Economic Concepts: Efficiency, Market
Failure, Property Rights, and more
ECX5001
Monash University
Session 1
What is environmental economics?
Application of standard economic tools to specific types of goods
• Goods with externalities
• Public goods
What questions can we address with enviro. econ.?
Plastics pollution as an example:
1. Why is it happening (behaviorally)?
▶ Individuals don’t have an incentive to drastically cut back
2. Why is it hard to solve?
▶ Plastics pollution is global and abatement is a public good
3. What are the benefits of mitigation?
▶ There are many, some of which are hard to measure
4. What are the costs of mitigation?
▶ Never forget opportunity cost!
5. How to optimally manage plastics?
▶ Find optimal quantity of plastic use
▶ Market-based solutions can minimize cost of mitigation
6. How to appropriately weigh costs and benefits?
▶ Not straightforward since many benefits accrue in the future
Economic efficiency
Economic efficiency ∼ maximize net benefits (i.e. economic
surplus).
• An allocation of resources is efficient if it maximizes the
overall economic surplus (i.e. sum of consumer and producer
surpluses).
• As we shall see shortly, efficiency is achieved by equating
marginal benefits and marginal costs → “equimarginal
principle”.
• Technically, we are discussing “static efficiency” right now,
where time is not a factor.
Note: We will sometimes use “efficient” and “socially optimal” interchangeably.
Consumer surplus graph
Consumer surplus ∼ difference between what consumers are willing
to pay for a good and what they actually pay.










































































































D
Q*
P*
S
Each point on the demand curve represents
willingness to pay
Price
Quantity
Consumer surplus
Producer surplus graph
Producer surplus ∼ difference between what producers are willing
to accept for a good and what they actually receive.






























































Quantity
P*

Q*
D
S
Price
Each point on the supply curve represents the cost of
production
Producer surplus
Market equilibrium graph
• Total economic surplus is defined as the consumer surplus
plus the producer surplus.
• In a competitive equilibrium (D = S), total surplus is
maximized






























































P*

Q*
Price
Quantity
CS
PS
Total surplus = CS + PS
S=MC
D=MB
The “equimarginal principle”
Equimarginal principle ∼ The efficient level of an economic
activity X ∗ occurs where marginal benefit equals marginal cost, i.e.
MB(X ∗) = MC (X ∗).
• Recall that Supply/Demand is another way of talking about
MC and MB
▶ Demand curve is defined by consumers’ marginal benefits
(D = MB).
▶ Supply curve is defined by producers’ marginal costs (S = MC )
• In Enviro. Econ., we often talk about MC and MB without
explicitly talking about the production of goods (i.e.,
Supply/Demand)
▶ E.g. The efficient level of pollution control is where the
incremental benefit of the last unit of abatement equals its
incremental cost.
“equimarginal principle” for pollution abatement:
total vs. marginal graphs










































































































Total
L
Marginal
x
$
$/Unit
Cost (X)
Benefit (X)
Abatement (X)
Abatement (X)
Max net
benefits
MB(X)
Slopes parallel at
MB=MC
MC(X)
Defining property rights
Property rights ∼ Entitlements defining the owner’s rights,
privileges, and limitations for use of a resource.
Property rights are given primacy in environmental economics.
• Well-defined rights are necessary for an efficient societal
outcomes within market-based economies.
• Characteristics of an efficient property rights structure:
1. Exclusivity — All the benefits and costs should only accrue to
the owner.
2. Transferability — Property rights should be transferable to
others.
3. Enforceability — Property rights should be secure from
seizure or encroachment.
Market Failure & Externalities
Market failure
Market failure ∼ Inefficient social outcomes due misaligned
private interests or misallocation of resources.
• The “invisible hand” does not maximize social net benefit via
decentralized decisions.
In environmental economics, market failure often arises because
“exclusivity” of property rights is violated. E.g.,:
• Externalities
• Public goods/bads
Externalities
Externality ∼ A cost or benefit, not transmitted through prices,
caused by someone else’s actions.
• “An externality results when the actions of one individual (or
firm) have a direct, unintentional, and uncompensated effect
on the well-being of other individuals or the profits of other
firms.” — K&O
Externalities reflect the (in)completeness of markets.
• Decision makers do not fully internalize costs and benefits.
• Property rights are not well-defined.
Negative externalities
Negative externalities impose a cost on a third party.
• Pollution from a factory, fisheries bycatch, second-hand
cigarette smoke, crying baby on an airplane, etc.
Marginal social costs (all costs to society) will not equal marginal
private costs (producer’s costs).
• Induces deadweight loss through this difference (i.e. the
marginal external cost).
• Deadweight loss is simply a loss in social surplus −→ figure on
next slide.
Bottom line: The market will produce too much of a good (at
too low cost) in the presence of a negative externality.
Negative externalities basic graph
• PMC: Private Marginal Cost (a.k.a Supply or Marginal Cost)
• MEC: Marginal Externality Cost
• SMC: Social Marginal Cost (PMC + MEC)
• DWL: Deadweight Loss










































































































