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Correcting the overuse or underprovision of important
assets
Addressing market failures
Whenever spillovers (externalities) exist, there is a coordination
problem-private marginal costs and benefits diverge from social marginal costs
and benefits, and policies that align the two are needed. While the focus is
generally on formal policies or mechanisms, informal community institutions,
which rely on informal norms and networks, can also be key means for addressing
coordination problems.
It is usually most efficient to address market failures at the lowest level
that can internalize the externality-this is known as the principle of
subsidiarity. Note that this can have a bearing on the roles of informal and
formal mechanisms.77
Spillovers that affect people in a single community should be addressed at that
level. But quite often spillovers extend much beyond a single community and
must therefore be dealt with in a broader setting. For example, maintaining a
hillside forest is of interest to groups at many levels. Local communities and
those living near the forest may want to manage it to provide fuel and food.
Communities in the larger watershed may have an interest in maintaining the
same forests to mitigate flooding and siltation downstream. The nation may want
to maintain the ecotourism potential of the forests. The world at large may be
concerned about the forest's ability to support biodiversity and carbon stocks.
This requires corresponding action at all levels.
Appropriate formal mechanisms to address a market failure can range from using
command and control regulations and harnessing market forces to creating
markets and engaging the public (figure 2.5). Usually
a mix of mechanisms is required to address a problem, although occasionally one
is applicable or sufficient. In general, the choice of mechanisms needs to be
guided by the following:
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The effectiveness of the instrument in meeting the objective
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The efficiency of the instrument-including whether it ensures static efficiency
(achieving the goal at minimum cost to society) and dynamic efficiency
(providing incentives for innovation and the search for alternative, more
efficient ways of meeting the objective)-while minimizing the implementation
costs (monitoring, enforcement)
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The extent to which the instrument minimizes the costs of meeting other
objectives when there are tradeoffs
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The effects on distribution and poverty.
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