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Plastic waste washes up on a Pacific Ocean beach.

Unit 10 Market successes and failures: The societal effects of private decisions

When people making economic decisions take full account of the impact of their actions on others, outcomes are efficient. But when contracts are incomplete and market-determined prices do not capture important effects, resources may be misallocated, and other remedies are needed.

Before you start

This unit builds on many concepts, models, and examples from Units 1 to 9. In particular, it develops the analysis of social dilemmas, external effects, and public good games in Unit 4, and applies the concept of Pareto efficiency as in Units 4 and 5. If you are not confident about using the Pareto criterion and Pareto efficiency to evaluate economic allocations, you should read Section 4.5 before beginning work on this unit.

You will need to be familiar with the concept of marginal cost, and how to measure the surplus and gains from trade (or exchange), from Unit 7. If you are not, you should also read Section 7.4 on production and costs, and Section 7.7 on gains from trade, before proceeding.

10.1 Bananas, fish, and cancer

In the Caribbean islands of Guadeloupe and Martinique (both part of France), the pesticide chlordecone was used on banana plantations from 1972 until 1993 to kill banana weevil. It was perfectly legal, and to the plantation owners it was an effective way of reducing costs and boosting their profits.

As the chemical was washed off the land into rivers that flowed to the coast, it contaminated freshwater prawn farms, the mangrove swamps where crabs were caught, and what had been rich coastal spiny lobster fisheries. The livelihoods of fishing communities were destroyed and those who ate contaminated fish fell ill.

The fact that this pesticide was a grave danger to humans had been known since the time it was introduced, when workers producing it in the US reported symptoms of neurological damage, leading to its prohibition in 1976. The French government received reports on contamination in Guadeloupe a few years later, but waited until 1990 to ban the substance, and were pressured by banana plantation owners to give them a special exemption until 1993.

Twenty years later, fishermen protesting against the slow pace of French government assistance in addressing the fallout from the contamination demonstrated in the streets of Fort de France (the largest town in Martinique) and barricaded the port. Looking back, Franck Nétri, a Gaudeloupean fisherman, worried: ‘I’ve been eating pesticide for 30 years. But what will happen to my grandchildren?’

He was right to worry. In 2012, the fraction of Martiniquean men suffering from prostate cancer was the highest in the world and almost twice that of the second-highest country, and the mortality rate was well over four times the world average. Neurological damage in children, including retarded cognitive development, has also been documented.

Social and private costs and benefits

external effect, externality
An external effect occurs when a person’s action confers a benefit or imposes a cost on others and this cost or benefit is not taken into account by the individual taking the action. External effects are also called externalities.

The devastating damage to health and livelihoods caused by chlordecone is an example of the external effects of some economic decisions. When the owners of banana plantations decided to use it, they considered the private costs and benefits: the cost to themselves of buying the pesticide, and the benefit of increased banana productivity and revenue. For them, it was a profitable choice. But they did not take into account the effects on other people: the external costs imposed on the local population. The social costs of producing more bananas using chlordecone—that is, the private and external costs added together—were much higher than the social benefits of additional banana production.

Pareto efficient, Pareto efficiency
An allocation is Pareto efficient if there is no feasible alternative allocation in which at least one person would be better off, and nobody worse off.

When people make decisions without taking into account the full social costs and benefits of their actions, the allocation of resources is not Pareto efficient: that is, there are allocations that would be better for everyone involved. Then the questions we need to address are: Why have these preferred allocations not been achieved? Are there institutions or policies that could make everyone better off? Or at least, those that society would prefer to the status quo?

Unit 4 examines some other social dilemmas in which external effects arise:

  • Neighbouring farmers, Anil and Bala, choose their pest control method without taking into account the negative effects of a pesticide, or the positive effects of beneficial insects, on each other.
  • Farmers relying on shared irrigation facilities have incentives to free-ride on each other, rather than contributing to the costs of maintaining the facilities, if they only take into account the private costs and benefits of contributing.
  • People throughout the world make decisions resulting in carbon dioxide emissions without considering how their decisions contribute to climate damage.

