The Role of Property Rights in the Creation of Markets and Correction of Market Failure

The role of property rights in the creation of markets and correction of market failure

In welfare terms a condition of efficient allocation is referred to as the Pareto condition. In terms of this criterion socially desirable policy change occurs when all are made better off or at least some are made better off without making anyone worse off. Usually the likelihood of making such choices is exhausted resulting in an allocation where it is inevitable that the policy change will make someone worse off, a Pareto optimal allocation (Johansson 1991:10).

A perfect market economy is an economy characterised by perfect competition where basically no individual buyer or seller can influence market price though their purchases or sales (Johnson 1991: 11).In such a market there is competitive equilibrium (i.e. a set of prices where there is no excess supply or demand-the market clears) (Johansson 1991:14).

When a competitive equilibrium exists it attains Pareto optimality because a perfect market economy is Pareto efficient. However sometimes markets fail to work properly. Because in the perfectly competitive model, both the demand and supply curve represent the willingness of individuals to pay for additional units of a good or service and the willingness of producers to produce additional units of a good or service. The market mechanism only caters for goods and services exchanged in the market place (goods and services that only acquire a monetary value).

Thus often production costs of a good and the benefits derived from consuming a good are not valued in this process. Hence market failure is a reflection of the inability of the market system to include these unpriced benefits and costs into the assessment of net social benefit (demand curve can also be defined as the marginal social benefit curve while the supply curve can also be defined as the marginal social cost curve).Therefore markets can be viewed as an inconsistency between net private and net social benefits.

Generally market failure exists because the required assumptions for perfect-competition are not satisfied in practice. However within this broad reason these are the main sub-reasons why markets fail to be Pareto efficient are:

1. The existence of externalities- making some goods produces pollution while consuming some goods spread benefits beyond the buyer (e.g. education).

2. Public goods- there are problems associated with marketing public goods, e.g. you may not be willing to pay for national defence, but the 'good' cannot be easily withheld.

3. Inadequate definition of property rights-E.g. the fisheries market where the basic resource, fish is openly accessible, and

4. Industry structures- in reality some industry structures ensure that market failure is inevitable, E.g. A monopolist intentionally withholding supply which raising prices and thus profits but results in a deadweight loss in welfare (Topic Notes ECON 224/324 2010, p.8).

Before a good reaches the market it has to be produced and once it reaches the market it is than bought and consumed. During this process both consumption and production externalities arise as production and consumption lead inevitably to waste and pollution. Thus pollution is inevitable when there is economic activity. Therefore aspiring to reduce pollution in the production process and during consumption to zero will result in zero production leading to an allocation of resources that is not Pareto efficient.

The problem of externalities raises the issue of rights. If firms have the right to produce and individuals have the right to consume goods that pollute then do others have the right to be protected from this pollution? The issue of externalities is also an issue of property rights. Externalities result in market failure however by making externalities marketable through the designation of property rights market failure can be averted.

The Coase Theorem sets out two ways to resolve this problem. Firstly the theorem states that if property rights are well defined and the cost involved in reaching and implementing an agreement are not significant the result will be an efficient allocation of resources even with externalities (Harris 2006:50). An example of this is the New York City Watershed Land Acquisition program where New York City working with nearby communities in New York State raised the level of permanently protected land in the Cat-Del System from 24 percent to 34 percent .This was achieved through the acquisition of fee title to or conservation easements on property deemed water quality sensitive, undeveloped land from willing sellers (U.S. Environment Protection Agency 2010).

The land was bought at fair market value prices with property taxes paid by the city authority. Prior to acquisition consultation was held with the towns and villages to ensure that their interests were accommodated in the agreement. Thus the goal of providing reasonable growth opportunities in and around existing population centres whilst preserving environmentally sensitive undeveloped areas was able to be realised (U.S. Environment Protection Agency 2010).

The other way the theorem seeks to solve this problem is by expressing the theory in terms of a right to pollute. Individual firms can obtain the right to pollute by purchasing transferrable permits which can also be traded amongst firms in polluting industries or bought by interest groups who can purchase and retire them permanently thus reducing a portion of total pollution. In welfare terms transferrable pollution permits are Pareto efficient as they encourage the implementation of least cost pollution prevention options (Harris 2006: 57).

The diagram below depicts how a transferable permit trading scheme is Pareto efficient. Here the policy goal is 40 units of pollution however both firms emit 100 units of pollution. To achieve this, 60 permits will have to be issued assuming 30 each way. If permits are not tradeable both have to reduce emissions by 20 units. The middle of the graph depicts this point; here the marginal costs for firm 1 and 2 are $ 200 and $ 600 respectively. Although this achieves the policy goal in terms of emission reduction it is not Pareto efficient as the combined cost to archive this 40 unit reduction is $ 8000 (A + B + C + D).

Pareto efficiency can be achieved by trading, as firm 1's control costs are lower ($ 2000) it can afford to reduce its emissions by an additional 10 units, a total reduction of 30 units. The saved 10 permits from its allocated 30 can be sold to firm 2 enabling a reduction from its exiting 20 units to 10.This combination archives the policy goal of 40 units at a lower cost of $ 6000 (A + B + C).