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It is expected that the competitive markets allocate resources in an efficient way in order to maximize benefits to the community, ensure all the demanded goods and services are produced efficiently, and motivate innovations. Actual market economies, however, differ from these ideal circumstances in many ways. The allocation of the resources is not efficient under the conditions of real world and this situations causes "market failures" to occur. Welfare economics is used to identify these market problems and recommend policies to restore them so that actual economies work better related to the objective of efficiency. Much of environmental economics is welfare economics of this kind. It concentrates on the identification and the correction of the market failure regarding to the services which are provided to the economy by the environment.

At this point, let us remember the necessary factors for producing efficient allocations to understand better how the absence of the factors will be listed below cause market failures. The necessary conditions for markets to produce in an efficient way :

Markets exist for all goods and services produced and consumed. : This can be considered as a fundamental factor. Unless there are goods and services for which markets exist, then it is not possible for the market system to produce an efficient allocation, as that concept applies to all goods and services that are interest to any agent, either as utility or production function arguments.

All markets are perfectly competitive. : In a perfectly competitive market, the production coasts are just equal to the price which is paid by each person for the goods produced. In an imperfect competition,however, can be considered as a market situation in which firms are not the price takers and they have some degree of control over the prices in an industry. It can be observed in the cases of monopoly,oligopoly and the monopolistic competition. A firm operates in an imperfect competition faces a downward sloping demand curve which shows some degree of in elasticity and allowing the firm to put higher prices by restricting the output. This can be eliminate by the barriers of entry to the industry and the existence of important cost advantages.

All transactors have perfect information. : Ideally, free markets are supposed that all the transactors are fully informed about themselves in the way of attaining of efficient outcomes although it is a quite difficult requirement to meet in actual market economies. Let us make it clear with a case of consumption-consumption external effect. taken from the book",.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,..,.," According to this; "two individuals share a flat and where A is smoker but B is not. Suppose that B does not find the cigarette smoke unpleasant, and unaware of the dangers of positive smoking. Then, notwithstanding that the government has legislated for property rights in domestic air unpolluted with cigarette smoke, B will not seek to reduce A's smoking. Given B's ignorance, the fact that bargaining is possible is irrelevant. The level of smoke that B endures will be higher than it would be if were not ignorant. Given B does not, when legally he could, bargain A's level of smoking, we could describe the situation as one of `conditional efficiency`.But this is not really very helpful. Rather, we recognize B's ignorance and consider it to be the source of an uncorrected externality." It can be seen, however, the provision of information as a corrective measure in that case is not that easy. In many situations, information play a role like a public good make it necessary for the government to involve. Since it is needed to consider the futuring results of current situations, the government sometimes may fail because of having ambiguous or inaccurate knowledge. For example, global warming is an issue that nobody have the complete knowledge about it and it becomes very important to be able to consider the futuring effects in a meticulous way since the consequences of the decisions about the use of environment is not reversible.

