Market Failure for Environmental Goods

A market is an exchange institution that serves society by organizing economic activity. Market use prices to communicate the wants and limits of a diffuse and diverse society so as to bring about coordinated economic decisions in the most efficient manner. Market work well when prices reflect all values. ‘Market Failure’ occurs when some costs and/or benefits are not fully reflected in market price. For environmental assets, market can fail if prices do not communicate society’s desire and constrains accurately. Price often understate the full range of services provided by an asset, or do not exist to send a signal to the market place about the value of asset.

Market failure occurs when private decisions based on these prices or lack of them; do not generate an efficient allocation of recourses. Efficiency is defined as Pareto optimality – the impossibility of reallocating resources to make one person better off without making anyone else worse off. Habitat destruction through deforestation has increased rapidly over the last few decades. The factors leading to habitat destruction and the loss of biodiversity originate in several sources of market failure. The market system fails to function properly for many kinds of environmental goods because such resources including the services they provide are often not traded in market.

Market failure for environmental goods can occur due to any or all of the following:

1. Incomplete markets: Markets for certain things are incomplete or missing under perfect competition. The absence of markets for such things as public goods and common property resources is a cause of market failure. There is no way to equate their social and private benefits and costs either in the present or in the future because their markets are incomplete or missing.

2. Lack of or weak property rights: A key requirement to avoid a market failure is that markets are complete - enough markets exist to cover each and every possible transaction or contingency so that resources and move to their highest valued use. Markets will be complete when traders can costlessly creates a well-defined property rights system such that a market will exist to cover any exchange necessary. Most of the market failures with environmental assets can be linked to incomplete markets. Markets are incomplete because of the failure or inability of institutions to establish well-defined property rights. For example, many people own land and are able to take action when damage is done to it, but they do not generally own the rivers or the air, though which significant amount of pollution travel. The lack of clear and well-defined property rights for clean air thus makes it difficult for market to exist such that people who live downwind from a coal-fired power plant can halt the harm that the plant does to them or successfully demand a fee, equivalent to the costs they bear, from the operator of the upwind plant.

3. Common Property Resources: Another cause of market failure is a common property resource. Common ownership when coupled with open access, would also lead to wasteful exploitation in which a user ignores the effects of his action on others. Open access to the commonly owned resources is a crucial ingredient of waste and inefficiency. Its most common example is fish in a lake. Anyone can catch and eat it but no one has an exclusive property right over it. It means that a common property resource is non-excludable (anyone can use it) and non-rivalrous (no one has an exclusive right over it). The lake is a common property for all fishermen. When a fisherman catches more fish, he reduces the catch of other fishermen. But he does count this as a cost, yet it is a cost to society. Because the lake is a common property resource where there is no mechanism to restrict entry and to catch fish. The fisherman who catches more fish imposes a negative externality on other fishermen so that the lake is overexploited. This is called the tragedy of the commons which leads to the elimination of social gains due to the overuse of common property. Thus when property rights are common, indefinite or non-existent, social costs will be more than private costs and there will not be Pareto Optimality.

4. Public Goods: Another cause of market failure is the existence of public goods. A public good is one whose consumption or use by one individual does not reduce the amount available for others. An example of a public good is water which is available to one person and is also available to others without any additional cost. Its consumption is always joint and equal. It is non-excludable if it can be consumed by anyone. It is non-rivalrous if no one has an exclusive rights over its consumption. Its benefits can be provided to an additional consumer at zero marginal cost. Thus public goods are both non-excludable and non- rivalrous. Moreover, environmental quality is generally considered as a public good and when it is valued at market price, it leads to market failure.

5. Externalities: Externalities arise because of the non-existence of market, that is, there are no markets in clean air or peace and quiet. An externality arises when a mutually beneficial transaction between two or more than two parties results in a third-party effect where someone not a party to the transaction is either better off or worse off. Externalities can be positive, that is, there can be gains for both the affected parties and the generators of externalities. A quantitative analysis of externalities would require that both parties can be precisely identified and that the externalities can be evaluated in monetary terms. In many situations, such an analysis of externalities is too difficult. This could be due to lack of information, an inability to define the monetary value of the external effects.

6. Asymmetric Information: Pareto optimality assumes that producers and consumers have perfect information regarding market behaviour. But according to Joseph Stiglitz, “In the real world, there is asymmetric (incomplete) information due to ignorance and uncertainty on the part of buyers and sellers. Thus they are unable to equate social and private benefits and costs.” Suppose a producer introduces a new antipollution device in the market. But it is very difficult for him to predict the current demand of his product. On the other hand, consumers may be ignorant about quality and utility of this anti-pollution device. In some cases, information about market behaviour in the future may be available but that may be insufficient or incomplete. Thus market asymmetries, fail to allocate efficiently.