SL/HL IB Economics (Google Slides) [7]

2.7 Market Failure— Externalities and Common Pool Resources

Common Pool Resources and Threats to the Environment - Notes

Kognity 2.8.7- 2.8.8 (Online Textbook) - HL; Kognity 2.8.6- 2.8.7 (Online Textbook) - SL

IB Core Concept Standard Level and Higher Level Concept

Market failure After studying this section, you will be able to:

● I can define all the terms appearing in orange highlights in the text.

● I can explain that negative production externalities can be used to

illustrate the overuse of common pool resources.

● I can explain and evaluate policies available to governments in response

to the overuse of common pool resources.

● I can draw diagrams to illustrate the policies available to governments in

response to the overuse of common pool resources.

WHAT ARE COMMON POOL RESOURCES?

● Common Pool Resources: Refers to resources that are not owned by anyone, do not have a
price, and are available for anyone to use without payment.

➔ Note!: Common pool resources are typically natural resources, such as fishing grounds,
forests and pastures where it is very difficult, or very expensive, to exclude people from
using them. Thus, they are considered to be non-excludable. In addition, if one person
uses the good, it reduces the value of that resource to others. In this sense, common pool
resources are said to be rivalrous.

Important!

Common pool resources are both rivalrous, and non-excludable. Non-excludable means
that it is very difficult, or very expensive, to exclude people from using a good. Common
pool resources are non-excludable because they have no price and anyone can use them
without payment. Rivalrous means that if one person uses the good, it reduces the value
(or benefit) of that resource to others. That is to say that one individual’s use subtracts
from the benefits available to others using the resource. The main consequence is that
in the absence of effective management, these resources are inevitably overused and
degraded.

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WHY ARE THE OVERUSE OF COMMON POOL RESOURCES A THREAT TO
SUSTAINABILITY?

● Sustainability refers to the ongoing effort to preserve the environment's capacity to meet present
and future needs and desires. Common pool resources are rivalrous but non-excludable. This
combination poses serious threats to sustainability.

➔ To see how this works, consider the example of the open seas (an example of a common
pool resource) and the global stock of fish. Fishing vessels can catch as many fish as they
are able to as no one can be excluded from fishing in these waters (non-excludable). But if
one vessel catches a ton of fish there will be one ton less available for all other vessels to
catch (rivalrous). One person’s use of a common resource subtracts from the amount
available for all others. This implies that others will have to fish longer and harder to
catch the same amount of fish.

■ As shown in the diagram above, the effect of such behavior may be illustrated
through a negative externalities diagram, which illustrates the decisions of a
fishing firm. In this case, the total cost of production for society (MSC) is greater
than the private cost (MPC), for every level of output. This is because commercial
fishers, taking into account only their own costs of production, have the incentive
to catch as many fish as they can, ignoring the external costs.

■ Therefore, the vertical difference between MSC and MPC represents the negative
externality (harmful effect on society). These might include, for example, the
collapse of fishing stocks and the ultimate loss of livelihood to fishers in the future,
along with many other ecological problems. Not only do the actions of some
groups hurt others in the present, but they are damaging the ability of future
generations to meet their needs, thus posing threats to sustainability.

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 ■ In the example of the commercial fishing industry, society produces an amount
Qm and sells it at a price Pm. However, from the society's point of view, the
optimum amount of fish produced should be at the point where the MSC curve
intersects the MSB curve), at Qopt.

■ Therefore, more resources are allocated to the production of this good than what is
optimal for society (Qm > Qopt). The market over-allocates resources to the
production of fish.

■ The yellow-shaded triangle shows a welfare loss – net ‘dollar’ value lost by society
from the production of units Qm being produced by the market even though they
should have been from society’s point of view. This area of loss is equal to the
difference between the MSB and MSC curves for the amount of output that is
overproduced relative to the social optimum (Qopt − Qm). It involves external
costs for society that are lost because too much fish is produced at too low of a
price. This is why it is a market failure.

Important!

The depletion or degradation of common pool resources poses a threat to

sustainability, as overexploitation implies that the resource will not be available
for others to use in the future. For a common pool resource to be sustainable it
must be consumed at the same rate of replenishment. This means that the
fishing industry should fish at the rate of natural replacement. If fish stocks have
the capacity to reproduce at a rate of 20% per year, then the fishing industry
should fish less than 20% of the total stock each year.

