Economics Q&A: Tragedy of the Commons and Market Failure

‘The tragedy of the commons’, although created by Garrett Hardin, is a famous concept which can be traced back to Adam Smith. It refers to a situation where individuals or private economic agents exploit scarce and rival common environmental resources for their own rational, self-interested aims, leading to over-production and the possible permanent depletion of the resource for all.

The essence of this problem stems from insufficient and poorly protected property rights. In other words, as consumers do not own these common goods, they have little incentive to take care of and maintain it, but rather an incentive to extract as much personal utility or benefit from it as possible at that particular time. Therefore, the provision of property rights over some grazing land may help to prevent it being permanently destroyed – instead allowing utility to be extracted from it at a sustainable rate. However, as the tragedy of the commons is a problem where one’s actions affect the benefits of others in the future, concerns for intergenerational equity usually end up being dominated by concerns for personal benefits.

One serious implication of this problem is that it shows a flaw in the capitalist system. Whereas Adam Smith originally argued that ‘an invisible hand’ will always lead self-interested, rational actions to socially optimal outcomes, in the case of the tragedy of the commons, the invisible hand fails to work.

Despite every fisherman acting in a completely individually rational way by fishing as much as they possibly can, the resulting unsustainable overfishing will not lead to a favourable situation for society in the future. Although left-wing critics may use this problem as an attack on capitalism, communism also suffers from the tragedy of the commons – perhaps even to a greater extent. With households having no direct property rights over anything under a communist system, they have even far less incentive to look after all the commonly owned land within the economy.

The problem of the tragedy of the commons can lead to market failures – a situation where market forces lead to an allocatively inefficient or inequitable outcome – in many ways.

One way in which markets can fail as a result of this problem is through the presence of negative externalities. For example, as no-one in the world actually owns the air that we breathe in everyday, when consumers decide whether to travel by car, which emits various pollutants, or public transport, they only consider their own marginal private benefits and their marginal private costs, ignoring completely the marginal external costs to the environment because no one is entitled to charge them for destroying the air as no one owns the air. Therefore, the marginal social cost is higher than the marginal private cost, resulting in an allocatively inefficient equilibrium (MPC = MPB), whereby there is an overconsumption of cars and hence a welfare loss.

The way in which the tragedy of the commons leads to environmental market failures can also be modelled through game theory, namely the prisoners’ dilemma.

Taking the most significant environmental issue of climate change, world leaders have essential become ‘prisoners’ during various international agreements.

They have two options: to cut CO2 emissions or to remain the same. Assuming that there are 2 big countries at the discussion table (e.g. USA and China), if both cut, then global warming will be slowed down and the socially optimum outcome will be produced. If one cuts while the other does not, the latter will enjoy both the slowdown in global warming as a result of the former’s cuts, as well as the fact that they do not need to make costly CO2 cuts. Finally, if both do not cut, global warming is sped up and the world as we know it could come to an end.

As can be seen, doing nothing is the dominant strategy, as it is always preferable to cuts, regardless of what the other country does.

However, due to the symmetry of the game, the Nash equilibrium becomes the (no cut; no cut) outcome, which is collectively worst than if both countries adopt the dominated strategy in order to reach a (cut; cut) outcome.

Hence, each country following individually rational outcome will paradoxically lead to a collectively irrational outcome.

In other words, the free market will lead to an overproduction of CO2 emissions (a market failure) and the accompanying welfare loss as it is individually irrational for any country to cut their own CO2 emissions. It is then of no surprise as to the failures of the 2009 Copenhagen Summit!

Researched and written by Parit Wacharasindhu and Karum Bachra

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