Market Failures: Externalties and Public Goods

Prof. Carlo Cambini Politecnico di Torino carlo.cambini@polito.it

Externalities
Externalities arise between producers, between consumers, or between producers and consumers Externalities are the effects of production and consumption activities not directly reflected in the market
They can be negative or positive

Externalities
Negative
Action by one party imposes a cost on another party
Plant dumps waste in a river, affecting those downstream The firm has no incentive to account for the external costs that it imposes on those downstream Production of electricity and emission of excessive CO2

Externalities
Positive
Action by one party benefits another party
Homeowner plants a beautiful garden where all the neighbors benefit from it Homeowner did not take their benefits into account when deciding to plant Network externalities: mobile users benefits from a big installed base in order to obtain lower call prices (for on net calls, but not for off net calls!)
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Negative Externalities and Inefficiency

Scenario plant dumping waste
Marginal External Cost (MEC) is the increase in cost imposed on users downstream for each level of production Marginal Social Cost (MSC) is MC plus MEC Equilibrium in a competitive market where market demand crosses supply curve

Assumption: the firm has a fixed proportions production function and cannot alter its input combinations
The only way to reduce waste is to reduce output
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External Costs
The profit maximizing firm produces at q1 while the efficient output level is q*.

Price

MSC MC

Price

There is MEC of production from the waste released. The MSC is Firm will produce q1 at P1. true cost of production.

MSCI S = MCI P*

P1 MEC

P1

MECI

D q* q1
Firm output

Q* Q1

Industry output
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Negative Externalities and Inefficiency

The MC curve for the firm is the marginal cost of production Firm maximizes profit by producing where MC equals price in a competitive firm As firm output increases, external costs on users also increase, measured by the marginal external cost curve From a social point of view, the firm produces too much output
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External Costs
Price

MSC MC

Price

MSCI

By not producing at the efficient level, there is a social cost on society.

S = MCI
Aggregate social cost of negative externality

P* P1 MEC P1

MECI

D q* q1
Firm output

Q*

Q1

Industry output
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Positive (Network) Externalities

Economists say that there is a network externality when the value of a good depends on the number of other people who use it. Examples are goods like the telephone network, the fax machines network, the email network, or the Internet itself. Thus, the utility of a single agent i depends not only on the quantity consumed (q) but also on the number N of agents in the market who use it:
U i (q) = U i ( N , q)
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Network externalities
We face direct network externalities when the utility of an agent of type A depends on the number of agents belonging to the same group (say network) A:
U i, A (q ) = U i, A ( N A , q)

An additional agent that enter the network generates a postive externality (positive feedback) to the existing agents since connection possibilities are enlarged (ex. the evolution of mobile adoption). The Metcalfes law
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A simple model (Rohlfs, 1974)

Let p be the (fixed) price to be connected to a
telecom network; the utility function of a consumers of type [0, 1] (= willingness to pay) is:

n(1 ) p if connects U ( ) = if no connect 0

Utility increases if the number n [0, 1] of
users increases.
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A simple model (Rohlfs, 1974)

Denote with the consumer indifferent between being connected or not, for a given price p and number of users n. For the marginal consumer, the price limit is given by: ~ n (1 ) p = 0 In equilibrium, the number of potential users should ~ be equal to the number of existing users, i.e. = n.
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A simple model (Rohlfs, 1974)

Thus, in equilibrium we have: p = (1 )
p p0

L 0

1/2 n

H 0

Two equilibria, one stable and one unstable. L is called the critical mass 0
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A simple model (Rohlfs, 1974)

What is the critical mass? The minimum level of coverage/penetration that a network/technology should reach in order to remain in the market. If you fail, you will exit the market. Relevant concept in high-tech industries: compatible vs. incompatible products. Relevant role of price and its impact on the coverage level. Important factors: switching costs and lock in effect
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Market analysis in presence of network externalities

From social point of view, the optimal coverage is the level that maximes welfare, given by the sum of consumer net surplus and firms profit, i.e.: W = Gross Surplus P*Q(P) + P*Q(P) C(Q) = = Gross Surplus C(Q) where Gross Surplus =
~ and in equilibrium n =
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~ n(1 )d = n 2

~2

Market analysis in presence of network externalities

From social point of view, it is easy to show that a 100% coverage should be reached (almost for c < 0.5).
Co s t i , Be ne f i c i
0 , 5

c=0 , 5

0 , 4 0 , 3

c=0 , 2 5
0 , 2 0 , 1

c=0 , 1
0 , 2 0 , 4 0 , 6 0 , 8 1
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Market analysis in presence of network externalities