HOW CAN THE GOVERNMENT REDUCE OR ELIMINATE THE WELFARE LOSS RELATED
TO THE OVERUSE OF COMMON POOL RESOURCES?

● To solve the problem caused by negative production externalities, the goal is to eliminate welfare
loss by reducing the quantity produced of the good until Qm reaches Qopt. There are several
possible ways in which the government can intervene to achieve this outcome:

➔ Impose a Pigovian (indirect) tax – The government could impose a Pigovian

(indirect) tax on fishing activities that contribute to overfishing or harm the environment.
These taxes could increase the cost of engaging in such activities, discouraging fishermen
from overexploiting fish stocks or engaging in environmentally harmful practices. The
purpose of this policy is to internalize the external costs associated with fishing
incorporating the social costs of commercial fishing into the market price. When fish are
caught through methods that generate negative externalities, such as overfishing, these
costs are not typically reflected in the market price. By imposing an indirect tax, the
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government aims to align the private cost of production with the social cost, ensuring that
producers account for the externalities they impose on society.

■ As shown in the diagram above, an indirect (Pigovian) tax has the effect of shifting
the supply curve vertically upwards from S = MPC = MSC to S2 (= MPC + tax).

■ Whereas producers of fish receive from consumers Pc, they must pay the
government Pc − Pp (tax per unit). Therefore, Pp is the final price received by
producers after payment of the tax.

■ At the lower price (Pp), commercial fish production is now less profitable, so
producers are incentivized to decrease their quantity of fish supplied to quantity
Qopt.

■ If the tax equals the external cost, the S2 (= MPC + tax) curve intersects MPB at the
socially optimum level of output, with production occurring at Qopt, reflecting
allocative efficiency.

■ Whereas a tax on emission is intended to achieve particular objectives, it does not

always work as expected:

Table 1. The limitations of a Pigovian (indirect) tax:

Limitations (of policy)

‒ Accurately measuring the full range of external costs from commercial

fishing is complex and prone to debate. This includes the monetary value
to the long-term environmental damage, economic losses, and health
impacts of overfishing which is complex to measure and prone to
uncertainty. Thus, setting a tax rate that is equal to the full external cost

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 may not be achieved. Additionally, inaccurately measured external costs
lead to inaccurate tax rates, which either fail to deter overfishing or impose
excessive burdens on the industry, hindering their effectiveness in
managing the externality.

‒ Aside from the technical difficulties, there is also a risk that even if taxes
are imposed some commercial fishing firms may not reduce the quantity of
fish caught, continuing to unsustainably catch even though they pay a tax.

‒ Additionally, resistance from powerful fishing lobbies and concerns about

economic impacts can create political hurdles to implementing effective
tax rates.

➔ Fishing quota – The government could impose a legal limit on the amount of fish that
can be caught by each fisherperson or fishing vessel within a certain period of time.
Quotas can be based on individual fishing quotas, which assign specific catch limits to
individual fishermen or commercial fishers, or they can be applied at a broader level, such
as total allowable catch limits for a specific species or region. The purpose of this policy is
to limit the rate of fish caught each year to a level that is below a fish stock’s rate of
replenishment.

■ As shown in the diagram above, quotas limit the quantity of fish available, which is
represented by the perfectly price-inelastic (vertical) supply curve Sq. By
decreasing the quotas of fish allowed from Sq1 to Sq2, the government reduces the
number of particular species that can be landed from Qm to Qopt. Prices rise from
Pm to Popt.

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 ■ If the quota is effective, the Sq2 quota curve intersects the MPB curve at the
socially optimum level of output, with production occurring at Qopt, reflecting
allocative efficiency.

■ Whereas a quota is intended to achieve particular objectives, it does not always

work as expected:

Table 2. The limitations of a fishing quotas:

Limitations (of policy)

‒ Similar to an indirect (Pigovian) tax, accurately estimating fish populations

and setting sustainable catch limits is a complex and challenging task.
Overly optimistic quotas can lead to continued overfishing, while overly
restrictive quotas can harm the fishing industry.

‒ Limiting quantities of fish will also raise the price of those species. This has
a significant impact on the ability of low-income consumers to continue to
afford fish.

