Necessary conditions for markets to produce efficient allocations

of resources
1. Markets exist for all goods and services produced and
consumed
2. All markets are assumed to be perfectly competitive.
3. All transactors have perfect information
4. Private property rights are fully assigned in all resources and
commodities.
5. No existence of externalities.
6. All goods and services are private goods. That is, there are
no public goods.
7. All utility and production functions are 'well behaved'.
8. All agents are maximizers.
• If a market neglects one of the above condition results
inefficiency in allocation of resources.
05/17/2024 1
 3.2.Property rights
• It is defined as a set of entitlement defining the owners’ rights and privileges
and limitations for the use of resources.

• It is the bundle of characteristics that convey certain powers to the owner of

the right.

• The way in which producers and consumers use environmental resources is

decided by the existing property rights in the society which direct the use of
resources.

• By examining such entitlements, and how they affect human behaviour, we

will better understand how environmental problems arises from government
and either with individuals or the economic system as a whole.

• The sources of environmental problems in a capitalist economy is the market

system it self for the pursuit of profits.
05/17/2024 2
• well defined property right brings efficiency, which is the
societies objective.
• Let us examine the incentives of consumers and producers
face when a well defined system of property rights is in place.

• The seller has the right to prevent the buyer from consuming
the products in the absence of payment; i.e, the buyer must
pay to receive the products.

• Given a market price, the consumer decides how much to

purchase by choosing that amount which maximizes his or her
individual net benefit.

05/17/2024 3
• In a competitive market price level determined by supply & demand.
• Given the price, both consumers and producers maximize their surpluses and the
market clears.

• Price Consumer’s surplus

ss

producer’s dd
surplus
Qd Quantity

• In this case, the allocation is efficient because according to static efficiency, the net
benefit is maximized by the market allocation and is equal to the sum of consumers
and producers surpluses.

• In the system, with well defined property rights and competitive markets,
producers try to maximize their surpluses and consumers try to maximize their
surpluses.

• The price system then induces those self interested parties to make choices which
are efficient from the point of view of society as a whole.
05/17/2024 4
Characteristics of Property Rights
• Property rights result efficient allocation of resource in a well functioning
market economy has four main characteristics.

• 1. Universality: refers to resources are privately owned and all

entitlements are completely specified.
• 2. Exclusivity: refers to all benefits and costs created as a result of
owning and using the resources should grow to the owner and only to the
owner, either directly or indirectly by sale to others.
• 3. Transferability: refers to all property rights should be transferable from
one owner to another in a voluntary exchange.
• 4. Enforceability: refers to property rights should be secured from
involuntary attack or encroachment by others.

• An owner of a resource with a well-defined property right (with the above

characteristics) has a powerful incentive to use that resource efficiently
because a decline in the value of that resource represents a personal loss.
• Example: a farmer who owns a land has an incentive to fertilize, irrigate,
5
or rotate crop.
3.3.Externality as a Source of Market Failure
• Externality occurs when the production or consumption decision of one
agent affects the utility or production possibility of another agent in
unintended manner.
• And when no compensation is made by the producer of external effect to
the affected body.
• Furthermore, it occurs when one of the characteristics of efficient
property right (exclusivity) fail to function properly.
• which means if the cost or benefit of owning or using the resources
belongs to other part which do not have the property right.

• The two key things to keep in mind about externality:

– effects from one agent to another which are unintended,
– and there is no compensation, in respect of a harmful effect, or
payment, in respect of a beneficial effect.

05/17/2024 6
Classification of externalities
• External effects can be positive or negative. If the utility or production of
some party is decreased by the decision taken by the other party, this
externality can be called as external diseconomy or negative externality.
• And, If the utility or production of some will have a benefit to other, it is
called external economy or positive externality. In this case, the market
will under supply the resources. Lets see type of externality ,Table 3.1

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• In Table 3.1 above, we are concerned only to set out the forms that unintended
interdependence between agents could take. Some examples will be provided
shortly.

• In the first row in Table 3.1, an example of a consumption externality is where

agent B’s consumption of commodity X is an argument in A’s utility function and
B’s consumption of X affects the utility that A derives from given levels of
consumption of X and Y.

