This lecture formalizes two related categories of market failure that arise from a failure of the property rights system to insure that all resources are excludable. Resources that are "non-excludable" tend to be allocated inefficiently (wasted) because anyone can use them; these are termed "open-access" resources because it is impractical to restrict free access to them. We will also analyze a special category of goods that are both "non-excludable" and exhibit "non-rival use," meaning that one person's enjoyment or use of the good doesn't limit or interfere with another's use of it; these are termed "public goods."
Resources such as the air, oceans, etc. are open-access by default. They are sometimes referred to as "common property" resources, implying they are "owned" by everybody. Other open-access resources may be (nominally) private property from which it is simply impractical for the owner to exclude others. Open-access resources are typically allocated on a "first-come, first-served" basis. Rational users recognize that the next person will take whatever they leave, so there is no conservation incentive. Each user immediately takes as much as he or she wants, and the resource is quickly depleted. So open-access resources are typically overused, allocated to inefficient uses, depleted too rapidly. Examples include marine fisheries, wildlife game stocks, subsurface "pools" of oil owned by multiple companies. This is the formalization of Hardin's open-access "commons" problem.
Consider the case of a competitive open-access fishery. Assume all the variable inputs to harvesting fish are lumped into a single variable called fishing "Effort" or E. The long-run relationship between aggregate fishing Effort E and fishery Yield Y is shown in the upper panel, where additional Effort increases Yield only up to the fish population's Maximum Sustainable Yield (MSY). Beyond that point, additional Effort actually reduces Yield.
The lower panel translates the Effort-Yield relationship into dollars. Suppose each unit of Effort costs $C, and each unit of fish sells for $P. Then Total Cost TC = C*E and Total Revenue TR = P*Y. Industry profit is TR - TC.
Ideally, the fishing industry would maximize its profits by applying Effort level E* to the fishery. In this example, E* = 95, Y* = 1,473 and Profit = $1,805. But that's not what happens.
As in any competitive market, any positive economic profits will attract additional boats into the fishery, increasing the aggregate fishing effort E. Here is where the inefficiency arises: the added fishing effort of the new boats reduces the efficiency of effort for all boats. The Yield per unit of effort declines for the entire fishery. (In an ordinary competitive industry, new entrants would not affect the productivity of other firms' inputs.)
As the efficiency of effort declines, the cost per unit of harvest increases. This cost increase wipes out the industry profit. The resource rents that the industry might have captured as profit are all wasted on too much fishing effort and too many boats. In the open-access equilibrium, Eoa = 190, Yoa = 1,140 and Profit = $0.
This situation can be interpreted as a congestion externality, where new entrants fail to consider how their entry reduces everyone's efficiency.
The inefficiency may be compounded if the stock's net reproduction starts declining as the stock gets depleted. A depleted stock usually has lower net reproduction than a healthy stock. So by reducing stock sizes, over-harvesting reduces future yield per unit effort even more.
The problem is further compounded if the market demand for the resource has low price elasticity, so that the market price for fish increases rapidly as fish get scarce. So while the biological stock is collapsing, the market is providing a price incentive to increase harvest effort even more!
An extreme example of this kind of open-access inefficiency is the African rhino. Powdered rhino horn is reputed to enhance male sexual potency, and there is a big and very inelastic demand for it many developing nations, so rhinos have been hunted to near-extinction. Even when rhino hunting is outlawed and poaching is punishable by death, the exorbitant black-market demand drives continued poaching. Since rhinos are very slow to reproduce, the long-term survival of the species remains doubt.
To side-track for a minute, consider some ways the rhino might be saved. (Look at the incentives!)
A public good is a good that is non-excludable, and consumption of it is non-rival. "Non-excludable" means that it is impractical to prevent people who haven't paid for it from using or enjoying the good, and "non-rival" means one person's use or enjoyment of the good does not use it up or preclude another's use or enjoyment of it.
Suppose I put a flowerbed in my front yard. My neighbor benefits by getting to see my beautiful flowers. Looking at flowers is non-rival consumption: the neighbors and I can enjoy them at once; one person's enjoyment doesn't preclude another's enjoyment. But if I ask my neighbor to contribute money to my gardening project, he will almost certainly decline. We both know he likes them and would be willing to pay at least something to have them next door, but he doesn't have to. He gets to "free-ride" on my flowers because they are non-excludable. I could threaten to put up big fence blocking his view and charge admission to see my flowers, but we both know that's impractical. I could threaten to stomp my flowers into the dirt and wreck the garden, but we both know I like the flowers--heck, I paid for them! There is simply no way to make him actually pay for the benefit he receives.