Private property rights are fully assigned in all resources and commodities. : By the definition of Olewiler(1986), a property right is defined as a bundle of characteristics that convey certain powers to the owner of the right. These characteristics include the conditions of appropriability of returns, the ability to divide or transfer the right, the degree of exclusiveness of the right, and the duration of the enforceability of the right. A private right exist when the right is exclusive to one person or corporation. When there is no property rights in market, there is also no efficient allocation. Therefore, government need to intervene for introducing some public policies. Regarding to the provision of inputs to production,natural resources, two major distinction can be made as flow and stock resources and for the latter, as renewables and non-renewables. Generally, in flow resources there are not private property rights. For instance, individuals or the corporations do not have property rights in the flow of solar radiation. On the other hand they may have the right on land, and therefore have the ability to capture the solar radiation which is falling on the land. Deposits of non-renewable natural resources are mostly the subject to private property rights. The problems arising from the non-existence of private property tights are not central to the economics of non-renewable resources. They do,however, on the feature large in the renewable resource economic literature. Many of the biotic populations exploited by humans as hunter-gatherers, rather than the agriculturists, are not the subject to private property rights like in the typical case of ocean fishery. In the absence of private property rights, two kinds of situation may obtain. In the case of open-access-resources exploitation is uncontrolled. The term common-property-resources is used whenever some legal or customary conventions, other than private property rights,regulate exploitation of the resource. Whereas an open-access regime will not promote exploitation that corresponds to efficiency, a common property regime may do some given the appropriate conventions and regulation. Another class of environmental service was distinguished was that of receptacle for the wastes arising in the economic activity. Generally, for many wastes, the environment as waste sink has not been subject to the private property rights, and has been, in effect, an open-access resource. With increasing awareness of the problems of polluting arising, governments have moved to legislate so as to convert many waste sinks from open-access resources to common-property resources. The case of amenity services that the environment provides is rather like that of flow resources in that the service itself will not generally be subject to private property rights, though the means of accessing it may be. For example, nobody can own a beautiful view, but the land that it is necessary to visit in order to see it may be privately owned, but the land that it is necessary to visit in order to see it may be privately owned. Private rights in a wilderness area would allow to say, develop it for agricultural use,thus reducing the amenity services flow from the area, or to preserve the wilderness. Whereas it is possible in principle for the owner to charge foe access to a wilderness area, in practice it is not feasible in many cases. Another thing is the life-support services provided by the natural environment are not subject to private property rights. Global atmosphere, the carbon cycle, and the climate system can be taken as examples. The global atmosphere has been a free access resource, but atmospheric concentrations of carbon dioxide have increased the greenhouse gasses. Thus, there is a consensus of expert judgments that it has affected the system of the climate, and unless action is taken to reduce the rate of growth of carbon dioxide emissions,further change will be harmful to human interests. That is why, most nations are now parties to an international agreement to act to decrease the rate of growth of carbon dioxide and the other greenhouse gas emissions.

No externalities exist. : An externality occurs when the production or consumption decisions of one agent have an impact on the utility or profit of another agent in an unintended way, and when no compensation is made by the generator of the impact to the affected party. We can classify the extarnalities as consumption and production externalities in a positive or negative way. Production externalities can be defined as production activities of one individual imposes costs or benefits on other individuals that are not transmitted accurately through a market. Consumption externalities means consumption of an individual imposes costs or benefits on other individuals that are not accurately transmitted through a market. Production externalities includes such examples like air pollution caused by burning coal, ground water pollution caused by the use of fertilizers, health problems caused by gold mining, food contamination,exposure of frames to toxic chemicals in pesticides, etc.

Mathematical Representation of Production Externalities :

The social Welfare Maximization Problem is:

Max{ W (Q)=B(Q)-C(Q)-E(Q)}

Q : Output

B(Q) = Total Social Benefit of Producing Q.

C(Q) = Total Private Cost of Producing Q.

E(Q) = Total External Cost of Producing Q.

W(Q) =Social Welfare Function (Total Surplus From producing Q)

Social Welfare is maximized where Q satisfies the First-Order Condition (FOC):

WQ=BQ (Q)-CQ (Q)-EQ (Q), which can be rearranged as

BQ(Q) = CQ(Q) + EQ(Q)


BQ(Q) =the partial derivative of B(Q) with respect to Q=MB

CQ(Q) = the partial derivative of C(Q) with respect to Q=MPC

EQ(Q) = the partial derivative of C(Q) with respect to Q=MEC

Socially optimum output, Q*, occurs when MB = MPC + MEC.

Unregulated Competi with Externalities :

Under unregulated competition, firms maximize profits, resulting in the FOC:BQ(Q) = CQ(Q), or MB = MPC.

When this FOC is solved for Q, call it QC, we find that QC< Q* whenever MEC > 0.

Because QC ¹ Q*, QC is inefficient.

Policies to attain social optimum Q*

Three possible policies :



-Restriction, Standard, or Quota

Choice of policy affects the distribution of economic benefits among producers, consumers and government.

Targeting: Process of deciding which economic variable to control to reduce externality.

Ex. Outputs, inputs, or the externality-generating activity itself (i.e., the pollutant).

Policy- 1:Tax 1

Externality Tax: t* = P* - PP=MEC (Q*), where t* is the required market correction to achieve Q* units of production.


















Firms treat the tax rate as an additional component of their marginal private cost; that is, a unit tax of t* shifts the MPC curve upwards in a parallel fashion by the distance t*.


t* = EQ(Q*) = MEC(Q*).

