of property rights based on who
holds these rights:
›Private property rights: rights held by individuals
and business enterprises, usually with a legally
recognized owner
›Common property rights: rights held by an
identified group of proprietors
›State property rights: rights held by the
government
›Open access: no specific property rights
recognized
10/17/2023 19
…CONT’D
Transferability: An efficient property right is transferable,
which allows resource to be allocated to their highest valued use
Transferability of property rights makes possible:
the leasing of private land,
creation of utility easements
the existence of restrictive covenants
All property rights should be transferable from one owner to
another in a voluntary exchange
Ownership, specificity and transferability of property rights are
of limited value in achieving efficient resource use without
enforceability
Enforceability requires that the property right be enforceable
and enforced when there is violation of the standard
Property rights should be secure from involuntary seizure or
encroachment by others
10/17/2023 20
…CONT’D
An owner of a resource with a well - defined property
right has a powerful incentive to use that resource
efficiently
Farmers who own the land have an incentive to fertilize
and irrigate it because the resulting increased production
raises income
When well-defined property rights are exchanged, as in
a market economy, this exchange facilitates efficiency
The seller has the right to prevent the consumer from
consuming the product in the absence of payment, the
consumer must pay to receive the product

10/17/2023 21
MARKET FAILURES
There are three conditions under which operation of free
market fails to achieve efficient resource use:
»The market is not purely competitive
»The resource is a common property or open access resource,
and
»There are externalities and public goods
The failure does not mean there is something morally or
ethically wrong with the market
Rather, it implies that the prices generated in the market do
not provide firms and households with the incentive needed
to achieve socially efficient resource use
A market failure occurs when the market for a resource is
not purely competitive
10/17/2023 22
…CONT’D
Suppose there is only one buyer of a resource
(monopsony) instead of many independent buyers
The demand curve for the commodity produced
using the resource (D), the marginal cost of
production in pure competitive market (MCc), and
for the monopsonist (MCm)

Price MCm

Pm MCc

Pc

0 Qm Qc Quantity
10/17/2023 23
…CONT’D
Under pure competition, individual firms can not influence the
price paid for the resource
Each firm can purchase as many units of the resource as needed
at the market price
Hence, MCc is determined by adding up the marginal cost
curves for all firms in the industry
When there is only one buyer of the resource, additional units
of the resource can only be purchased by paying a higher price
The higher price applies not only to the last unit purchased, but
to all units purchased
Therefore, MCm > MCc, which causes the equilibrium price to
be higher (Pm > Pc), and the equilibrium quantity to be lower (Qm
< Qc )
Resource use is not efficient with monopsony:
Inefficiencies caused by monopsony and other forms of
imperfect competition reduce economic welfare
10/17/2023 24
COMMON PROPERTY AND OPEN ACCESS RESOURCES
Natural resources can be managed as common property or open
access resources
Common-pool resources
 Non-exclusivity (exploited by anyone)
 Divisibility / rivalry (your use diminishes my use)
Common-property resources are those shared resources that are
managed in common rather than privately
Common property resources are resources that are owned in common
and managed for a common purpose
Owners jointly have exclusive rights to the property but cannot
exclude one another from using it
Entitlements to use common-property resources may be formal,
protected by specific legal rules, or they may be informal, protected by
tradition or custom
There may or may not be restrictions on how frequently owners may
use the resource
10/17/2023 25
…CONT’D
If frequency of use is not restricted, then the resource tends to be overexploited,
which results in Garrett Hardin's ‘tragedy of the commons’
Tragedy of the commons: common resources become de-facto open access if
exploitation rules are not well articulated and regulated.
Overexploitation of a common property resource is illustrated for cattle grazing on
rangeland
The efficient stocking rate (number of cattle per acre) for rangeland owned in
common by a group of ranchers
Suppose the ranchers do not control the stocking rate selected by each rancher
This means each rancher has complete freedom to select his or her own stocking rate
Define the marginal net private benefit (MNPB) of cattle grazing as the difference
between the price(P) and the private marginal cost(PMC) of production for cattle:
MNPB= P- PMC
Profit for each rancher is maximized by selecting a stocking rate of Qr
where
10/17/2023
MNPB = 0 26
…CONT’D