To clarify the nature of a public good, contrast it with a conventional market good like cheeseburgers that are excludable with "rival" consumption. The aggregate demand for a conventional market good is constructed as the horizontal summation of the individual consumers' demand schedules, as shown in this graph:
In contrast, the non-excludable and non-rival nature of a public good implies that the aggregate demand (ΣWTP) schedule is the vertical summation of the individual demand (WTP) schedules. In this diagram, a public good costs $18 per unit, so a would buy Qa = 20 units for herself. But she cannot exclude b or c from it, so they simply free-ride on what a purchased.
But since this is a non-rival good, the socially optimal quantity of it is Q* = 90 units, where the sum of all the WTP's equals MC. Unfortunately, these people are unlikely to cooperate in a collective purchase of Q*. Each person has an incentive to free-ride on what the others buy. Nobody has any incentive to reveal his or her true WTP. They won't split the cost of any group purchase equally, because there is no quantity for which they would all have the same WTP.
The public good problem is equivalent to a "prisoners' dilemma." In general, public goods are under-supplied unless each user can be induced to contribute his or her true marginal WTP, but there is no practical market mechanism to accomplish this.
Examples of public goods include national defense, scenic landscapes, air and water quality, biological diversity, etc. As the flower garden example shows, however, public goods are not necessarily publicly-owned or publicly provided.
Many pollution problems can be analyzed as public "bads." Your discomfort from air pollution does not prelude my discomfort. Indeed the persistence of pollution problems suggests that public action to make polluters stop polluting is an undersupplied public good. As we noted in the previous lecture, Coasian bargaining between polluters and victims assumes the costs of negotiation are negligible. But in cases where the number of victims is very large, effective bargaining requires organized collective action against the polluter. If no individual is harmed enough to be motivated to organize such collective action, Coasian bargaining will not occur. Since victims have an incentive to free-ride on the organizational efforts of others rather than contribute to the effort themselves, collective action efforts are likely to be under-funded and ineffective.
In cases where free-rider incentives cause an under-supply of collective public action, it is appropriate for government to adopt a facilitative role, perhaps negotiating with the polluter on behalf of the public. This function is formalized in environmental laws and regulations, and in the creation of environmental agencies such as the EPA.
Civil courts in the US facilitate collective action by permitting class action lawsuits in which several lawsuits of plaintiffs against a common defendant may be combined into a single case, with the named plaintiffs representing the entire class of plaintiffs. Successful class action lawsuits recover damages on behalf of all plaintiffs in the plaintiff class. The contingency fee system, under which lawyers are paid a percentage of the total damage award, creates a strong incentive for lawyers to get cases certified as class actions.
Other Market Failures
Inconsistent social and private rates of discount
Financial interest rates are the sum of the expected inflation rate, the risk of default, and the underlying discount rate (rate of time preference). In the absence of inflation expectations, and with risk spread across society as a whole, the social cost of capital is simply the discount rate. But the private cost of capital is the discount rate plus the risk premium. There is a clear economic cost of risk because rational investors are risk-averse. So the cost of capital is higher in risky industries.
Some industries like wildcatting for oil are inherently high-risk. In other cases, the government may actually increase uncertainty for natural resource industries. The return on a US timber investment will depend on Congress's decision to extend tariffs on lumber imports from Canada or eliminate them, and uncertainty over this will reduce bids in timber sales. The return on a Texas oil field investment depends on the price of oil, which depends on uncertainty in the Middle East. One big source of uncertainty is government regulation. US pharmaceutical companies face extremely high costs in bringing new drugs through the FDA approval process, and high uncertainty over approvals discourages R&D into new medications. Privately-owned resources will be depleted too rapidly if private rates of discount significantly exceed social rates of discount. If you lease public grazing lands for your cattle, your land management will depend in part on the duration of your lease. If it is a short-term lease, your implicit rate of discount is high: you will be more inclined to overgraze the land, and you won't invest much in soil conservation practices on it. But if you have a very long-term lease, your implicit rate of discount will be lower: you will have a better incentive for sustainable use of the land.
Monopoly & Oligopoly
You should already be familiar with the basic monopoly model. The monopolist sells to the entire market demand schedule. To sell more, since prices are publicly known, he has to reduce the price for all buyers (even a monopolist can't be a price discriminator), so his Marginal Revenue is less than Average Revenue (where his AR schedule corresponds to the market demand schedule). He produces and sells quantity QM (less than the competitive market quantity Q*) where MR=MC. He then searches out the maximum price PM (greater than competitive market price P*) that he can charge for that quantity on the demand schedule. So the monopolist produces less than a competitive industry and creates an artificial scarcity in order to charge a higher price, capturing a monopoly profit.
The problem with monopolies is that they are socially inefficient, and the cost of this inefficiency can be calculated as the net deadweight loss (DWL) of consumer and producer surplus. The monopolist's profit is less than the aggregate surplus loss. The deadweight loss is manifested in diversion of consumer expenditures to second-choice goods, and the misallocation of productive resources to second-best uses.