Economic Theory and Market Failure: A Synopsis

To speak about economics as applied to environmental harms, one must know something about economics generally and its conceptual frameworks as applied to policy. While possibly seeming dry and abstruse, these fundamental concepts have direct relevance, including for those more interested in environmental than economic issues. However, this publication also covers issues relevant to people more concerned about questions of economics and public policy generally. In past decades, economics has provided much of the language in which environmental harms have been discussed. The purpose of this chapter is to introduce some of the basic terminology and concepts that will be useful later, attempting to limit jargon and eschewing graphs and mathematics (which do little for those trained in basic economics and risk turning off those who aren’t).

This chapter runs through the basic functioning of markets as presented to beginner students of economics. Markets enable spectacular human feats and allow coordination across culture, geography and even time. While imperfect, the logic of this functioning is worth stressing prior to considering the ways in which markets can result in outcomes that call for intervention. Following an outline of these situations there follow some idealised policy responses to the externality problem at the heart of many environmental concerns (addressed in more detail in Chapters 2 and 3).

Markets at Work: An Ideal Type

One of the first tasks of an economics instructor is to illustrate the emergent benefits of self-interested behaviour by individuals. In the nineteenth century the pamphleteer and economist Frédéric Bastiat wrote of how Paris managed to get fed even though no one person or bureaucracy was tasked with ensuring this. This answer is obvious at a mundane level: the customer at the bakery and the person behind the counter are engaged in a positive-sum trade. The goods that appear in the shop only do so because of a series of profit-seeking – if not always profit-achieving – acts. Extending out these interconnecting and overlapping mundane relationships that populate our commercial life shows the rather amazing functions of markets to encourage social cooperation through the billions of voluntary acts that occur in markets every day.

This behaviour takes place in the face of scarcity. Resources are inherently limited, while human wants and needs are largely unlimited. This scarcity creates the need to make choices about how best to allocate resources. In a market society this is achieved through the process of commercial transactions. In the 1930s, Lionel Robbins formulated a definition of economics that is still popular: ‘Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.’[1]

When making decisions, individuals must consider the opportunity cost; that is, the value of the next best alternative course of action. Gold may make a great conductor for electrical wiring but this inherent feature doesn’t result in its being so used because alternative uses are more highly valued. Opportunity cost determines the trade-offs that individuals negotiate in how they and others use resources. Thinking about these trade-offs makes it clear there are opportunities for exchange if the value derived from holding a good is less than the value from trading it for something else. Voluntary exchange in markets is by its very nature mutually advantageous for buyers and sellers, and because of their exchange, society at large becomes wealthier.

The key to this process is the price mechanism. Individuals and firms engage in voluntary exchanges, buying and selling goods and services. As these transactions occur, prices naturally form based on the supply and demand for each product or service. These prices then serve as signals, informing both producers and consumers about what is valuable and how resources should be directed.

Some buyers may be willing to buy a pastry at £3, others at £5; some bakers may be willing to sell it for £3, others for £1. In this situation we can see that if the market price is £3, the consumer who values the pastry at £5 has garnered a consumer surplus of £2 (what they were willing to pay less what they did). A producer willing to sell a pastry for £1 has garnered a producer surplus of £2 when it is sold for £3. All gains from trade are exhausted when markets clear. This occurs in equilibrium at a price where the marginal benefit of buying the final good is equal to the marginal cost of selling it. Both buyers and sellers can vary in their valuations, but the basic point is that the diversity of valuations is what generates gains from trade, whereby resources flow to those who value them.

But prices do more than just allocate current resources: they also serve as beacons for potential profit opportunities. In this sense the price mechanism not only coordinates immediate economic activity but allows dynamic, long- term improvements in economic organisation with the help of interest rates and accounting practices that allow intertemporal calculation. The prospect of earning profits by introducing innovative products, services or institutional arrangements spurs experimentation and progress. Producers who do not create value do not garner profits. If the inputs cost more than consumers are willing to pay for a product, the business is unlikely to stay viable for long. The COVID-19 pandemic demonstrated the amazing resilience of markets, as they continued to operate in extreme circumstances.