‒ Additionally, higher prices due to quotas create a strong incentive for

illegal fishing activities like exceeding quotas, using unauthorized gear, or
fishing in restricted areas. This undermines the conservation goals of the
quota system and can put endangered species at further risk.

‒ Enforcing catch limits can be costly for governments. In this case, the
government will need to allocate resources to ensure that stakeholders
comply with regulations, and have mechanisms in place to punish those
who do not comply.

➔ Government regulations – The government could pass laws to limit the production
activities that contribute to overfishing. This may include fishing gear restrictions, which
prohibit the use of certain types of fishing gear that are particularly harmful to fish stocks
or bycatch, fishing seasons and closure, which limit fishing activity during certain times of
year or in specific areas to allow fish populations to recover, or minimum size limit, which
specify the minimum size at which a fish can be harvested, allowing them to reach
maturity and contribute to the replenishment of the population. The purpose of this
policy is to address the specific activities that result in negative externalities by imposing
rules and laws that limit or prevent their use in the production process.

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■ As shown in the diagram above, regulations have the effect of shifting the S1 = MPC
curve (due to the firm’s higher costs of production due to the purchase of fishing
gear that limits the quantity of fish caught) towards the MSC curve until S2
overlaps with MSC.

■ If the regulation is effective, the S2 (= MPC) curve intersects the MPB curve at the
social optimum output, with production occurring at Qopt, reflecting allocative
efficiency.

■ Whereas a regulation is intended to achieve particular objectives, it does not

always work as expected:

Table 3. The limitations of a regulations:

Limitations (of policy)

‒ Governments may lack sufficient data and understanding of complex

ecological systems to establish truly effective regulations. This can lead to
overly restrictive measures causing economic hardship for fishers and
communities with little environmental benefit, or inadequate regulations
that fail to address the core issues, allowing overfishing to continue.

‒ Additionally, regulations often involve compliance costs for fishers,

requiring changes in fishing gear, technology, or practices. In this case, high
costs can push smaller operators out of business, leading to job losses and
opposition from the commercial fishing industry.

‒ Beyond information gaps, effective enforcement of regulations requires

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 adequate resources and manpower, which can be limited, especially in vast
ocean areas. This can lead to widespread non-compliance and illegal
fishing activities undermining the goals of the regulations, or corruption
and bribery further jeopardizing enforcement efforts and environmental
protection.

‒ Enforcing regulations can also be costly for governments. In this case, the
government will need to allocate resources to ensure that stakeholders
comply with regulations, and have mechanisms in place to punish those
who do not comply.

➔ Education – The government could launch campaigns to educate the public about the
consequences of unsustainable fishing practices, such as overfishing, bycatch, and habitat
destruction. These initiatives can include training programs which equip fishermen with
knowledge and skills for adopting sustainable fishing methods, or collaborative initiatives
in which government partner with retailers to promote and label sustainable seafood
options and empower consumers to make informed choice, or community outreach
programs in which the government engaged coastal communities in conservation efforts,
fostering a sense of ownership and responsibility towards protecting marine resources.
The purpose of this policy is to equip producers with the knowledge and resources
necessary to make informed decisions that minimize external costs associated with
certain fishing activities.

■ As shown in the diagram above, educational campaigns have the effect of shifting
the S1 = MPC curve (due to the purchase adopting more sustainable practices

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 which result in higher costs of production) towards the MSC curve until S2
overlaps with MSC.

■ If the education campaign is effective, the S2 (= MPC) curve intersects the MPB
curve at the social optimum output, with production occurring at Qopt, reflecting
allocative efficiency.

■ Whereas education is intended to achieve particular objectives, it does not always

work as expected:

Table 4. The limitations of education:

Limitations (of policy)

‒ Awareness campaigns for sustainable fishing may also struggle to reach

isolated communities and face obstacles when confronting deeply
ingrained cultural practices and limited access to information. This
disconnect can hinder the effectiveness of conservation programs.

‒ Fishers focused on short-term economic gains may also prioritize catching

fish over adopting sustainable practices, especially if the educational
programs don't offer tangible benefits like alternative income sources. This
is because long-term benefits of sustainable fishing (healthy fish stocks,
future livelihoods) may be difficult to grasp for those struggling with
immediate needs.

‒ The fishing industry itself might engage in “greenwashing campaigns”,

promoting superficial "sustainable" practices without addressing the core
issue of overfishing.