ERE Week 1 - Market failure

Pareto improvement

At least 1 person benefits & no one is worse off

Pareto efficiency vs Pareto improvement

Social welfare function

W(U₁,U₂)

Helps us choose which project to undertake

Efficient policy

Where winners from the project compensate the losers

• only works if the transfers are feasible

  • If compensation then pareto improvement

If no compensation then on aggregate everyone should benefit

When is a project worth undertaking

if it is a Pareto improvement

Pareto efficiency

Pareto improvements are no longer possible

No one can be made better off without making

anyone worse off

Conditions for efficient markets

• Markets exist for all goods and services

• Perfectly competitive markets

• Perfect information

• Property rights are fully assigned

• No externalities

• All goods and services are private goods

Public goods

Non-rival

Non excludable

Voluntary provision of public goods almost always leads to under provision due to free riding

Non rivalrous goods

My consumption does not diminish your consumption

Non-excludable

No one can be excluded from consumption

Types of good table

Externality

Production or consumption decisions of one agent affect the utility or production possibilities of another agent in an unintended way

Basic Pollution diagram

Without policy polluters emit E₀ → MC abatement = 0

Optimal Pollution diagram

Optimal pollution = E₁ → MC abate = MC pollute

Total cost minimised + Total benefit maximised

Polluter + victim want to maximise joint benefit → Victim pays polluter to reduce E to E₁ OR Polluter pays victim to allow E₁

Government role in environment

• Assign and enforce property rights

  • Doesn’t matter for efficiency to whom property rights are assigned

Coase theorem

When property rights are assigned, bargaining between affected parties will result in the efficient level of pollution irrespective of the distribution of property rights

Victim pays polluter

Victim pays polluter to reduce E to E₁

Victim holds property rights

Polluter pays victim to allow E₁

Problems with Coase theorem

Transaction costs

Strategic behaviour

Instability of the grand coalition

Problems with Coase theorem - transaction costs

• Identifying all polluters and victims

• Identifying Costs + Benefits

• Getting all agents together (Free riding)

• Cost of bargaining

Problems with Coase theorem - Strategic behaviour

Bargaining may break down

Problems with Coase theorem - Instability of the grand coalition

• At least 3 parties + 2 externalities → Ideal is a grand deal that solves all externalities at once

• Some parties could break away from that and come up with own deal that solves their own problems → At expense of those left out

Coase theory example - Vittel overview

• Mineral water source in NE France was being polluted from nearby farmers

• Late 1980s: Vittel notes increase in nitrate concentration in spring water from nearby intensive farming (corn)

• However under EU law, farmers weren’t going over the legal level

Coase theory example - Vittel options

Coase theory example - Vittel TC

Coase theory example - Vittel overcoming TC

Coase theory example - Vittel Results

• Contracts with 34 out of 37 farmers in 10 years

• 96% of targeted lands

• Contracts for 18 – 30 years

• Decrease in nitrate concentration

Coase theory example - Vittel Costs to get results