As emphasised by Friedrich Hayek and then generally accepted towards the end of the last century, this decentralised, market-driven process of price formation allows for far greater social coordination than a centralised, top- down system could achieve, despite the numerous deviations of markets in practice from idealised models and idealised alternatives to markets.

In the proper institutional context, individuals do not need to know or trust one another to engage in these cooperative relationships – they can simply rely on the underlying incentives created by the price system. The prospect of mutual gain encourages people to specialise, innovate and coordinate their efforts, resulting in a far higher standard of living than could be achieved through isolated self-sufficiency.

Pareto efficiency – after the Italian economist and sociologist Vilfredo Pareto – occurs when resources are allocated such that no individual can be made better off without making another worse off. This matters because it gives us a straightforward way to evaluate economic outcomes that most people can agree on: if we can make someone better off without hurting anyone else, that’s clearly a good change. The Pareto standard of efficiency set a high bar by requiring that economic changes help some people without hurting anyone, which proved impractical for most real-world policy decisions. The Kaldor-Hicks approach – after the economists Nicholas Kaldor and John Hicks – considers a change efficient when total benefits exceed total costs, even if some people end up worse off without compensation. It is this standard that is the basis of cost–benefit analysis covered later in this publication.

Adam Smith’s famous ‘invisible-hand’ metaphor suggests that the pursuit by individuals of their self-interest in free markets can lead to socially beneficial outcomes. In ideal conditions, competitive markets tend towards Pareto efficiency, as if guided by an invisible hand. However, market failures can prevent this optimal allocation, necessitating careful analysis of real-world conditions and potential interventions to achieve efficiency.

Markets Aren’t Perfect: Externalities and Public Goods

In any industry, where there is reason to believe that the free play of self- interest will cause an amount of resources to be invested different from the amount that is required in the best interest of the national dividend, there is a prima facie case for public intervention.[2]

Arthur Pigou

 

The simple but counterintuitive world of commercial exchange resulting in social benefits is one whereby individuals acting in their own interest leads to the best outcomes for society at large. While Adam Smith was a more nuanced thinker than many suppose, he represented the paradigmatic turn. In The Hesitant Hand, Steven Medema sets out the aberrational nature of Smith’s system as compared to earlier thinkers who little appreciated how the sifting process of markets could lead to social improvement.[3] As he shows, the general tendency of Anglo-American economics in the century after Smith was away from the simple world and towards one with special cases, in which the general case for markets did not hold.

As these special cases became more prevalent, ideas about the general performance of markets changed. Unsurprisingly this is also related to broader conceptions of the appropriate role of the state over time. Thinking about what we would consider theories of market failure started in the nineteenth century, as John Stuart Mill and Henry Sidgwick began writing in the shadow of this shift in attitudes. This perspective – that markets are generally beneficial but subject to market failures which create a prima facie case for intervention – is still widespread, despite additional developments within economics, as described in Chapter 2. Nevertheless the following outlines the conventional framework for understanding these issues.

The concept of externalities refers to impacts that spill over from economic activities but aren’t captured in market prices. These effects involve people who aren’t directly buying or selling in that market. When externalities exist, what’s best for individual buyers and sellers doesn’t match what’s best for society as a whole. This happens because market prices only reflect the costs and benefits that matter to those directly involved in transactions, while ignoring wider impacts on others. A classic example is a factory that maximises profits without considering how its pollution affects nearby residents.

A basic finding from welfare economics is that when externalities are present, markets produce outcomes that aren’t socially optimal. This means there is an inefficiency in how resources are used because decision-makers are responding to incomplete information about true social costs and benefits (i.e. when the third-party costs and benefits are included). In the standard analysis, understanding and addressing these spillover effects is essential for evaluating how well markets work and for designing policies that better serve society’s interests. In the paradigmatic case of pollution from a factory, the true cost to society is higher than what the factory owner pays. If factory owners had to pay for the full pollution costs, they would account for all relevant social costs.

