A Student's Guide to Cost-Benefit Analysis for Natural Resources

Lesson 2: Market Failure and Public Investment

I. Introduction

The purpose of cost-benefit analysis (CBA) is to determine the economic merit of public investment projects. From an economic viewpoint, should the government invest taxpayers' money in a public project?

Much of the rationale for public investment, and thus the need for CBA, is to correct so-called market failures.

Market failures are instances where the private sector either cannot, or will not, act as an efficient producer of goods and services, even though society may demand (i.e., be willing to pay for) these goods and services. In instances of market failure, the public sector (government) is often called upon as the producer.

We will examine 5 examples of market failure which lead to possible government intervention. But before that, we will look at the characteristics of an economy which functions effectively.

Neo-classical economic theory provides a model for us to examine the behavior of economic agents. This model can take various forms: 1) verbal/logical, 2) graphical, 3) mathematical. Neo-classical economic theory was what you learned in "Econ 101," and what you applied in your courses in "Environmental Economics." Its tradition began in the late 1800s under Alfred Marshall, an economist at Cambridge University in England.

II. Conditions for a Perfectly Competitive Market

Neo-classical economic theory maintains that certain conditions should exist in order for a market economy to be an efficient allocator of resources. When these conditions exist, this constitutes what is called the so-called "perfectly--or purely--competitive market." Neo-classical theory argues that the competitive market system is an optimal economic allocation/distribution system. The theory maintains that market economy best provides what the people want, in the amounts demanded and at the lowest cost.

A perfectly competitive market is defined as one in which "the impersonal forces of supply and demand, of prices and costs, determine and achieve the optimal allocation of resources and distribution of income; producers and consumers act in their own self-interest."

In order to have perfectly competitive markets, a number of ideal conditions must exist.

Among these ideal conditions are:

1) many producers and consumers each acting in their own self-interest - no one person, or group, can influence production or prices. No monopolies (one seller) or monopsonies (one buyer) who can single-handedly influence the market.

Furthermore, each of the many economic agents acts in their own self-interest, in an atmosphere of anonymous rivalry, not animosity. Producers aim to max profits; consumers max satisfaction thru their consumption. In seeking their own self interest, the agents cause the market to allocate resources efficiently, thus improving the lot of all. A classic quote: the "invisible hand" in Adam Smith's Wealth of Nations: "each person is led if by an invisible hand to promote an end which was no part of his intention...by pursuing his own interest, he frequently promotes that of society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good."

2) homogeneous divisible products - similar types of products are identical, or so nearly so that demand/competition is based upon price alone. Thus, if all other things about a product are equal except price, consumers are indifferent to any motivation other than prices. This forces efficiency because producers must try to produce at the lowest cost and offer goods for sale at the lowest price. People are not influenced by non-price competition.

3) free mobility of resources - the factors of production: land, labor and capital will move quickly to where they are needed most; that is, earn their greatest return. Resources are employed at their highest and best use (unemployment of resources is transient, rarely permanent). If the market no longer demands buggy whips, then the market will no longer produce them. All the buggy whip resources will gravitate to where the demand is (perhaps for computers?). As wage rates fall in one area, qualified people tend to gravitate, on the margin, to where the higher salaries are.

4) perfect knowledge - producers and consumers have information and use it. They make informed decisions from the head, not the heart. They have knowledge of prices, costs, trends, expectations now and into the future. And everyone has the same knowledge available; no "Information asymmetries." People are always seeking information; information is the key to making correct decisions.

5) an effective property rights system - the inputs to production (including natural resources) as well as final goods and services are:

* exclusively owned (not free for the taking), and

* ownership rights are enforceable (an owner can control/prevent people from using/taking their property).

Perfect competition provides a benchmark of economic performance., i.e. what "could" be.