Value per
Cow MD

MNPB

0 Qh Qs Qr Stocking
Rate

10/17/2023 27
…CONT’D
Suppose that when a certain stocking rate is exceeded,
namely, Qh, increasing the number of cows grazed in the
common area reduces quantity and quality of forage for each
cow
»In other words, overgrazing occurs
The marginal damage (MD) from overgrazing equals the loss
in income from grazing an additional cow when the stocking
rate exceeds Qh
When each rancher/farmer independently selects the profit
maximizing stocking rate, namely, Qr, damages to the
rangeland are a maximum
This suggests there are potential benefits from joint
management of the rangeland
10/17/2023 28
…CONT’D
Consider at a stocking rate of Qs, MNPB =MD and net social
benefit is greater than it is for any other stocking rate
Notice that the socially efficient stocking rate (Qs) is less than
the privately efficient stocking rate (Qr)
There is no guarantee that the ranchers will agree to limit
the stocking rate to Qs
In the case of open access resources, no one owns the
resource and over exploitation occurs
Open access resources are those that are not exclusively
controlled by a single agent
Non exclusivity implies that resources can be exploited by
anyone, the capture of part of the resource by one group
subtracts it from the amount available to other groups
10/17/2023 29
…CONT’D
TB, TC Total Cost

Total Benefit

0 E1 E2 Harvest Effort

MB, MC

MC = AC
Scarcity
Rent MB Average Benefit
0 E1 E2 Harvest Effort
10/17/2023 30
…CONT’D
Scarcity rent= revenues from harvest – cost of harvest
Total surplus = total revenue - total cost
For privately owned resource, the efficient level of
harvest in this model (E1) maximizes the surplus
(benefits)
At E1 MB, which is the addition to the surplus from
an additional unit of effort equals MC, which
measures the reduction in the surplus due to the
additional cost of expending that last unit of effort
At E1, Average benefit > Average cost & MC, the
surplus (scarcity rent) is reinvested
10/17/2023 31
…CONT’D
With all hunters having completely unrestricted access to the
resource, the resulting allocation would not be efficient
No one have an incentive to protect scarcity rent by
restricting harvesting effort
If the resource is open access, effort is continued until the
net gain (scarcity rent) is zero
Individuals, without exclusive rights, would exploit the
resource until TB = TC, at (E2)
Two characteristics of this formulation of the open-access
allocation are worth noting:
»In the presence of sufficient demand, unrestricted access will
cause resources to be overexploited;
»The scarcity rent is dissipated; no one is able to appropriate the
rent, so it is lost

10/17/2023 32
…CONT’D
Unlimited access in open access destroys the
incentive to conserve the resource
Using game theory: open access and prisoner’s dilemma
Person A
Cooperate Non-cooperate
Cooperate (30 ,30) (10, 40)
Person B
Non-cooperate (40, 10) (15, 15)
The dominant strategy is (non-cooperate, non-cooperate)
Open access ultimately result in lower benefit to the society

10/17/2023 33
…CONT’D
If they cooperate, the total benefit is 60 but now it is 30
The case of common property:
Person A
Cooperate Non-cooperate
Person B Cooperate (50, 50) (10, 10)

Non- cooperate (10, 10) (20, 20)

There is no dominant strategy for the two persons
The Nash equilibrium is (coop, coop) and (non-coop, non-
coop)
If they agree they maximize at (50, 50), if they does not
enter in to agreement they fail and maximize less (20, 20)
10/17/2023 34
EXTERNALITIES AS A SOURCE OF MARKET FAILURE
Exclusivity: is one of the chief characteristics of an efficient
property rights structure
This characteristic is frequently violated in practice
Violations occurs when an agent making a decision does not
bear all of the consequences of his or her action
Suppose two firms are located by a river: the first owns a
garage and the other is fisherman
Both use the river, although in different ways the garage
owner uses it as a receptacle for its waste
It could be expected to dump too much waste into the river,
and an efficient allocation of the river would not be attained
This situation is called an externality
10/17/2023 35
…CONT’D
An externality exists whenever the welfare of some agent,
either a firm or household, depends not only on his or her
activities, but also on activities under the control of some
other agent
When an externality is present, the welfare of the affected
party is influenced not only by its own activities, but also by
the activities of the acting party
It exists when the consumption or production choices of one
person or firm enter the utility or production function of
another entity without that entities permission
Markets are incomplete because there is no institution that
facilitate the exchange of benefits and costs

10/17/2023 36
…CONT’D
The Market for Garage service
Price
MCs
MCp
P*
Pm
D
0 Q* Qm Quantity