It’s important to understand that the optimal use of goods with negative externalities isn’t zero. Even if a product from a polluting factory creates social costs, it still provides value to buyers. The problem occurs when some units are produced that are worth less than their total cost to society. For example, if someone is willing to pay £30 for a steel pan that costs a supplier £20 to produce, but also creates £5 in pollution costs not borne by the supplier, the consumer should buy it because the value (£30) exceeds the total social cost (£25). On the other hand, optimal policy would mean that a consumer who values the pan at less than the full cost of the product (including the harm of the pollution) would no longer purchase it. This distinction matters when we think about policy solutions.

The same logic applies to goods with positive spillover benefits. For instance, flu vaccines protect the person getting the shot, which may be chief among the benefits they consider when deciding whether to get vaccinated.However, from society’s perspective there are other benefits, namely reduced disease-spread, which protects others.

Another standard example, from the Nobel Prize winner James Meade, has to do with two agricultural producers.[4] Imagine an area of the countryside with both orchards and beehives. A farmer’s orchard provides the resources honeybees need to make honey, but this benefit is external to the decision-making process of the orchard owner. The apiarist benefits from the decision of the farmer to plant an orchard, but without capturing this spillover, basic analysis suggests the orchard owner will underprovide. His private benefit from planting an additional tree is lower than the social benefit. If there were a way to capture the broader benefit (the honey produced by the bees as a result of the orchard), the farmer would plant more trees. In the basic theory, spillovers suggest that there may be a role for policy to improve market outcomes.

Public Goods, Clubs and Commons

The concept of externalities is closely related to the economic theory of public goods. While externalities refer to the unintended side effects that arise from the production or consumption of a good or service, public goods are specific types of good that inherently exhibit certain externality- like characteristics. In the 1950s the economist Paul Samuelson formalised the definition of public goods.[5] This built on previous ideas about the state provision of goods and was part of a broader, mid-century conceptualisation of the proper role of the state vis-à-vis markets.

Unlike standard consumer goods that are bought and sold in everyday markets, public goods possess two distinctive features identified by Samuelson: non-rivalry and non-excludability. Non-rivalry means that when one person uses the good it doesn’t reduce its availability to others – in contrast to standard goods like shirts or cars, which can only be used by one consumer at a time. Non-excludability means that people can’t be prevented from benefiting from the good, even if they haven’t paid for it. Because of these twin attributes, markets typically underprovide public goods compared to what would be socially optimal, as private actors cannot capture the full benefits of their investments and thus have little incentive to provide them.

A classic example – originating in nineteenth-century English economic writing[6] and then used in twentieth-century textbooks – is a lighthouse that helps guide ships safely along a certain coast. Using language from the twentieth century, the light from the lighthouse is non-excludable: once operational its benefits can’t be excluded from passing ships, whether they paid for it or not. The light is also non-rivalrous: one ship benefiting from it doesn’t diminish its usefulness to others. This makes the lighthouse a quintessential public good.

This non-excludability creates a free-rider problem. Self-interested ship captains have an incentive not to pay for the lighthouse service since they cannot be prevented from consuming its benefits. But if everyone followed this logic, the privately funded lighthouse would not be built in the first place due to lack of demand, even though its presence increases maritime safety and benefits society. This free-rider problem helps explain why many public goods end up being underprovided by private markets alone.

The underprovision of public goods like lighthouses is a classic collective- action problem, stemming directly from the characteristic of non- excludability. Because the benefits of a lighthouse cannot be excluded from passing ships, whether they paid for it or not, each individual ship operator has a rational incentive to free-ride and not contribute funding. However, if everyone follows this individually rational strategy of free-riding, it leads to a collectively irrational outcome: the under-provision or non-provision of the socially beneficial lighthouse service. While it would be in everyone’s collective interest to fund the lighthouse, this inability to exclude creates a disconnect between individual and group interests.