Private optimization problem:

Max {(Q)=PQ-C(Q)-t*Q}



Q(Q)-P-C Q(Q)-t*=0 or, P = CQ(Q) + t*.

Since P = MB at all points along the demand curve, and t* = EQ(Q*), we can express the private condition (which is identical to the condition for a social optimum) under the tax as:

BQ(Q*) = CQ(Q*) + EQ(Q*)

Welfare Implications of Externality Tax :

Consumer surplus= ABP*

Producer surplus= OFPP

Government revenue= P*BFPP

Policy- 1:Tax 2

Production tax: If the government knows how much pollution is produced per unit of production output, then it can set a tax on production output that achieves the same results as an externality tax. However, the relationship between pollution and production output is often very difficult to estimate with any degree of precision.

Policy-1: Tax 3

Consumption Tax: Sales tax on polluting goods. Demand curve for firms in the market shifts downward to represent the net price of each unit sold. The net price, or Net Marginal Benefit (NMB), is the Marginal Benefit of consumers less the level of the sales tax (NMB = D - t*).

Q*=Social Optimum output

Pc*=Optimal Consumer price

Ps*=Pc*-t=net producer price

t=consumption tax

Policy-2: Output Reduction Subsidy

Subsidy = P* - PP for each unit of output that is not produced.

If Q(equloibrium) = the current level of output, firms in a competitive industry have the following objective:


Optimal subsidy level: (i.e., the unit subsidy that equates the optimal social and private outcomes) S* = t* = MEC(Q*).

Problem with the subsidy is In the long run, subsidies for pollution reduction may actually increase pollution because the subsidy may attract more firms into the market.

Policy- 3: Standards on pollution/output

Command-and-control approach through production quotas to restrict output to Q*.

Quotas vs. Externality Taxes

Producers prefer quotas to externality taxes because they gain a larger share of social surplus.

If quota is transferable, producers will bid against each other for the quota rights until the quota price equals P*- PP.

Consumption Extarnalities

Consumption extarnalities occur when one individual`s consumption imposes costs on the other indivuals that are not transmitted through the market.


MSC=Marginal social cost of production (0 production externality)

MECcons=Marginal External Cost of consumption

MPBcons=Marginal Private Benefit = Individual Demand

MSBcons=Marginal Social Benefit = MPBcons - MECcons

Socially optimal outcome = Q*, Pc*, Pp*

Inefficient outcome under unregulated competition=Qcomp,Pcomp

There are no public goods. : Some of the services that the natural environment provides to economic activity have the characteristics of the public goods, and cannot be handled properly by a pure market system of economic organisation.There are two characteristics of goods and services that are relevant to the public/private question. These are rivalry and excludability.Rivalry refers to whether one agent`s consumption is at the expense of another`s consumption. Excludability refers towhether agents can be prevented from consuming.Pure private goods exhibit both rivalry and excludability. Pure public goods exhibit neither rivalry nor excludability.For example, the services of the national defence forces. Whatever level that is provided at is the same for all citizens of the nation. Open-access natural resources exhibit rivalry but not excludability. For example; ocean fishery that lies out of the territorial waters of any nation. In that case, no fishing boat can be prevented from exploiting the fishery, since it is not subject to private property rights and there is no government that has the power to treat it as common property and regulate its exploitation. Congestable resources exhibit excludability but not, up to the point at which congestion sets in, rivalry. The example given is the services to visitors provided by a wilderness area. Public goods causes the market to fail for the reasons of free-riders and user fees problems. Whnen the consumption is non-rival user fees result in inefficiency. If we take a bridge example which the consumers are charged to pass:

Price (Fee)

Revenues from the fees

Revenues equal to

the cost of the bridge number of users


| number of users

deadweight loss due to user fees

In the problem of free riders problem there is an unwillingness to pay for the goods which are non-excludable. In this case government takes the responsibility for the provision and forces the individuals to pay by taxation. Efficiency conditions for the public goods provision;

Marginal benefit to the society is the sum of the marginal benefits of all individuals

The marginal benefit of an individual is the marginal utility he derives from the consumption-consumption

Therefore, the marginal benefits of a public good is equal to the sum of the marginal utilities of all individuals.