But if one or more of these conditions is severely violated, we are said to have "a market failure." Result: a less than efficient allocation of resources; economic welfare will not be maximized. A great deal of effort by economists has gone into quantifying and analyzing the effects of market failure conditions and the effects on society. The general field of study is called "welfare economics." Note: welfare here doesn't have the modern connotation of government payments to the poor. It has to do with the overall economic well-being of the people.

III. Five Instances of Market Failure

1. Public goods: Pure public goods are defined by 2 essential characteristics:

Nonexcludable - A good is said to be nonexcludable when individuals cannot reasonably be excluded from consuming it. "Fully accessible" is another term. Once provided, anyone can use the fully accessible good at no cost. This gives rise to the "free-rider problem:" once provided, people can use the public good without paying for it.

Thus, there is no incentive for the private sector to provide the public good; they cannot collect subsequent revenues.

Examples of nonexcludable goods: street light, radio waves, scenic beauty, clean air, biodiversity, carbon sequestration. Example of excludable: all private consumer goods.

Nonrival - Consumption by one does not prevent consumption by another (a.k.a. non-subtractable, indivisible, nonpackageable). Many can benefit at once from consumption. Unlike a rival good like a hamburger which can be consumed only by one person.

Summary: Public goods constitute a market failure because:

1) lack of enforceable property rights (nonexcludable),

2) not a divisible homogenous products (nonrival).

The private market has no incentive to provide such goods, hence market failure.

Typically government must either produce the public good or subsidize the private sector to produce. Thus, a need for CBA.

Small groups can sometimes work-out the free-rider problem and provide public goods by negotiating an acceptable price and means of payment. Example: neighborhood association that provide streets, street lights, culverts.

Large groups, however, are unable to negotiate. Typically, government must provide public goods for large groups such as national defense, weather forecasting services.

Other classes of public goods:

Club goods (aka, "toll goods") example: rock concerts. A type of public good; people pay to become a club member and thus share in the exclusive consumption of the good.

2. Open Access Property

Open access property - property openly accessible to all so that people can freely enter and take the resources on a first-come, first-served basis without paying a price. No single agent controls the property. Was once called "common property," but the terminology has changed. Common property strictly speaking refers to collectively ("commonly-owned") property which may have controlled access (e.g., the village commons). Open access is sounding a bit like public goods. But there is a difference.

A comparison of public goods and open access resources:

Open access and public good resources share the trait of non-excludability (i.e., full accessibility). For both public goods and open access resources, it is impossible to exclude users.

However, open access resources (i.e., timber, fish) are rival, hence subtractable,

but pure public goods are not (i.e., scenic beauty, clean air).

Users of open access resources will reduce the amount available for use by others (e.g., timber, water).

Examples of open access abound in natural resources: Ocean fisheries are a good example.

Consider a rain forest in Brazil with timber open for exploitation because only 10% of the property has "iron-clad" property rights. Loggers come and take timber and never replant.

Other examples: migratory animals, air, water, aquifers, pools of oil.

Summary: Economic characteristics of open access resources:

1. In the presence of sufficient demand and many harvesters, it is impossible for any agent to capture the scarcity rent (scarcity rents = profits + fixed costs) stemming from their own conservation efforts. If one conserves by harvesting less, someone else reaps the benefits. In fact, restrained, profitable management by one agent is an incentive for higher harvest by others.

2. Because agents cannot capture the profits, harvesters tend to exert a higher level of effort than the private market would.

3. The average price of the resource tends to be lower than private market.

4. Incomes of the harvesters tends to be lower than private market.

Open access property constitutes a market failure; it violates the exclusive property rights requirement of perfect competition.

3. Economic Externalities:

Economic externalities: Occur when benefits or costs resulting from a production or consumption activities are passed to parties not directly involved in the primary market activity as a producer or consumer. External costs (bad) are called "negative externalities." External benefits are called "positive externalities." This concept dates back to A.C. Pigou (c.1932) but really came into its own in the 1960s. It forms the basis of the sub-discipline of "environmental economics."

