ECO 370 Week 1 Externalities and Market Failure Example

Who Pays When Toledo's Water Turns Green? Phosphorus Runoff From Maumee Basin Farms as a Negative Externality and Why the Market Alone Does Not Fix It

[Student Name]

University of Phoenix

ECO/370: Environmental Economics

Week 1 Assignment

[Instructor Name]

[Date]

The farm and the utility are composites written for a model paper; the 2014 water emergency, the science of the blooms and research findings come from the sources listed and are stated generally.

In August 2014, the city of Toledo, Ohio, told about 400,000 residents of the city and its suburbs not to drink or cook with tap water for nearly three days after a toxin produced by an algal bloom in western Lake Erie was detected in treated water. Stores ran out of bottled water, and the National Guard distributed supplies. Scientists had long linked the blooms to phosphorus carried by the Maumee River from farmland in Ohio, Indiana and Michigan. A composite family farm near Defiance, Ohio, growing 1,800 acres of corn and soybeans, applies phosphorus fertilizer and manure as nearly every farm in the basin does. Nothing the farm does is illegal or unusual, yet part of the cost of its fertilizer decisions ends up in a city's water treatment plant forty miles away. This paper explains why economists call that a market failure.

The Science in Brief

Phosphorus that is not taken up by crops can wash off fields during heavy rains, especially in spring, and flow to the lake in dissolved form that algae use readily. Warm, calm summer water then allows cyanobacteria to multiply, some producing toxins harmful to people and animals. Research and monitoring have tied the size of the summer bloom closely to the amount of phosphorus delivered by the Maumee in spring (Michalak et al., 2013).

What an Externality Is

An externality is a cost or benefit of an activity that falls on people not party to it and is not reflected in its price. Pigou (1920) argued that when private and social costs diverge, markets produce too much of activities with external costs. The farm buys fertilizer at a market price that covers the costs of producing and shipping it, but not the costs that runoff imposes on the lake's users.

Private Cost Versus Social Cost

The farm decides how much phosphorus to apply by comparing the value of extra yield with the cost of the fertilizer and its application. Those are its marginal private costs. The marginal social cost adds the harm downstream: treatment costs at water plants, lost property value along the shore, lost fishing and tourism income and health risks. Because the farm does not pay the downstream costs, it applies more than it would if it bore them, and the basin as a whole applies more phosphorus than is socially efficient.

A Simple Per-Acre Illustration

Suppose that on a typical field, the last few pounds of phosphorus per acre raise expected yield worth $6 an acre and cost $5 in fertilizer and application, so the farm applies them for a $1 gain. If those pounds also add runoff that imposes $4 an acre of downstream costs, the social cost is $9 against a $6 benefit. From society's point of view, those pounds do more harm than good. Across millions of acres, small per-acre gaps add up to large external costs.

Who Bears the Costs

The costs fall on many parties. Toledo and other utilities spend millions of dollars a year on extra treatment and monitoring; Toledo has invested heavily in upgrades since 2014, costs ultimately paid by its ratepayers through higher water bills. Lakeside homeowners see property values fall in bloom years. Charter fishing and tourism businesses lose customers, and lakeside towns collect less in hotel and sales taxes. Residents bear health risks and the disruption of emergencies. None of them is a party to the farm's fertilizer purchase.

Can Bargaining Fix It?

Coase (1960) argued that if property rights were clear and bargaining were cheap, those harmed could pay farms to reduce runoff, or farms could pay to pollute, and either way the efficient outcome would result. In the Maumee basin, the conditions fail. Runoff comes from thousands of farms, each contributing a small, unmeasured share, and the harm falls on millions of people. Identifying who caused what, negotiating with each party and enforcing agreements would be prohibitively costly. High transaction costs, not ignorance, keep private bargaining from solving the problem.

Public Goods and the Commons

Clean water in Lake Erie has features of a public good: one person's enjoyment of a bloom-free lake does not reduce another's, and people cannot easily be excluded from it. Private parties therefore underinvest in protecting it, since each hopes others will pay. The lake is also a common pool resource for absorbing nutrients: each farm's runoff uses up some of the lake's capacity, and no one owns that capacity, so it is overused.

Why the Farm Is Not the Villain

The farm responds to prices and to agronomic advice, as any business would. Applying phosphorus generously protects yields against uncertainty, and the costs of runoff are invisible in its accounts. Market failure means the price system gives it the wrong signal, not that its owners intend harm. That framing matters for policy, which works best when it changes incentives rather than assigning blame.

Is There Also a Positive Externality?

Practices that reduce runoff, such as cover crops and buffer strips, create benefits for downstream users that the farm does not capture. That positive externality means farms also adopt too few conservation practices on their own, the mirror image of the overuse of phosphorus.

Questions for Policy

The analysis raises the questions later weeks address: how large the external costs are in dollars, whether reducing runoff passes a cost-benefit test, which policy tool, a tax, a cap, regulation or payments to farms, would reduce runoff at least cost, and how businesses in the food supply chain should respond.

Conclusion

Lake Erie's algal blooms are a textbook negative externality: farms' fertilizer decisions impose costs on water utilities, homeowners and tourism businesses that the price of fertilizer does not reflect. Private bargaining cannot fix the problem because transaction costs are high and the lake's capacity is a common resource. Correcting the market failure requires policies that bring private incentives closer to social costs.

References

Coase, R. H. (1960). The problem of social cost. The Journal of Law & Economics, 3, 1-44. https://doi.org/10.1086/466560

Michalak, A. M., Anderson, E. J., Beletsky, D., Boland, S., Bosch, N. S., Bridgeman, T. B., Chaffin, J. D., Cho, K., Confesor, R., Daloğlu, I., DePinto, J. V., Evans, M. A., Fahnenstiel, G. L., He, L., Ho, J. C., Jenkins, L., Johengen, T. H., Kuo, K. C., LaPorte, E., ... Zagorski, M. A. (2013). Record-setting algal bloom in Lake Erie caused by agricultural and meteorological trends consistent with expected future conditions. Proceedings of the National Academy of Sciences, 110(16), 6448-6452. https://doi.org/10.1073/pnas.1216006110

Pigou, A. C. (1920). The economics of welfare. Macmillan.