Price
Quantity

D=MB
Qm
Pm

Q*
P*
MEC
S=PMC
SMC
DWL
Negative externalities (numerical example)
Let’s try a practice example: A market for steel.
• Demand is defined by the marginal benefits curve:
PD = 18− Q.
• Supply is defined by the (private) marginal costs curve:
PM = Q.
• But there are external costs from steel production. The
marginal external costs are increasing with production; each
unit produced increases the MEC by $1 (i.e., MEC = Q).
▶ Sketch the market supply and demand for steel.
▶ How much steel will the market produce?
▶ Draw the social supply curve.
▶ What is the socially optimal amount of steel?
▶ What is the deadweight loss associated with the market
equilibrium?
Negative externalities: numerical example graph
Market Equilibrium
SMC P 18 Q
Ps Q
18 sepmc 18 Q Q
18 20
12 Qu 9
9 Lowe Social OptimumPs DMC Q
MEC Q
SMC PMCTSMC
6 9 18 SME 20
DWI 18 0 20
18 39SMC Q91 18 9 6
TWC I 97 37 13.5
Positive externalities
Postive externalities confer a benefit on a third party.
• Vaccinations and flu jabs, R&D spillovers, neighbourhood
effects, etc.
The reciprocal of the negative externality case that we’ve just seen.
Bottom line: The market will produce too little of a good (at too
high cost) in the presence of a positive externality.
Public Goods
A taxonomy of regimes
Nonrivalry ∼ My consumption of a good does not diminish the
amount available for others.
Nonexcludability ∼ Cannot exclude others from enjoying the
benefits of a good once it is provided (even if they don’t pay for it).
A Taxonomy of regimes (cont.)
Nonrivalry
N
on
ex
cl
u
d
ab
ili
ty
PURE PRIVATE GOODS
OPEN-ACCESS RESOURCES
CLUB GOODS
PURE PUBLIC GOODS
Open-access leads to tragedy of the commons
Open-access resources are non-excludable and rival. E.g.,
• Fisheries
• Aquifers
• Oil reserves
Open-access leads to “tragedy of the commons”
Public goods
Public goods are both nonrival and nonexcludable.
• E.g. Biological diversity −→ Amount of genetic variation
among individuals within a single species and the number of
species in a community (ecosystem).
• Other examples include charming landscape, clean air, etc.
• Individuals have an incentive to “free ride” −→ derive benefit
from public goods without contributing to the supply of the
good.
Bottom line: Public goods are underprovided by the market
because of the free-rider problem.
Socially Optimal Allocation of Public goods vs.
private goods
In a standard Supply/Demand setup, efficient allocation
determined by how you aggregate individual demand curves.
• Private goods: Aggregate horizontally because each unit can
only be consumed by 1 individual
▶ For a particular price, how many units demanded?
• Public goods: Aggregate vertically because each unit can be
consumed by everyone
▶ For a particular quantity, what is society’s WTP?
Public vs private goods graph












































4 4
MC L
I
2 4
95 1
6
5
Me 2
4
Market demand (private good)Individual demands
Market demand (public good)
Public goods graph takeaways
• Vertical summation of demands tells us socially optimal
quantity for public goods.
• How much is provided in market equilibrium (P=2)?
▶ Suppose the blue line is A and green is B
▶ At P = 2, note that B’s quantity demanded is zero.
▶ A demands 1 unit, and since nobody else in the market
demands any at P = 2, they will buy it.
▶ 1 unit is provided (by A), and B gets to free-ride!
This unique situation occurs because only one market
participant demands the good at P = 2.
• How much is provided in market equilibrium (P=0.5)?
▶ Both A and B demand a positive quantity
▶ Because both get to consume the good if the other buys it,
both have the incentive to fee-ride off the other.
▶ Private allocation graph doesn’t tell us market allocation
▶ Need game theory to determine best responses
Model of public goods: model preliminaries
N identical individuals
w : income
x : amount of private good
G : amount of public good
Px = PG = 1
Utility = U(x ,G )
g : individual’s contribution
G¯ others’ contribution
→ G = G¯ + g
w = g + x
• Budget constraint; if we contribute to G , it reduces money
available for x
→ Utility = U(w − g , G¯ + g)
Model of public goods: graph intuition (1)
• Consider tradeoff between my contribution (g) and others’
contribution G¯ . See below for graph.
• Remember, as g ↑, G ↑ (U ↑), x ↓ (U ↓)
• Remember, an indifference curve shows all combinations of G¯
and g to which I am indifferent - starting at G¯1 (and g = 0),
what could the indifference curve look like?
▶ Straight up? My contribution is constant at 0 and others’
contribution increases. I’d be on a higher indifference curve.
(impossible)
▶ Horizontal? Increased utility from G exactly offset by decreased
utility from x (possible, but assume no)
▶ Upward sloping? G must increase by more than my contribution g
to offset my lost utility from x (possible, but assume no)
▶ Downward sloping? I value G more than x , in fact so much more
that my utility will remain constant even if others contribute slightly
less G¯ (yes!).
Because G¯1 is so low (and thus I have little G and a lot of x), the
MRS between G and x favours more G .
Model of public goods: graph intuition (2)
• At higher initial G¯ like the initial MRS between G and x is relatively more
favorable toward x (because you already have so much G).
• At high enough initial (G¯4), indifference curve never slopes down
• Consider a fixed level of G¯ , how would you choose g?
▶ Choose g such that you’re on the highest possible indifference curve (i.e.,
at the minimum on the curve).
▶ At G¯0, choose g0.
▶ Eventually (at G¯4), it is optimal to contribute nothing (g = 0).
▶ The line between each of these points is the “best response” line
• Because consumers are identical, we know G¯ = (n − 1)g
▶ Defines a basic relationship between G¯ and g
• Market equilibrium: where “best response” line crosses G¯ = (n − 1)g
• Efficient allocation: highest indifference curve touching G¯ = (n − 1)g
Model of public goods graph









































































