In each case, the social costs or benefits of people’s decisions differ from the private costs or benefits—that is, the cost or benefit experienced by each individual decision-maker themselves.

Markets and market failure

In this unit, we will discuss many more examples, and potential solutions. In cases where small numbers of decision-makers are involved, there may be institutions that could facilitate bargaining to a mutually acceptable solution. Communities may be able to influence individual behaviour by establishing social norms so that people take more account of the effects of their actions on others, as Elinor Ostrom demonstrated.

In other cases, we search for the source of the problem in the market system, and consider whether institutional reforms or governmental intervention could address it.

The logic of Adam Smith’s famous claim, that the businessman in pursuit of his own interest is ‘led by an invisible hand’ to promote the interests of society, is the basis of the economic model of a perfectly competitive market (Unit 8). Friedrich Hayek explained how, in the market system, prices send messages about the real scarcity of goods and services, motivating people to produce, consume, invest, and innovate in ways that make the best use of an economy’s productive potential.

If the market for a good is perfectly competitive, and affects no one other than the buyers and sellers, the allocation of the good is Pareto efficient (as explained in Section 8.5). In that case, market prices send the right messages to decision-makers about the costs of supplying the good and the benefits of consuming it. But if others are affected, prices will send the wrong messages: for example, the price of fossil fuels typically reflects the suppliers’ costs of extracting and distributing them, but not the costs of global warming which affect all of us.

market failure
If the allocation resulting from market interactions is not Pareto efficient, we describe the situation as a market failure. The term may be used loosely to refer to any interaction resulting in a Pareto-inefficient allocation, whether or not a specific market is concerned.

When the market system results in a Pareto-inefficient allocation—a misallocation of resources—we describe this as a market failure. Markets fail when prices don’t send the right messages, and also in some cases because markets do not exist: some goods that matter to people—like clean air or uncongested roads—cannot be bought and sold.

Unit 7 describes an example of a price sending the wrong message: the producer of a differentiated good sets a price above the marginal cost of production. The allocation of the good is not Pareto efficient, since some consumers who would be willing to pay more than its marginal cost do not obtain it. Although this seems very different from the pesticide case, market failure occurs because the producer does not consider the external effect on these consumers.

Smith himself explained that markets do not always work well. In areas such as education and the legal system, government policies were needed to promote social wellbeing. He was also clear that some things should not be bought and sold in markets. Most people today find the buying and selling of human organs to be wrong, and the same goes for buying and selling votes, or life-saving medical care.

Diagnosis and treatment

In studying the misallocation of resources, we will think of the issues as a doctor would. We diagnose the problem, and attempt to devise an appropriate treatment. In the case of chlordecone, the banana plantation owners ignore the danger they cause to the fishermen’s livelihood and health. Why does this happen? There are often several different ways of thinking about external effects, that may suggest possible treatments.

We could find instances where prices send the wrong messages. For example, the price of using the pesticide is too low, in that it doesn’t reflect the costs imposed on the fisheries. So the plantations use too much pesticide and produce too many bananas. Would regulating or taxing their activities be an effective treatment?

Another approach is to think about property rights: if the fishermen had a right to fish in clean water, the plantation owners would have to find an alternative pesticide, or compensate the fishermen for any pollution caused. Before it was eventually banned, the use of chlordecone could have been vastly reduced if the plantation owners had been required to pay the damages that their pesticide use inflicted on the fishing communities and others.

Sometimes it is more helpful to focus on incomplete contracts and asymmetric information between the buyers and sellers of a good. The labour discipline model in Unit 6 is another case of external effects: the worker decides how hard to work without taking account of the external benefit of effort for the employer. This happens because effort is not observed by the employer, and hence cannot be specified in the contract, and results in a labour market equilibrium in which some workers are unemployed.

We will discuss examples of all of these approaches in this unit—but you will learn that resolving external effects depends on practicalities and power as well as economic analysis.

Exercise 10.1 Identifying market failures

Using recent news headlines in economics and business, politics and current affairs, or science and technology:

  1. Identify two situations of market failure that have been reported. (Try to use examples not discussed above.)
  2. For each, explain why it satisfies the definition of market failure (in other words, why is the allocation or situation described Pareto inefficient?).