This misalignment, where pursuing narrow self-interest generates an equilibrium harming the group as a whole, defines a collective-action problem. The root cause is the public good’s non-excludability. If exclusion were feasible, users could be forced to pay, aligning individual incentives with the collective good; but when it is not, cooperating for the group’s interest becomes a challenge absent external interventions.

While pure public goods suffer from free-rider problems due to non- excludability, these issues are largely resolved for club goods.[7] Club goods are excludable, though non-rivalrous in consumption. They exclude non- payers from accessing the benefits, even though no single person’s use diminishes the availability for others. A streaming service like Netflix isa common example: only fee-paying members can gain access. Before technology enabled excludability, this was a widely held argument for state regulation and consumer licence fees for radio and television broadcasting. With the excludability of club goods, free-riding is addressed since non- payers can simply be excluded. This allows suppliers to capture the benefits they create by getting users to pay fees or membership dues.

A common-pool resource is a type of good that is rivalrous, meaning one person’s consumption diminishes availability for others, but it is also difficult to restrict access. Examples include fisheries, forests, irrigation systems and grazing lands. When open access allows overexploitation without any incentive to conserve the shared resource, it can result in the ‘tragedy of the commons’ that Garrett Hardin popularised.[8] The logic is not new to Hardin– the defence of private property has rested on the problems of common ownership since at least Aristotle – but the phrase stuck. It refers to the situation whereby individuals acting independently and rationally according to their own self-interest behave contrary to the best interests of the whole group by depleting the resource held in common.

The ‘tragedy’ arises because each individual receives the full benefit of their own use of the resource but the costs of overuse are dispersed among all those with access. Without any incentive to limit consumption and exclude others, the optimal response is to maximise personal exploitation before others do so. Inevitably this leads to overconsumption, degradation and depletion of the finite resource, leaving all parties worse off than if they had successfully cooperated and restricted their consumption.

Some Policy Responses to Market Failures: Command-and- Control vs Pigouvian Tax

Policymakers and citizens have instituted a full range of policies to regulate markets. In many cases those regulated fit roughly into the theories presented above about how certain features of markets will result in suboptimal outcomes. While politicians have sought to address markets that economists think are prone to problems, this doesn’t mean policies are in line with the recommendations of economists.

Perhaps the most common approaches to environmental harms are direct regulation of pollutants, such as smoke, along with taxes aimed – at least in part – at correcting externalities. The benefits of the tax approach as opposed to command-and-control regulation are usually stressed by economists. The practicalities of other options and their rates of take-up will be discussed later. But first, why are economists generally less keen on regulation that simply bans the harmful acts?

The tax solution to externalities, namely Pigouvian taxes, are named after the twentieth-century British economist Arthur Pigou. A government can assess a tax on the sale of goods that have a negative externality in production. The easiest example is a coal-fuelled power station that spews out harmful emissions while powering factories producing things consumers want. By assessing a tax equal to the size of the harm, market participants will optimise their decisions in a way that leads to the optimal social outcome. Consumers will face a higher price and reduce consumption and producers will also make decisions about their methods of production in response to a tax. The consumers least willing to pay the higher price won’t purchase the product and on the supply side the least efficient producers will reduce production.

Taxing externalities can generate ‘double dividend’ welfare benefits beyond just reducing harmful activities. Taxes that do this correct market distortions by making polluters pay the true social cost of their actions while simultaneously generating revenue that can replace other distortionary taxes – such as income and sales taxes – that create inefficiencies by discouraging productive economic activity. Taxing ‘bads’ not only reduces them, but in replacing taxes on ‘goods’ it generates additional benefits.

Unlike command-and-control regulations, Pigouvian taxes don’t dictate specific solutions but instead harness the market’s efficiency by allowing countless individual decisions collectively to determine the least-cost methods of reducing harmful activities. The tax simply ensures these decisions reflect true social costs rather than just private ones, enabling the market’s invisible hand to arrive at the socially optimal outcome.

