Unit 10 Flashcards
(6 cards)
What are externalities and market failure?
Externalities: when a person’s action imposes a benefit or cost on others and this benefit or cost is not taken into account by the individual. When this happens, the allocation of resources is not Pareto efficient, ie there are allocations that are better for everyone.
Market failure: when the allocation resulting from market interactions is not Pareto efficient so there is a misallocation of resources
Outline the example of market failure between farmers and fishermen
Farmers use pesticides for banana production. The pesticides pollute water sources killing fish. Hence the use of pesticides has a negative external effect on fishermen - external cost.
The marginal cost for the farmers is the marginal private cost (MPC). It is an upward sloping straight line because the cost of producing an additional unit of bananas increases.
Marginal social cost (MSC) is the cost to society as a whole (ie including the fishermen). MSC=MPC+MEC where MEC is marginal external cost, ie the negative external costs
When negative externalities are present, MSC>MPC
MSC is an upward sloping curve that is greater than the MPC line and the difference between the two is MEC.
What is the Pareto efficient level of output in a market with a negative externality?
For every 1 unit of banana output reduced, the gain for fishermen is the MEC of that unit and the loss to the farmers is the surplus they would have made from it (P-MPC)
When MEC>P-MPC, it is possible for both groups to be better off with reduced output if the fishermen shared the benefit by making a payment to the farmers.
Therefore, reduce output if P<MEC+MPC or P<MSC
The Pareto efficient level of output is where P=MSC
Farmers produce at P=MPC
The condition for Pareto efficiency is therefore MSC=MPC so that MEC=0
What is Coasean bargaining?
Ronald Coase argued that private bargaining over external effects might be preferable to government intervention because the two parties often have better information about the effects than the government does.
Eg:
- Bridgman is a confectioner who uses noisy machinery
- Sturges is a doctor whose consulting room is on the boundary of his property nearest to Bridgman’s kitchen
- The noise created by Bridgman had external effects on Sturges
- The court granted the doctor an injunction preventing Bridgman from using the machinery (property rights)
- Once the doctor’s right to prevent the use of machinery was established, bargaining could be used
- The doctor would be willing to waive his right to stop the noise in return for a compensation payment grater than the costs it imposed on him
- The confectioner will pay if his gain from using the machinery exceeds the payment
- if the benefit from the machinery was greater than the social cost, a mutually beneficial payment could be reached
How can market failures be resolved through regulation, taxation and compensation?
- the government could cap the total output of bananas at the Pareto efficient level. This would reduce the costs of pollution on fishermen but lower the farmers’ profits as they lose the surplus between the output at MSC=P and MPC=P
- the government sets a tax equal to MEC (MSC-MPC). The after-tax price for the firm is lower than the original price. To maximise profits, the farmers choose output so that MPC = after tax price which is Pareto efficient output (MSC=P). The cost to fishermen are reduced by the same amount but the reduction in farmer profits is greater since the farmers pay taxes as well as reducing output
- the government could require the farmers to pay compensation for the costs imposed on fishermen. The compensation would be equal to MSC-MPC. Once compensation is included, the marginal cost of bananas is the MPC+compensation = MSC, so the farmers choose output at MSC=P. The effects are similar to that of the tax but the fishermen do better as they, rather than the government, receive the payment from the farmers.