[Note: There is another class of externalities referenced in the economic literature:

pecuniary externalities - this usage is somewhat outdated. Pecuniary externalities are those transmitted by market activity that results in higher prices. Example: a new company moves into an area and the demand for housing drives up the price of housing for everyone. Pecuniary externalities are not a market failure. They are in fact, the market at work transmitting information about resource scarcity thus contributing to an efficient allocation of resources.]

Summary of Negative Externalities: Externalities are another form of market failure related to unenforceable property rights. In the case of negative externalities:

1) the market tends to set too low a price for the good that causes the externality,

2) as a result the market produces more of the commodity that is causing the negative externality than is social optimal.

4. Potential monopoly situation

A monopoly situation is where "only one firm sells a product or service." Recall we said in order to have perfect competition we needed many producers of a homogeneous product. Monopoly is a clear violation of the competitive condition: that we have many producers.

The theory in summary: when a monopoly occurs in a competitive industry, there is a tendency for the monopolist to: 1) charge too high a price to the public for their output, and as a result, 2) the public consumption to be lower than it would be under competition. There is a social cost to society due to the fact that output is lower and price higher than it would be many sellers.

There is also a special case of monopolies called "natural monopolies" which has nothing to do with "natural" resources per se. Natural monopolies are those where the fixed cost of business start-up is prohibitively high. So high that the monopolist, if she went into business, could not charge an affordable price and still cover her costs, i.e., remain in business. She would suffer negative profits because of the huge fixed cost incurred.

Examples of natural monopolies: public utilities, bridges and roads. In natural resources: national parks like the Grand Canyon, Yellowstone. A private producer would not likely "start" such a park because an entrance fee needed to cover the fixed cost would not be affordable to most. The natural monopoly will not likely exist without government help.

Thus, in those cases with very high fixed start-up costs, government can subsidize the cost and create of a "natural monopoly" to provide goods and services. The price that the natural monopolist charges is lower than the "private" monopolist would charge and the consumption (visitation rate) is higher. Think of a major national park owned and operated by a private company versus the government. The private entrance fee would have to be prohibitively higher and the visitation rate, much lower, than with a government subsidized park. Read about natural monopolies in the text.

5. Information Asymmetries

One requirement for perfectly competitive markets is that identical information must exist for both buyers and sellers so that they both can make informed decisions.

However, information asymmetries do exist where one party knows more than the other thus causing them to make "better" decisions. Information asymmetries will result in economic welfare losses.

Should government provide the missing information? This depends on: a) can consumers get the information with relative ease, b) are there third parties that will provide the information as a market commodity (e.g., Consumer Reports)?

The strongest argument for government intervention is the information needed is very expensive and/or requires very long-term records. Examples: weather service, longterm health/environmental effects of chemicals and drugs.

Natural resource examples of government information services: weather reports, forest pest damage reports, timber price reporting (now supplanted by private price reporting services).

IV. Tabular Summary of Economic Implications of Market Failure                       

V. Possible Solutions to Market Failure

Several possible solutions involving government have been recommended to correct market failure problems such as those discussed.

1. Government as producer - this is the most obvious solution, the one we've been considering. Simply get government involved in the production of public goods. That's what happened when the U.S. national forests were created in the 1800s. Government became a producer of timber. (Note: other govt.-as-producer solutions: national defense, post office, garbage collection, education.)

2. Regulation through law/courts/police power - government requires the private sector to do or not do something. Forest practice acts, zoning, anti-noise laws, no-burning laws, anti-pollution, nuisance laws, anti-poaching.

3. Government incentives - government provides public funds/incentives to promote some production activity in the private sector (e.g., reforestation incentives). Forms a sort of government-private partnership.

4. Assignment of property rights - government can, by various mechanism, assign property rights where they do not exist and where they may be inherently difficult to assign. Example: the use of individual transferable quotas (ITQs) and marketable pollution permits (MPMs). ITQs assign property rights (total harvest limits and individual quotas) to fisheries. MPM sets total pollution level for an airshed and then assign individual pollution rights.

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