• In the second row, A’s consumption of Y is shown as affecting the production of

X, for given levels of capital and labour input.
• Row 3 has B’s consumption of X affecting both A’s utility and the production of
Y.

• In row 4, the amount of X produced, as well as A’s consumption of X, affects A’s

utility.

• Row 5 has the production of Y determining, for given capital and labour inputs,
the amount of X produced.
05/17/2024 8
• In case of positive externality, the market will under supply the resources.
There is another class of externality called pecuniary externality (pseudo
externality).

• This type of externality occurs when an individual’s activity level affect the
financial circumstances of others but it need not produce misallocation of
resources in pure competition.

• It may arise when the external effect is transmitted through altered

prices.

• When there is negative externality, marginal social costs (MSC) are higher
than marginal private costs (MPC).

• The difference is marginal extraction cost (MSC-MPC =MEC).

• On the contrary, positive externality exists when marginal social benefits

(MSB) are higher than marginal private benefits (MPB).
• The difference is the marginal external benefit (MEB). That is MSB-MPB 9
Externalities and Economic Efficiency
• Externalities are a source of market failure. Given that all of the other
institutional conditions for a perfect market system to realise an
efficient allocation hold, if there is;
– a beneficial externality the market will produce too little of it in relation to
the requirements of allocative efficiency
– a harmful externality the market will produce more of it than efficiency
requires.

• Since we are concerned with the application of welfare economics to

environmental problems,
• And, the main relevance of externalities with regard to environmental
pollution, we shall look in any detail only at harmful externalities case
here;
– a consumer to consumer case
– a producer to producer case
– a case where the unintended effect is from a producer to consumers
05/17/2024 10
Consumption–consumption externality
• Suppose that A and B live in adjacent flats (apartments). A is a
saxophone player, who enjoys practicing a lot. B does not like music,
and can hear from A practicing. Their utility functions are,
U A  U A(M A, S A )

U B  U B (M B , S A)

• Where M represents wealth and SA is the hours that A plays

saxophone each week, with ∂UA/∂MA>0, ∂UB/∂MB>0, ∂UA/∂SA>0
and ∂UB/∂SA<0.
• Let MB is the marginal benefit of playing to A, and MEC for marginal
external cost of playing to B.
• Marginal benefit is the amount that A would pay, if it were necessary,
to play a little more.
• Conversely, MB is the amount of compensation that would be
required to leave A as well off given a small reduction in playing.

05/17/2024 11
 The bargaining solution to an externality problem
•Given that A does not in fact have to pay anything to play her
saxophone in her flat, she will increase her hours of playing up
to the level M0, where MB is equal to zero.

• At that level, A’s total benefit from playing is given by the sum
of the areas of the triangles a, b and d, and B’s total suffering is
measured in money terms by the sum of the areas b,d and c.

12
• This is not an efficient outcome, because at M0, MEC >MB. The
efficient outcome is at M* where MEC =MB.

• At any M to the left of M*, MB >MEC, so that for a small increase in

M, A would be willing to pay more than would compensate B for
that increase.
• At any M to the right of M*, MEC >MB so that for a small decrease
in M, B would be willing to pay more for a small decrease in M than
would be required to compensate A for that decrease.

• An inefficient level of saxophone playing at M0 comes about

because there are no payments in respect of variations in M, no
market in M, so that the effect on B is unintentional on the part of A.

• The problem is that A does not compensate B because B does not

have any legal right to such compensation, does not have a
property right in a domestic environment unpolluted by saxophone
music.
05/17/2024 13
• So, the solution is to set up a property right, to give B the legal right to
a domestic environment that is not noise polluted.

• Such legal arrangements would support bargaining which would lead

to M* as the level of M.

• The argument that establishes that M* would be the outcome under a

legal regime where B can claim compensation from A exactly parallel to
the argument that establishes that M* is the efficient outcome.

• To the left of M*, with MB >MEC, A will be willing to pay more in

compensation for a small increase in M than B requires, so will pay and
play more.