10/17/2023 37
…CONT’D
The demand for garage service is shown by the demand curve
D, and the private marginal cost of producing the service
(exclusive of pollution control and damage) is depicted as
MCp
Social marginal cost function (MCs) includes both of these
costs as well - Because society considers both costs
If the garage faced no outside control on its emission levels, it
would seek to produce Qm
But that is clearly not efficient, since the net benefit is
maximized at Q*, not Qm
Conclusions about market allocations of commodities causing
pollution externalities:
»The output of the commodity is too large
»Too much pollution is produced
» The prices of products responsible for pollution are too low
10/17/2023 38
…CONT’D
»As long as the costs are external, no incentives to search for ways
to yield less pollution per unit of output are introduced by the
market
»Recycling and reuse of the polluting substances are discouraged
because release into the environment is so inefficiently cheap
The effects of a market imperfection for one commodity end up
affecting the demands for raw materials, labour, and so on
The ultimate effects are felt through the entire economy
External effects, or externalities, can be positive or negative
External diseconomy (affected is damaged) and have been used
to refers to circumstances in which the affected party is damaged
by the externality
External economy (affected is benefited) have been used to
refers to circumstances in which the affected party is benefits
from the externality
Generally, when external economies are present, the market will
undersupply the resources
10/17/2023 39
EXTERNALITIES AND PROPERTY RIGHTS: RONALD COASE
THEOREM
An externality results from the absence of efficient
property rights
This suggests that a major way to eliminate or reduce
externalities is to establish efficient property rights
If property rights can be established, then normal
market transactions can be used to achieve efficient
resource use
The classical treatise on this subject was developed by
Ronald Coase
He argued that acting and affected parties have an
incentive to negotiate a reduction in external
diseconomies provided:
10/17/2023 40
…CONT’D
»The economy is decentralized making it possible for both
parties to negotiate an agreement freely and without
government interference
»The cost of negotiating and enforcing an agreement is low
»Efficient property rights are established
Consider applying these conditions to the externality caused
when the rancher's cattle graze on a neighbour's property
The first condition is assumed to be satisfied
Because there are only two parties, the second condition is
likely to be satisfied
What is the likelihood of the rancher and neighbour
negotiating a settlement without the establishment of
property rights (third condition)?
10/17/2023 41
…CONT’D
This is addressed in terms of the demand and supply
curves for reducing an external diseconomy
The externality is greatest at zero externality reduction
and is completely removed at RMax
Suppose that the neighbour is willing to bribe the
rancher to keep cattle off his property
If the amount of the bribe decreases with respect to the
level of externality reduction, then there are decreasing
marginal benefits of externality reduction
The neighbour is willing to make a lower bribe per cow
as the number of cows on his property decreases
10/17/2023 42
…CONT’D
Hence, the demand curve for externality reduction is
downward sloping
The rancher is willing to compensate the neighbour for
damages from the externality and that the level of
compensation per cow decreases as the number of cows
on the neighbour's property increases
In other words, the rancher is willing to provide a higher
compensation for the 1st cow than for the 2nd cow, a
higher compensation for the 2nd cow than for the 3rd etc
Compensation per cow increases as the number of cows
removed from the neighbour's property increases or,
equivalently, as the externality is reduced

10/17/2023 43
…CONT’D
Therefore, the supply curve for externality reduction (S) is upward sloping
Price
S
Fig. Equilibrium
price and
quantity for
P* D external
diseconomy

0 R* Rmax Externality
Reduction

10/17/2023 44
…CONT’D
The efficient quantity and price of externality
reduction occur where the demand and supply
curves intersect, namely, at R* and p*, respectively
At R*, the bribe that the neighbour is willing to
make equals the compensation the rancher is willing
to accept
While the 1st and 2nd conditions make it possible for
the acting and affected parties to negotiate a
settlement to the externality, negotiation is unlikely
unless property rights are assigned

10/17/2023 45
ASSIGNMENT OF PROPERTY RIGHTS
Does it make any difference how property rights are
assigned to the parties?
Ronald Coase showed that the efficient level of externality
reduction is achieved regardless of the assignment of
property rights, as long as transaction costs and income
effects are zero
Transaction costs refer to all the costs of settling externality
disputes, including expenses for attorney's fees and time
spent negotiating a settlement
Low transaction costs mean that the cost of negotiating a
settlement between the acting and affected parties is
negligible (In case of two parties)

10/17/2023 46
…CONT’D
In the example of lake eutrophication (depletion) from
livestock manure, transaction costs are high because of the
potentially large number of acting parties (polluting
farms)
Income effects occur when bribes shift the demand curve
and/or compensation shifts the supply curve for
externality reduction
When income effects are zero, the demand and supply
curves are not affected by the assignment of property
rights
For example, consider two property rules:

