1. Market failure occurs when private costs and benefits differ from social costs and benefits, leading to an inefficient allocation of resources. 2. For environmental goods like air and water, market failure arises because there are no property rights, they are non-rival and non-excludable public goods, and pollution externalities are not priced into production. 3. Externalities can be corrected by taxing polluters an amount equal to the external cost imposed on society, known as a Pigouvian tax, which internalizes the externality into the firm's production decision and leads to a more efficient market outcome.

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Environmental Economics
MARKET FAILURE
Prof. Prabha Panth,
Osmania University

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Perfect Market
• Neo-classical model of perfect competition
is taken as optimum for allocation of
resources.
• P = MC = MU,
• All private costs = private benefits
• Maximisation of individual benefits
• Social benefit = Σ individual benefits
• Pareto optimality

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What is Market Failure
• Market failure occurs when the market
through the price system cannot obtain an
optimal allocation of resources, due to the
differences between private and social
costs and benefits.
• SMC ≠ Σ Private MC
• SMB ≠ Σ private MB
• Inefficiency of the real market

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MARKET FAILURE
• Market failure: Private decisions based on
market prices cannot generate an efficient
allocation of resources for Society.
• This is especially true of Environmental
goods and services.
• Difference arises between Private costs
and Social costs, and Private Benefits and
Social benefits.
• Most assumptions of perfect competition
do not exist in reality.

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ENVIRONMENTAL GOODS AND
MARKET FAILURE
Three reasons for market failure:
1) No Markets for Environmental Goods:
Most environmental goods are “Free”
goods – e.g. atmosphere, water, etc.
 No one owns environmental goods, so
they cannot be bought and sold.
 There is no price for their use or
misuse.
 Therefore they are overused

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2. Pure Public Goods: Environmental goods
are pure public goods.
Two characteristics of Pure Public Goods:
a) Non Rival: one person’s use does not
reduce another person’s supply. E.g.
oxygen, sunshine, river
b) Non-exclusive: Cannot exclude another
person from using the environmental
good. For e.g. if one person uses the river,
he cannot stop another from using it.

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3) Externality:
Since environmental goods are non-rival
and jointly consumed, one person’s
consumption will affect another’s
consumption outside the market.
One user can impose external costs to
others.
For example: paper mill cuts the forest,
affects biodiversity and forest based
industries, climate change, etc.
No payment is made for the misuse of the
resource.

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Qx
Rs
0
AR = MRP
PMC
Q1
E
MARKET FAILURE
SMC
F
EXTERNAL
COST
Q2
G
P1
H

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• Production adds environmental costs – for e.g.
thermal plants produce electricity as well as CO2
which leads to Greenhouse effect.
• But the cost of pollution is not added to the
private MC of the firm.
• Pollution imposes an external cost or externality
to society = EF.
• If it is included then the new equilibrium is at F,
and P = FQ1
• Or else, Q should fall to G, where P = SMC.
• Thus perfect competition leads to over
production (Q1>Q2), and charges lower price
(P< P1)

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Correcting Market Failure
• Firms don’t pay the External cost, as they
are not affected by the pollution.
• According to Pigou, if a tax = External cost
is imposed (Tax = EF), then the externality
can be internalised.
• Called Pigovian tax.
• Therefore if External cost is internalised,
then new equilibrium will be at G, and Q
will fall.
• Pollution levels or social costs will fall.

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How to internalise external costs
• Pigovian taxes:
• Tax the polluter or the creator of the
externality.
Such as: Green taxes on carbon dioxide
releases, or on effluents from factories,
– Raising the prices of more polluting or more
environmentally damaging goods,
– Making polluters bear the cost of controlling or
mitigating their pollution.

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How to internalise external costs
• Pigovian Subsidies:
• Reward by lowering the price and cost of
environmentally safe products, and techniques.
– Green products,
– Alternative renewable energy,
– Bio degradable plastics,
• These measures will send market signals to
reduce environmentally unsafe activities, and
encourage environmentally friendly ones.