Question

b. List and explain the 4 causes of market failure included in the slides, including how they actually lead to market failure. Don’t miss this part! Need more detailed explanation here. How do these actually lead to market failure.

Answer 1

There is non-attainment of Pareto optimality due to a number of constraints in the working of perfect competition. An important cause of environmental degradation is market failure. It means poor functioning of markets for environmental goods and services. It reflects failure of government policy in removing market distortions created by price controls and subsidies.

1. Asymmetric Information:

Pareto optimality assumes that producers and consumers have perfect information regarding market behaviour. But according to Joseph Stiglitz, “In the real world, there is asymmetric (incomplete) information due to ignorance and uncertainty on the part of buyers and sellers. Thus they are unable to equate social and private benefits and costs.”

Suppose a producer introduces a new antipollution device in the market. But it is very difficult for him to predict the current demand of his product. On the other hand, consumers may be ignorant about quality and utility of this anti-pollution device. In some cases, information about market behaviour in the future may be available but that may be insufficient or incomplete. Thus market asymmetries, fail to allocate efficiently.

2. Indivisibilities:

The Pareto optimality is based on the assumption of complete divisibility of products and factors used in consumption and production. In reality, goods and factors are not infinitely divisible. Rather, they are indivisible. The problem of divisibility arises in the production of those goods and services that are used jointly by more than one person.

An important example is of road in a locality. It is used by a number of persons in the locality. But the problem is how to share the costs of repairs and maintenance of the road. In fact, very few persons will be interested in its maintenance. Thus marginal social costs and marginal social benefits will diverge from each other and Pareto optimality will not be achieved.

3. Common Property Resources:

Another cause of market failure is a common property resource. Common ownership when coupled with open access, would also lead to wasteful exploitation in which a user ignores the effects of his action on others. Open access to the commonly owned resources is a crucial ingredient of waste and inefficiency.

Its most common example is fish in a lake. Anyone can catch and eat it but no one has an exclusive property right over it. It means that a common property resource is non-excludable (anyone can use it) and non-rivalrous (no one has an exclusive right over it). The lake is a common property for all fishermen.

When a fisherman catches more fish, he reduces the catch of other fishermen. But he does count this as a cost, yet it is a cost to society. Because the lake is a common property resource where there is no mechanism to restrict entry and to catch fish. The fisherman who catches more fish imposes a negative externality on other fishermen so that the lake is overexploited.

This is called the tragedy of the commons which leads to the elimination of social gains due to the overuse of common property. Thus when property rights are common, indefinite or non-existent, social costs will be more than private costs and there will not be Pareto Optimality.

4. Imperfect Markets:

Pareto efficiency increases under perfect competition. But it declines under market distortions or imperfections. Let us consider a case of monopoly. Initially, monopoly equilibrium is at point E where the private marginal cost curve, PMC, cuts the marginal revenue curve, MR, from below.

The monopolist produces OQ₁ output at OP₁ price. But the production process generates smoke in the air. Therefore, the pollution board levies a tax equal to ТЕ on the monopoly firm. The imposition of a pollution tax is, in fact, a fixed cost to the monopoly firm. Now the social marginal cost curve cuts the marginal revenue curve at point e.

The monopolist increases the price of his product from OP1 to OP2 and restricts output to OQ2 and thereby reduces consumers’ surplus to Q₂ MLQ₁ (= OQ₁ LP₁ – OQ₂ MP₂). In fact, Q₂MLQ₁ is the social cost of OQ₂ output. But the net loss to society is Q₂ MLQ₁ – TE= eMLT, the shaded area in the figure.