• A will not increase M beyond M* because the compensation that it

would be necessary to pay B would be greater than the worth to A of
the small increase thereby attained.
05/17/2024 14
The Coase theorem
• Coase is a Nobel prize winner economist based on his indgenious idea of given a proper
assignment of property rights, private bargaining between individuals can correct
externality problems and brings efficient allocation.

• In addition, he favored the idea that an efficient outcome can also be attained by vesting
the property right in the generator of the external effect- a victim will offer money for
generator of the externality to reduce the externality and lead to the efficient level.

• As can be seen from the above graph, B is willing to pay for the possible reduction of
externality until MEC > MB. However, externality to the left of M* makes B unwilling to
pay and A will not reduce the externality.
• Hence, at M* efficiency is achieved.

• NB. It needs to be explicitly and carefully noted that there are two things that
are not being claimed.
– First, that it is not being said that the outcome will be the same in both
cases.
– Second, that it is not being said that either way of assigning property rights
necessarily promotes equity.
05/17/2024 15
 – For the case where B gets the property right –there is an M reduction
of (M0−M*) and A pays to B an amount equal to the area of triangle
‘b’, the money value of B’s suffering at the efficient outcome M*.

– For the case where A gets the property right – there is an M reduction
of (M0−M*) and B pays to A an amount equal to the area of triangle
‘d’, the money value of A’s loss as compared with the no-property-
rights situation.

• Clearly, which way the property right is assigned affects the wealth of A or
B. in neither cases does the increase in wealth affect the receiving
individual’s tastes.

• According to Coase theorem there will be an efficient outcome under

either assignment of property rights, not that there will be the same
efficient outcome under either assignment- equity problem.

05/17/2024 16
 Production–production externality
• Consider two firms with production functions of;
X  X(K X , LX , S)

Y  Y(K Y , LY , S)
• where S stands for pollutant emissions arising in the production of Y,
which emissions affect the output of X for given levels of K and L input
there.

• As an example, Y is paper producer in a mill which discharges waste

matter S into a river upstream from a laundry which extracts water from
the river to produce clean linen, X.

• Then, the assumption is that ∂Y/∂S >0, so that for given levels of KY and LY
lower S emissions means lower Y output, and that ∂X/∂S<0, so that for
given levels of KX and LX higher S means lower X.

05/17/2024 17
• Profits in the production of X is given by
πX =PxX(KX, LX, S) −PKKX−PLLX
• where ∂πX/∂S<0. The impact of a small increase in S on profits in the
production of X is similar to terminology of figure above, marginal external
cost, MEC.
• Profits in the production of Y is given by
πY=PyY(KY, LY, S) −PKKY−PLLY
• where ∂πY/∂S>0. The impact of a small increase in S on profits in the
production of Y is similar to terminology of Figure above, marginal benefit,
MB.
• To the producer-to-producer case; in the absence of a well-defined
property right S will be too large for efficiency,
• while an efficient outcome can result from bargaining based on a property
right assigned to either the producer of X or the producer of Y.

• In collusion joint profits maximization will only occur if both firms believe
that their share of maximized joint profits will be larger than the profits
earned separately.
18
Production–consumption externality
• Consider that the external effect impact on two agents, and with respect
to them is non-rival and non-excludable in consumption.

• Emissions arising in production adversely affect individuals in ways that

are non-rival and non-excludable.
• In terms of two-person, two-commodity economy we assume that:

U A U A ( X A U A
A
,Y
with 0
,S )

S
B B B B
U U ( X ,Y , S ) U B
with 0
S
X  X ( K X , LX )
Y  Y ( K Y , LY , S ) with Y 0
S

05/17/2024 19
• Emissions arise in the production of Y and adversely affect the
utilities of A and B. The pollution experienced by A and B is non-
rival and non-excludable.
• Example: fossil-fuel-burning and electricity plant located in an urban
area..etc.
• However:
– private bargaining based on assignment of property rights will
not deal with the externality problem.
– joint profit maximisation solution is not relevant.
• Hence:
– correcting the market failure requires some kind of ongoing
intervention in the workings of the market by some government
agency through:
– use of taxation
Given cost function as: C  PK K Y  PL LY  C (Y )

PMC  C
05/17/2024 Y 20
• Where, PMC stands for private marginal cost. Private costs are the input
costs that the Y producer actually takes account of in determining output
level that maximizing its profit.