Should a private firm choose to cover all the marlet or not? ~ ~ ~ ~ ~ ~ ~ In monopoly: ( ) = p c = (1 ) c ~ ~ FOC: 2 3 2 c = 0
0,5 0,4 0,3

Costi, Ricavi

c = 0,5

c = 0,25
0,2 0,1

c = 0,1 0
0,2 0,4 0,6 0,8 1

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Market analysis in presence of network externalities

Using simulation we determine the optimal coverage/penetration rate:
Cost c 0,5 0,25 0,2 0,1 0 Efficiency 1 1 1 1 1 Monopoly 0 0,5 0,54 0,61 0,67
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Network externalities
Generally consumers would like to be connected to as large a network as possible. This implies that if there are several different providers of networks, then it is very advantageous to consumers if they interconnect Despite the fact that interconnection is typically in the social interest, it may or may not be in the private interest. There may be cases where a large incumbent may find it attractive to avoid interconnection with new entrants in order to preserve its market power.
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Network externalities
It is important to understand that if the value of the network increases through interconnection (due to Metcalfe law), then there should be a way to divide that increase in value so to make all participants better off. If the pie gets bigger, everyone can get a larger price. However, the increased size of the pie also means that threats not to interconnect become more significant. And, of course, a larger pie is a more tempting target for someone to try to snatch than a smaller one.
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Network externalities
If two networks of size n1 and n2 interconnect (with n1 >> n2 ), what increase in value accrues to each one? Applying Metcalfes law:

Each network gets equal value from interconnecting!! This calculation, simple though it is, gives some insight into why peering, or settlement-free interconnection, is common among large backbone providers. The gains from interconnection are split more-or-less equally, even among somewhat different size networks.
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Network externalities
But not all networks are willing to interconnect on a payment-free basis. What happens if one network acquires the other (say 1 acquires 2)?

Network 1 captures twice as much value by buying out network 2 rather than interconnecting with it. Essentially the threat of non-connection increases the larger networks bargaining power.
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Indirect network externalities

We face indirect network externalities when the utility of an agent belonging to a group (say network) A depends on the number of agents of the group B and viceversa:

U i , A ( q ) = U i , A ( N A ( N B ), q ) U i , B ( q ) = U i , B ( N B ( N A ), q )
Example: all the so called intermediation market
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Indirect network externalities

Example (from Armstrong, 2004):

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Indirect network externalities

Example (from Armstrong, 2004):

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Indirect network externalities

Example (from Armstrong, 2004):

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Indirect network externalities

Example (from Armstrong, 2004):

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Indirect network externalities

In all the examples, we have a (physical or virtual) platform that intermediate between the two groups of agent. When we have several groups of agents that interact via one or more platform, we say that we face a twosided market Surplus is created or destroyed only when groups interact, but this interaction should be mediated in some way. In these cases, the surplus enjoyed by a member of one group depends on the number of the agent of the other group that join the same platform
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Two-side markets

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Two-side markets
Business strategy for the platform: getting both side on board. Only maximizing the number of agent in both side of the market permit to create higher surplus in the market Pricing issues: prices are related to: a) relative impact of the positive externality; b) level of price elasticity. Tariff level and tariff structure
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Two-side markets: a simple model

Two-sided market. Price competition.

with eij 0 and e12e21 < 1 Note:

if D(p2) increases (due to a decrease of p2), positive effect also on the market demand 1, raising by e21D(p2).
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Two-side markets: a simple model

Benchmark model. Independent platform: suppose each market served by one platform:

We obtain:

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Two-side markets: a simple model

Now suppose only one platform serves all markets: Price equilibrium:

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Two-side markets: a simple model

Case I: intermediate level of indirect externalities

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Two-side markets: a simple model

Case II: high externality from 2 to 1 (i.e. e21 > e12)

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Two-side markets: a simple model

Case III: high externality from 1 to 2 (i.e. e21 < e12)

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A comparison: benchmark vs. Integration

If the cross effects are symmetric (e12 = e21), we obtain: 1. prices are lower with only one platform: p*i < pind 2. consumers surplus is higher with only one platform 3. Profits are higher with only one platform Having a single platform that internalizes all network externalities is Pareto Efficient!!
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A comparison: benchmark vs. Integration

More generally (e12 e21): a single platform operating in both markets is able to internalize externalities; this benefits both the firms and the consumers. It results:
* * p1 + p2 =1 ind ind p1 + p2 = 1+

e12 + e21 (1 e12 ) >1 4 e12 e21

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A general model (Rochet and Tirole, 2006)

A platform maximizes: For first order conditions we find:

We can re-write these conditions as: Where is the opportunty cost for group c is the opportunty cost for group m
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An empirical analysis
Rysman (2004): Yellow Pages Data: US Two sets of estimates:

log( x j ) = 1 log( y j ) + controls log( p j ) = log( y j ) + 2 log( x j ) + controls

where xj and yj are the n. users of yellow pages (= diffusion) and n. advertisers, pj is the price of ads and 1 and 2 are the degree of externalities between sides, respect. Results show that 1 = 0.154 and 2 = 0.565. The indirect effect of users over advertisers is 4 times bigger!!

