This lecture addresses two important classes of market failure, both deriving from failures of the property rights system.

Common Property Resources

Common property resources are inefficiently allocated because users cannot earn rents by conserving them from other users--a violation of the "exclusivity" principle of property rights.  Examples include fisheries, game stocks, subsurface "pools" of oil owned by multiple companies.  This is the formalization of Hardin's "commons" problem.

Competitive firms will extract from the resource to the point where the average revenue product of extraction effort equals the unit cost of effort.  There is no incentive for any firm to conserve, since no one owns the resource or has the ability to exclude others from it; whatever one firm leaves the next will take.  As long as firms can cover their harvesting costs, they keep on harvesting.

Consider the case of an open-access fishery, where we examine the factor market for fishing effort.  Let the unit cost of fishing effort be constant (MC=AC).  The marginal value product (MVP) of fishing effort declines more rapidly than the average value product (AVP).  In a typical market, each firm owns all its inputs, and maximizes its profits by using each input to the point where MVP=MC (marginal factor cost).  The factor "rent" is the amount the factor earns minus its cost, which is the portion of firm's total profit attributable to that factor.  This is shown as the yellow rectangle.

As in any competitive market, the existence of positive economic profits attracts new entrants to the industry.  So the open-access fishery attracts new fishing boats and more fishing effort, making fish scarcer and harder to catch, and this reduces the MVP and AVP of everybody's effort.  This can be interpreted as a type of externality, where new entrants don't consider how their entry reduces the productivity of existing boats in the fishery.  The new entry doesn't stop until fish become so scarce that the AVP=AC and all profits are dissipated.

We will revisit the open-access fishery problem in more detail later in the course.
 

Public Goods

A public goods is non-excludable and consumption of it is non-rival.  This means that it is impractical to prevent people who haven't paid for it from using or enjoying the good, and one person's use or enjoyment of the good does not use it up or preclude another's use or enjoyment of it.

The aggregate demand for a conventional market good (excludable with "rival" consumption) is constructed as the horizontal aggregation of the individual consumers' demand schedules.

In contrast, the non-excludable, non-rival nature of a public good implies that its aggregate demand schedule is the vertical summation of the individual demand schedules. 

In the diagram to the right, A buys Q' units for herself, and since A cannot keep B from using or enjoying it too, B simply free-rides on the quantity A purchased rather than buying his own.

The social optimum quantity of the public good is Q*, where A and B's collective marginal willingness-to-pay equals 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 general, public goods are under-supplied unless each user can be induced to contribute his or her marginal WTP. The costs of negotiating such collective purchases are often prohibitive.

Examples of public goods include national defense, scenic landscapes, air and water quality, biological diversity, etc. Note that public goods are not necessarily publicly-owned or publicly provided. Public goods motivate free-rider behavior: the person who wants it the most pays for as much as he or she wants, and everyone else enjoys it for free.

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 categories of market failure

We briefly note several other cases in which competitive markets may fail to achieve Pareto efficiency:

Imperfect markets involve monopoly powers generating market distortions and deadweight losses.

Diverging social and private rates of discount may reflect risk premiums which are higher for individuals than for society as a whole. Privately-owned resources will be depleted too rapidly if private rates of discount exceed social rates of discount,

Government failure involves regulatory distortions of market incentives. Special interests use the political process for rent-seeking (protectionist legislation, tax loopholes, etc.). Most of the public remains "rationally ignorant" of these: it's not personally worthwhile for individual citizens to oppose them. In effect, citizen action to counter special interests is an undersupplied public good.