O
Model of public goods graph






















U
Model of public goods graph
G Because everyones
know G ngand
G m
Basicrelationship
between Gandg
Slope n I
Model of public goods graph
MarketAllocation
9m
EfficientAllocation
g
g gm
Public bads
The reciprocal of public goods.
• E.g. Plastic pollution.
▶ I buy things in plastic packaging.
▶ The marginal benefit that I would see from my decrease in
plastics use is negligible. But the cost of changing my
behaviour is high.
▶ Requires policies that change incentives at every level −→
we’ll revisit this issue later in the course.
Bottom line: Public bads are overprovided by the market because
of the free-rider problem.
Pursuit of Efficiency
The pursuit of efficiency
We’ve already shown:
• Goods with negative externalities are over-provided relative to
the social optimum (vice-versa for goods with positive
externalities)
• Public goods are under-provided relative to the social
optimum (vice-versa for public bads)
Next:
• How do we get from the market equilibrium to the social
optimum?
The Coase Theorem
Ronald Coase’s (1960) insight: We don’t need government to solve
our problems as long as we are able to negotiate freely with each
other.
Coase Theorem ∼ Absent transaction costs, private bargaining
will result in an efficient resolution of negative externalities
(without government intervention), as long as property rights are
fully allocated to at least one party.
What makes this result so striking is that it holds irrespective of
who holds the initial property right(s).
• Only the distribution of costs and benefits among the effective
parties is changed.
Coasean bargaining example
Consider two parties: steel plant and riverside resort hotel
• Steel plant pollutes the river, which flows near the resort hotel
▶ Steel production has a negative externality (affecting hotel)
Coasean bargaining graph
Smc
PMC
C
D
Price
A
B
Q Qm
Coasean bargaining graph
Suppose steel producer has right to pollute
• PS: A+B+C
• TEC: B+C+D
• Difference in PS between Qm and Q∗: C
• Difference in TEC between Qm and Q∗: C+D
▶ Equal to hotel’s maximum WTP to reduce production from
Qm to Q
∗
Would steel plant accept payment of C+1,...,C+D to reduce
production to Q∗?
• With free bargaining (zero transaction costs), equilibrium steel
production is Q∗.
Coasean bargaining graph
Suppose hotel has right to clean water
• Difference in PS between 0 and Q∗: A+B
• Difference in TEC between 0 and Q∗: B
▶ Equal to steel plants’s minimum WTA to increase production
from 0 to Q∗
Would hotel accept payment of B+1,...,B+A to increase
production to Q∗?
• With free bargaining (zero transaction costs), equilibrium steel
production is Q∗.
The Coase Theorem (cont.)
Advantages of Coasean Solution (i.e. just assign property rights):
• Solution is efficient when conditions are right.
• Government doesn’t need to guess/estimate private marginal
damages and benefits (information asymmetries).
Disadvantages of Coase:
• Bargaining breaks down with transactions costs.
• Fails when n > 2 (Ellingsen and Paltseva, REStud 2016).
• Suffers from free-riding when goods are non-excludable.
• Can lead to distorted incentives −→ pollute simply to extract
payment (ransom?) from others.
What’s next
In future weeks, we focus on government intervention:
• Limiting production to some optimal Q∗.
• Pollution taxes, emissions trading schemes, zoning laws,
technology requirements, etc.

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