• Given there are two sufferers, the MEC is equal to the sum of willingness
to pay of each of them, as consumption of suffering is non-rival and non-
excludable. So that, Social marginal cost : SMC =PMC +MEC

• From graph below to maximize profit, Y firm will produce at Y0, where
PMC is equal to the output price PY.

• This is not that, Y output goes with efficiency, as balancing costs and
benefits at the margin it is ignoring the costs borne by A and B. However,
efficiency requires balancing at the margin of benefits and costs which
include the external costs borne by A and B, i.e., SMC=PY.

• In the absence of any correction of the market failure that is the external
costs imposed on A and B, the market-determined level of Y output will be
too high for efficiency, as will the corresponding level of S.
• Graphically is seen as: 21
 Taxation for externality correction

•The above graph shows PMC increasing with Y in the usual

way.
•The SMC line has a steeper slope than the PMC line, so that
MEC is increasing with Y– as Y production increases, S output
increases.
05/17/2024 22
• PMCT, stands for private marginal cost with the tax in place. It shows
how the Y firm’s marginal costs work given that the government is
taxing S at the appropriate rate.

• The appropriate tax rate is t=SMC* −PMC* =MEC*

• That is, the tax needs to be equal to marginal
t  PX ( MRUS XS A
 MRSUexternal
B
XS ) cost at the
efficient levels of Y and S.
In other words, MEC *
 PX ( MRUS A
XS  MRSU B
or )
XS

• The XS subscripts indicate that it is the MRUS for commodity X and

pollution S that is involved here.

• MEC* is the monetary value of the extra consumption of commodity X

by A and B that would be required to compensate them both for a small
increase in S, from the efficient level of S.

• This also applies to commodity Y and the condition is the same.

05/17/2024 23
• Taxation at the rate MEC*(MEC in the corrected situation) is required to
bring about efficiency.
• Nevertheless, to impose the appropriate tax it requires identifying the
optimal output Y*- identifying how MEC varies with S by knowing the
utility functions of A and B.
• Further emission arises from many production activities. Assume two-
person, two-commodity economy.
U A  U A ( X A , Y A , S ) with U
A
0
S
U B  U B ( X B , Y B , S ) with U
B
0
S
X  X ( K X , LX , S X ) with S 0
S X
Y  Y ( K Y , LY , S Y ) with S 0
S Y
S  S X  SY

• Both production activities involve emissions of S, and both individuals

are adversely affected by the total amount of S emissions.
• In this case, efficiency requires that emissions from both sources be
taxed at the same rate, t=MEC*
05/17/2024 24
3.4 Public Goods
• Public goods are goods that are not supplied by the market system and
even if they are supplied by the market, their amount is insufficient in
quantity.

• Peace and security of a nation, national defence, air pollution control,

street light, public television, road, environmental amenities etc are
examples of public goods.

• Pure public goods have two basic characteristics.

• Non-rival (indivisibility): the consumption of an individual does not affect
another person’s consumption of a good (it did not diminish the amount
available for others). Example street lights.

• Non-excludability: once the resources are provided, even those who fail
to pay for it cannot be excluded from consumption of the goods or
services.
05/17/2024 25
Characteristics of private and public goods

Rivalry refers to whether one agent's consumption is at the

expense of another's consumption.
Excludability refers to whether agents can be prevented
from consuming.
Pure private goods exhibit both rivalry and excludability.

05/17/2024 26
• Congestible resources exhibit excludability but not rivalry. Example,
the services to visitors provided by a wilderness area.

• If one person visits a wilderness area(Tana Haike) and consumes its

services recreation, wildlife experiences and solitude, it is not
possible to prevent others from consuming those services as well.

• In principle, excludability is possible if the area is either in private

ownership or subject to common-property management.

• Open-access natural resources like fisheries exhibit rivalry but not

excludability. No one can prohibit from catching a fish as there is no
individual that has exclusive right.