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An application of the Two-Sided Theory: the credit card industry

AmEx, MasterCard and Visa provide a payment instrument which consumers can use to pay goods and services purchased from merchants,and which merchants can use to receive guaranteed payment for goods and services sold to consumers. Two different schemes
Proprietary card schemes: ex, American Express Card association schemes: ex, MasterCard or Visa

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Proprietary Schemes
Such schemes directly attract cardholders who wish to use cards to pay at merchants, and merchants who wish to accept such payments from cardholders. A central decision made by the card scheme is how much to charge cardholders versus how much to charge merchants. Merchant fees are obtained as a percentage of the value of each card transaction. In contrast, consumers are only sometimes charged annual fees, and often are given rebates such as frequent flyer miles based on the value of their card transactions. Fees charged to merchants are not typically passed on by merchants to their customers who pay by cards (no surcharge rule), the structure of pricing set by payment networks clearly matters.
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Proprietary Schemes

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Proprietary Schemes
As card schemes charge less to cardholders and more to merchants, there will be
1. increased card holding, 2. increased card usage, 3. fewer merchants willing to accept cards.

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Card Association: the VISA case

A card association faces the same problem as a proprietary scheme of achieving the right balance between cardholder and merchant fees. However, card associations differ from proprietary schemes since they do not set these fees directly. Instead, it is the members of a card association which set these fees.
In a card association, member banks and other financial institutions deal directly with cardholders (issuers) and with merchants (these institutions are called acquirers). The scheme administrator authorises, clears and settles transactions between issuers and acquirers, it does not directly set retail prices such as cardholder annual fees or merchant fees.

Instead, to balance the two sides of the market, a card association sets what is known as an interchange fee.
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Card Association: the VISA case

System

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Card Association: the VISA case

The crucial role of Interchange Fees An interchange fee is a fee paid from the merchants bank (the acquirer) to the cardholders bank (the issuer) whenever the cardholder uses his card to make a purchase at a merchant.
An increase in the interchange fee will lead to an increase in acquirers costs for every card transaction they process. Acquirers will therefore respond to an increase in the interchange fee by increasing their merchant fees. From the point of view of issuers, the interchange fee is a rebate obtained for providing their services to cardholders (a payment that they receive). Issuers will therefore respond to an increase in the interchange fee decreasing their card fees.

The interchange fee is the key instrument the card association can use to achieve a particular structure of cardholder and merchant prices.
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Empirical estimation
Evans (2003): determinants of transactions with VISA Data: US, 1981-2001 Results show the following relationship:
log(Y ) = 8.49 + 0.84 log( yc ) + 1.73 log( ym )

Where yc and ym are the number of users of VISA and the number of merchants accepting the VISA card, respec., while Y is the number of transactions. Note that the number of merchants has a relatively higher impact on total transactions than the number of users.
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Public Goods
Characteristics
Nonrival
For any given level of production, the marginal cost of providing it to an additional consumer is zero

Nonexclusive
People cannot be excluded from consuming the good

Example use of lighthouse by a ship

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Public Goods
Nonexclusive goods
Goods that people cannot be excluded from consuming, so that it is difficult or impossible to charge for their use Example: fireworks, national defense

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Efficiency and Public Goods

Efficient level of private good is where marginal benefit equals marginal cost For a public good, the value of each person must be considered
Can add demand of all those who value good

Must equate the sum of these marginal benefits to the marginal cost of production Allocation mechanism: see slides by Prof. Buzzacchi (later on)
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Public Goods and Market Failure

Free Riders
There is no way to provide some goods and services without benefiting everyone Households do not have the incentive to pay what the item is worth to them Free riders understate the value of a good or service so that they can enjoy its benefit without paying for it

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Private Preferences for Public Goods

Government production of a public good is advantageous because the government can assess taxes or fees to pay for it Determining how much of a public good to provide when free riders exist is difficult

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