These benefits are more apparent in contrast to the kinds of command- and-control interventions one can imagine or see in the real world, such as requiring all coal-fuelled power stations to install a piece of technology like a scrubber to limit sulphur dioxide emissions, or requiring all stations to reduce emissions by a certain percentage. With these interventions the policy barely distinguishes the abatement costs between polluters: those who can achieve reductions relatively cheaply are not incentivised to continue doing so beyond the intervention required of all producers.

Regulations that vary based on the age of the facility – as some do in the real world as a proxy of cost – result in the incentive to keep older facilities around. The outcome of these interventions is that emissions are reduced inefficiently; that is, at a greater cost than necessary.

Perhaps the most basic counterintuitive economic point about pollution is that the optimal amount of it in the real world is almost always not zero. In the example of a product whose production emits smoke pollution, this smoke is clearly the by-product of making goods valued by consumers. It may cause physical discomfort and financial losses for the owners of nearby land (as the harm of the disturbance is priced into the land as it works through the market), but this harm is just one side of the ledger, with the net value of the products to the consumers on the other.

Additionally, the diversity of users means many standard policy responses are likely to be less efficient than Pigouvian taxes. Some users are willing to pay more for a product than others; some suppliers are willing to sell them cheaper than others. Therefore a tax in line with the social cost means that goods will still be used by those who place the highest value on using them. Furthermore, the supply-side response elicited by the tax comes from the producers who can reduce pollution at the least cost (discussed in detail in Chapter 3).

Conclusion

This chapter has introduced a basic analytic framework for understanding how markets function: supply and demand and the idea that individuals’ incentives can lead to social benefits. It has also discussed market failure – specifically in relation to externalities, public goods theory and the commons – which many draw on to critique market performance and suggest policies that can lead to better outcomes. Taken together, this has offered the type of view of the market that many hold; that is, in some cases it performs well, in others poorly and requires intervention. Chapter 2 builds on this cursory introduction with later economic theory and findings.

Notes to Chapter 1

[1] Lionel Robbins, An Essay on the Nature and Significance of Economic Science (London: Macmillan & Co., 1932), p. 15.

[2] Arthur C. Pigou, The Economics of Welfare, 4th edn (London: Macmillan & Co., 1932), p. 331; Steven G. Medema, The Hesitant Hand: Taming Self-Interest in the History of Economic Ideas (Princeton, NJ: Princeton University Press, 2009), p. 64, doi:10.1515/9781400830770.

[3] Medema, The Hesitant Hand.

[4] James E. Meade, ‘External Economies and Diseconomies in a Competitive Situation’, The Economic Journal 62, no. 245 (1952), pp. 54–67, doi:10.2307/2227173.

[5] Paul A. Samuelson, ‘The Pure Theory of Public Expenditure’, The Review of Economics and Statistics 36, no. 4 (1954), pp. 387–9, doi:10.2307/1925895. Though contemporary historians argue that this attribution should be shared with Richard A. Musgrave; see

Maxime Desmarais-Tremblay, ‘Musgrave, Samuelson, and the Crystallization of the Standard Rationale for Public Goods’, History of Political Economy 49, no. 1 (March 2017), pp. 59–92, doi:10.1215/00182702-3777158.

[6] ‘… it is a proper office of government to build and maintain lighthouses, establish buoys, etc. for the security of navigation: for since it is impossible that the ships at sea which are benefited by a lighthouse, should be made to pay a toll on the occasion of its use, no one would build lighthouses from motives of personal interest, unless indemnified and

rewarded from a compulsory levy made by the state’, John Stuart Mill in Principles of Political Economy, as quoted in R. H. Coase, ‘The Lighthouse in Economics’, The Journal of Law & Economics 17, no. 2 (1974), p. 357.

[7] James M. Buchanan, ‘An Economic Theory of Clubs’, Economica 32, no. 125 (1965), pp. 1–14, doi:10.2307/2552442.

[8] Garrett Hardin, ‘The Tragedy of the Commons’, Science 162, no. 3859 (December 1968), pp. 1243–8, doi:10.1126/science.162.3859.1243.