• However, it is rival because an increase in the catch by one fishing

boat means that there is less for other boats to take.
05/17/2024 27
Public goods and economic efficiency
• For an economy with two persons and two private goods, product-
mix condition for allocative efficiency is given as:
MRUSA = MRUSB = MRT
• For a two-person economy where X is a public good and Y is a
private good, the corresponding efficiency condition is given by:
MRUSA + MRUSB = MRT
• However, this condition will not be satisfied in a market economy.
• A pure market economy cannot supply a public good at the level
MRUS  1 , MRUS  2 / 5, MRT  1
A B

required by allocative efficiency

5 criteria.
• Example: if

• So that, MRUSA+MRUSB < MRT means no Pareto optimal, efficient

allocation.
05/17/2024 28
• The fact that the MRT is 1 means that, at the margin, the private and
public commodities can be exchanged in production on a one-for one
basis the marginal cost of an extra unit of X is a unit of Y, and vice versa.

• The fact that MRUSA is 1/5 means that A could suffer a loss of 1 unit of
X, and still be as well off if she received 1/5th of a unit of Y by way of
compensation.

• Similarly, the fact that MRUSB is 2/5 means that B could suffer a loss of 1
unit of X, and still be as well off if he received 2/5 of a unit of Y by way of
compensation.

• Now consider an initial allocation where MRT =1, MRUSA=2/5 and

MRUSB=4/5 so that,

• MRUSA+MRUSB > MRT there is the possibility of a Pareto improvement,

so the initial allocation could not have been efficient.

05/17/2024 29
• Markets cannot provide public goods in the amounts that go with allocative
efficiency. In fact, markets cannot supply public goods at all. This follows from
their non-excludability characteristic.

• For open access resources where access is not conditional on payment, a

private firm cannot function as it cannot derive revenue from the production of
that resource.

• Because of the direct link between payment and access is broken by non-
excludability, goods and services that have such characteristic have to be
supplied by some entity that can get the revenue required to cover the costs of
production from some source other than the sale of such goods and services.

• Such an entity is government, which has the power to levy taxes so as to raise
revenue.

• The supply of public goods is part of the business of government. The existence
of public goods is one of the reasons why all economists see a role for
government in economic activity.

05/17/2024 30
• Given that it is the government that must supply a public good, the question
which naturally arises for an economist is:
• what rule should government follow so as to supply it in amounts that
correspond to efficiency?
• In a two-person, two commodity economy, the efficient level of supply of public
good is: MRUS A
 MRUS B
 MRT

• Given more public and private goods, efficiency is attained when the above
condition is satisfied across all goods and services.

• MRT is the marginal cost in terms of forgone private goods consumption, so that
the rule becomes the supply the public good at the level where the sum of all
the MRUS is equal to the marginal cost.

• Now, it follows from its definition that the MRUS is the same as marginal
willingness to pay(MWTP), so this rule can be stated as; supply the public good
at the level where aggregate marginal willingness to pay is equal to marginal
cost.
• Graphically:
05/17/2024 31
 The efficient level of supply for a public good

05/17/2024 32
Preference revelation and the free rider problem
• In order to apply the rule of efficiency for the supply public goods, the
government needs to know the preferences, in terms of marginal willingness
to pay, of all relevant individuals.

• It is in the nature of the case that those preferences are not exposed in
markets.

• Moreover, individuals have no incentives for revealing their truthful

preferences.

• Given that all consume equal amounts of a public good, and that exclusion
from consumption on account of non-payment is impossible, individuals will
try to ‘free-ride’ with respect to public goods provision.

• Example: for installing street light.

• Assume there is no government. There are two individuals A and B. Both have
an endowment of private goods worth £1000.
05/17/2024 33
• Installing the street lighting will cost £100.
• Both individuals have preferences such that they would be willing to
pay £60 for the installation of street lighting.
• In this regard, since the sum of individuals WTP is greater than the
cost, the decision is yes to install the street lighting.
• However, suppose that A and B agree to proceed in the following way.
Each will independently write down on a piece of paper either ‘Buy’
or ‘Don’t buy’.
• If when the two pieces of paper are brought together, both have said
‘Buy’, they buy the street lighting jointly and share the cost equally.

