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.”

Open-Access Resources

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," denoted as E. Each boat seeks to maximize its profit by fishing at effort level E*, where MVP = MFC. The total resource "rent" extracted by the boat would the total revenue it earns from E* units of fishing effort (TR = E* times AVP) minus the total variable cost of that effort (VC = E* times AFC). If effort includes all variable inputs, then the boat's profit equals the total rent minus its fixed costs.

But the open-access nature of the resource precludes this efficient solution. As in any competitive market, the existence of any positive economic profit will attract additional boats into the fishery. This increases the aggregate fishing effort applied to the stock of fish. Here is where the inefficiency arises: the added fishing effort of the new boats reduces the efficiency of effort for all boats. So 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.

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 a decline in aggregate yield from the resource causes a large increase in its market price. 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 in Asia, 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!)

• One strategy would be to promote rhino tourism and “privatize” the rhinos, giving each family of poachers a concession to sell camera supplies, tours to see rhinos, etc. This would give the locals a stronger economic interest in conserving the rhinos than shooting them.
• Male potency drugs such as Viagra, which are substitutes for powdered rhino horn, can be expected to depress black market prices for rhino horn, thus reducing poaching incentives.
• Since poachers are after the horn rather than the whole rhino, it might make sense for game wardens to shoot rhinos with tranquilizers and just saw off their horns. (I’m assuming rhinos don’t really need their horns; I doubt they’re critical for self-defense, but they may be important for rhino courtship!)

Public Goods

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 aggregation 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 its aggregate demand schedule is the vertical summation of the individual demand schedules. In this diagram, A might buy QA units for herself, and since A cannot exclude B from it, B simply free-rides what A purchased. Alternately, B might buy QB units for himself and A would free-ride on his QB units and just buy the extra QA-QB herself. Either way, if they just follow their own self-interests, they won’t buy more than QA in total.

But since this is a non-rival good, the social optimum quantity of it is Q*, where A’s and B's collective marginal willingness-to-pay adds up to the MC. Unfortunately, it will be difficult for A and B to agree on a collective purchase of Q*, since their marginal WTP's for any level of Q are different. In this example, A’s WTP for Q* units is greater than B’s. B would reject a proposal to split the cost of Q* units evenly. 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 incentive for people to state their true WTP when they can free-ride!

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 quantity 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.

Government Failure

While democracy is the best system for promoting individual and market freedoms, it is not necessarily a very efficient system. Governments often create market distortions that generate substantial economic waste.

Many special interests use the political process for “rent-seeking,” lobbying Congress for special favors such as protectionist legislation, tax loopholes, etc. These provisions may be very profitable for the special interests, but they often carry a high net social cost. There are countless examples of appalling government waste supported by special interests. Here are a couple of my favorites:

• In 1925 Congress created a Strategic Helium Reserve in Amarillo, Texas, to insure an adequate supply of helium for military dirigibles. Airplanes quickly made military dirigibles obsolete, so once the Air Force no longer needed dirigibles, you would think they would close down the Strategic Helium Reserve, but you would be wrong: eighty years later we still have a Strategic Helium Reserve! The very existence of the Reserve created political special interests that have maintained it all these years: people employed by the program who want to keep their jobs (politicians love to “save jobs!”), helium producers (helium is a byproduct in natural gas extraction) who fear that selling off the Reserve will depress the market price of helium, etc.
• US sugar producers have a powerful Congressional lobby to maintain sugar import quotas and other price supports. US sugar is about 22 cents per pound, versus a world price of about 6.5 cents per pound. US sugar producers don’t have to be very competitive as long as Congress doesn’t let much cheap foreign sugar into the US. They would never survive global competition without these protections. But consider the distortions this program creates. Sugar production is causing severe environmental damage to the Everglades. Candy manufacturers move to Canada for cheaper sugar, eliminating jobs in the US. Other nations retaliate against other US industries for our unfair sugar trade policies. Poor nations where sugar production is efficient can’t sell us their sugar, so their economic development is impaired, and their cropland may be diverted to producing crops they actually can export to the US (legally or not) like marijuana and cocaine.

Most of the public is aware of government waste in general, and most legislators will readily admit that sugar quotas and the Strategic Helium Reserve should be eliminated. So why doesn’t Congress shut these programs down? These wasteful special-interest programs persist because there are so many of them, and every legislator has his or her own pet projects to protect. “Pork-barrel” projects are particularly important: it is critical for members of Congress to maintain the flow of Federal money to their states and home districts. So legislators engage in “log-rolling” to obtain majority support for their favorite programs. The votes get traded one by one: if you vote for my pet sugar quotas, I’ll vote for your pet highway project. Everyone does it. Every legislator needs the powerful friends behind those pet projects, friends providing the big campaign contributions it takes to get reelected. If you don’t play this game, you won’t survive. It’s like a whorehouse: put out or leave.

This system naturally gives well-funded political incumbents a huge advantage over challengers. Politics is a sort of dual-currency economy, with money and votes jointly deciding the outcomes. Public disgust with the legislative process sometimes boils over, and incompetent (or overly moral) incumbents sometimes get defeated, but this doesn’t happen very often.

The overall problems are pretty obvious, but the devil is in the details. It is easy to rail about government waste in general, but if you actually want to solve the problem, where do you start? Citizens are “rationally ignorant” of the thousands of different ways they are getting screwed. It is simply not worthwhile for an individual citizen to get or stay informed about these thousands of programs. OK, so you are getting ripped off for an extra 15 cents per pound for sugar. Will this motivate you to get informed about US sugar quotas, and write your Congressman a convincing letter about them, and buy a stamp to mail the letter? No. The only thing you letter might do is assuage some feeling of moral outrage. And your Congressman (or one of his staffers) will write you a nice response agreeing with you. Congressmen get lots of letters from cranks and wackos.

Special-interest legislation is hard to track because it is typically tucked into some omnibus spending bill along with hundreds of other pet projects, or included in some irrelevant amendment to another bill. This is death by a thousand cuts. You might stop one or two wasteful programs, but you can’t stop the rest. So it is not personally worthwhile for individual citizens to oppose programs like these. At the individual level the costs are too trivial. Collective citizen action to counter special interests is an undersupplied public good!