10/17/2023 47
…CONT’D
Rule 1 legalises open grazing (which gives the rancher
the right to graze cattle on the neighbour's land), and
rule 2 makes open grazing illegal
The appropriate forms of settlement are for the
neighbour to bribe the rancher with rule 1 and for the
rancher to compensate the neighbour with rule 2
Rule 2 reduces the income of the rancher and increases
the income of the neighbour but rule 1 does the opposite
When income effects are zero, such changes in income
do not shift the demand and supply curves

10/17/2023 48
 CONT’D
If the income effect for each party is positive and nonzero,
then a lower income for the rancher reduces the amount of
compensation offered for a given externality reduction and a
higher income for the neighbour increases the amount of the
bribe offered for a given externality reduction
Therefore, the demand curve with rule 1 is below the demand
curve with rule 2 (D1 < D2)and the supply curve with rule1 is
above the supply curve with rule 2 (S1 > S2)
Therefore, the equilibrium level of externality reduction is
greater with rule 2 than rule 1 (R2 > R1)
Equilibrium prices can be higher or lower with rule 1 than rule
2 depending on the relative magnitude of the income effects
for the acting and affected parties
10/17/2023 49
 CONT’D
Price
S1

S2

D2
D1

0 R1 R2 Externality
Reduction
Fig. Equilibrium externality reduction with nonzero income effect

10/17/2023 50
PUBLIC GOODS
A public good has two characteristics: non-excludability and non-
rivalry
 Non-excludable (even if do not pay cannot be excluded from enjoying it)
 Indivisible/ non-rival (my enjoyment does not lessen your enjoyment)

Property rights to the good are not exclusive; and use of the good
by one person does not diminish the benefits that the good provides
to other person
The term public good is generic and encompasses both natural and
environmental resources
While these resources could be managed by the private sector, it
would lead to a more limited supply of the resource and a higher
price
Therefore, inefficiency results because each person is able to
become a free rider on the other’s contribution
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 Free-rider Problem
• A free rider is someone who derives the value from a
commodity without paying an efficient amount for its supply
• Inefficiency results because each person able to free-ride on
another’s contribution
• Due to indivisibility and non-excludability, consumers reap
the benefits of any diversity purchased by others
• Diminishes incentives to contribute
• If contributions are not large enough to finance public good, it
will be undersupplied
– How to correct these failures? (property rights / market /
govt)
1. bargaining (private negotiation or courts)
2. regulation (price/ tax or quantity/ limits)
• This is why we see gov’t control of many public goods
(compel you to pay through taxation)
 GOVERNMENT INTERVENTION
Because of the limitations of property rules, other
approaches have been used to reduce external
diseconomies
This includes liability rules, economic incentives and
regulation
With a liability rule, the courts establish that acting
parties are legally liable for the damages inflicted on
affected parties
If affected parties claim damages then the court
determines the appropriate amount of compensation for
the damages incurred

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 CONT’D
Economic incentives, such as taxes and subsidies, can be
used to reduce externalities
Regulations can be used to limit the amount of the
externality to some administratively determined level
Establishment of property rules and other mechanisms for
reducing externalities usually involves government
intervention
Proponents claim that government intervention is needed to
reduce economic losses from external diseconomies
It has been the primary means of addressing externalities
associated with national security, health and safety, social
welfare and environmental pollution

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 CONT’D
Pigou laid the foundation for such intervention when he
stated: “It is the clear duty of government , which is the
trustee for unborn generations as well as for its present
citizens, to watch over, and if need be, by legislative
enactment, to defend the exhaustible natural resources from
rash and reckless exploitation"
But, some economists have argued that government
intervention to mediate externalities is often cost-ineffective,
premature, unnecessary and misguided
The new approach attempts to explain government failure in
terms of the relationship between principals and agents and
the influence of transaction costs on this relationship

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 CONT’D
In this approach, politicians and bureaucrats/officials are
the agents and citizens are the principals
Efforts to reach agreement (establish a social contract)
are thwarted by imperfect information, that increase the
transaction costs of achieving agreement
The higher the transaction costs, the greater the
likelihood of government failure
The newer approaches emphasize the formation of
markets to internalize externalities by establishing
effective property rights and reducing transaction costs

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 Pigouvian Taxes The Market For Steel
• Use taxes to correct
divergence between MPC
and MSC
• Set Pigouvian tax =
divergence (measured at
Q*) – this raises firm’s
private costs, forcing
MPC=MSC
• “Internalizing the
externality”
 Questions for self-consumption!!!

• Should land be private property? State property? Or

common property?

• Is natural resource endowment a curse or a blessing? Why?

• Why do you think conflicts arise over the use of resources?

• What is the tragedy of the commons? How can it be

prevented?

• What are other causes of market failures?