• For two ‘Don’t buy’ responses, the street lighting is not bought and
installed.
• In the event of one ‘Buy’ and one ‘Don’t buy’, the street lighting is
bought and the individual who voted ‘Buy’ pays the entire cost.

05/17/2024 34
 The preference revelation problem

•Clearly both are better off if both write ‘Buy’ and the street lighting is
bought. But, either will be even better off if, as in the bottom left or top
right cell, they can ‘free-ride’.

•‘Don’t buy’ is the dominant strategy.

•While installing the lighting and sharing the cost equally is a Pareto
improvement, it will not come about where both individuals act
independently to serve their own self-interest.

•So a kind of coordination to bring Pareto improvement is needed. And

given what we have already said about public goods, government would
35
seem the obvious way to bring about the required coordination.
• It can install it and cover the cost by taxing each individual according
to their willingness to pay.

• However, in practice, given self-seeking individuals, the free rider

problem also attends this program. The problem comes up in trying to
get the individuals to reveal their true preferences for the public good.

• Assume the existence of government, given the cost of installation,

government will finance the installation through taxing all citizens
proportional to their willing to pay – the total tax raised is equal to the
total cost of installation.

• Hence, given there are only two individuals, if they express their WTP
is £60, the street lighting will go ahead and each will pay £50 in tax.
This represents a Pareto improvement .

• The problem is that the incentives facing each individual are not such
as to guarantee truthful preference revelation.

05/17/2024 36
• Given that tax liability will be proportional to
stated willingness to pay, there is an incentive to
understate it so as to reduce the tax liability if the
street lighting goes ahead, and to get something
of a free ride.

• Furthermore, for a government to make decisions

about the supply and financing of public goods
according to the criteria recommended by
economists requires that it have lots of difficult-to-
acquire information, and can involve equity
questions as well as efficiency questions.
05/17/2024 37
3.5. Common property resources

• Common property resources refers to

– A resource in which property rights cannot be assigned to any individual for some
commodities.
– The individual cannot sell his or her right to the benefit of the property to
another member of the group because the benefits of the property are made
equally available to all members of the group.

• The problem which arises from the use of common property resources is the tragedy
of commons.
• Example: as the grazing land is free for each member, individual will tend to over
graze the pasture.

• The result is that the property will rapidly deteriorate and this unregulated self
interest behaviour of each individual produces a less than optimal solution for the
group as a whole.

• This problem resulted from indivisibility of the common property and the size of the
beneficiary group.
05/17/2024 38
• Common property rights are desirable where there are no scarce
resources.
• However, these rights will lead to misuse of resources such as over
grazing, over hunting, over fishing etc.
• David Hume observed that it was government’s role to regulate
individual behavior there by reducing the tragedy of commons.
• There are two characteristics of open access allocation of resources.
Those are
– in the presence of excess demand, open access causes resources to be over
exploited.
– The scarcity rent is dissolute; no one appropriates the rent, so it is lost.
• Open access to resources promotes an inefficient allocation.
• These are the possible solutions suggested for tragedy of commons.

– Privatization ( assigning private property right)

– Central government management (state property)
– Effective local self governance (common property right)
05/17/2024 39
3.6.Correcting Market Failure

• Market failure is a system where the market

condition does not reflect the true social values, say
the true costs and true benefits.

• It can be caused due to the following reasons

– The existence of monopoly power
– Common properties
– The existence of pure public goods and externality
– Imperfect information
– Uncertainty

05/17/2024 40
Methods of Correcting market failure
• Redefining the property rights: The problems of over exploitation of resources
can be solved through property rights.
• Regulation: There is a general consensus that there are some problems
particularly those concerning the environment which needs government
intervention.

• Internalizing externality (private transaction and government instruments).

• Merging: this is putting production units under the same management to
maximize aggregate profit.

• Taxes and subsidies: Taxes imposed on pollution are costs and thereby can
discourage pollution.
• Subsidies are another way of giving incentive for the producer to reduce
pollution, may be in credit but are not as such economically efficient.

• Marketable permit: Companies buy a permit from the government that allows
them to discharge a certain amount of pollution
05/17/2024 41