Lecture 3 Externalities

Question 1

Define Market failure (Economic & Non-Economic View) & 5 Examples

Answer 1

Market failure: socially undesired or economically (allocatively) inefficient market result

Non-economic view
* Illegal trade with restricted goods or services
* Ethical concerns
* Violation of postulates of equality and fairness
* Undermining of governmental or state controls

Economic view
* The allocation of goods by a free market, where agents’ pursuit of pure self-interest, are not Pareto efficient and thus leads to a net loss from the societal point of view.
= economically (allocatively) inefficient market result

1. External effects
2. Public goods
3. Monopolies
4. Oligopolies
5. Cartels

Question 2

Know the concept of externalities thoroughly

Answer 2

Externality: the cost or benefit of one person’s decision on the well-being of a bystander (a third party) which the decision-maker does not consider when making the decision. Externalities (negative or positive) cause markets to be inefficient, and thus fail to maximize total surplus

Question 3

Negative Externality

Answer 3

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Question 4

What are positive and negative externalities?

Answer 4

Negative Externality: the cost of a decision imposed on a third party (e.g. pollution)
· The market produces more than is socially desirable.
Positive Externality: the benefits to a third party of a decision (e.g. education)
· The market produces less than is socially desirable.
· The social value of the good exceeds the private value of the good.

Question 5

Positive Externality

Answer 5

Planting trees
The benefits (cleaner air, lower temperatures, aesthetic improvement) extend to others in the community who didn’t bear the cost of planting or maintaining the trees. These external benefits are not reflected in the market price of planting the tree, leading to under-provision of this socially beneficial activity.

Question 6

Explain governmental internalisation of externalities
3 Examples

Answer 6

An internalisation of an externality aims at changing incentives so that individuals take account of externalities:
1. Taxation of negative externalities
2. Subsidisation of positive externalities
3. Industrial policy: e.g. protection of patents

Question 7

Show how private internalisation of externalities works

Answer 7

Pigouvian tax shifts the supply curve left (upwards), and moves the market optimum to the left.

Pic 3

Question 8

Measure outcomes of a pigouvian tax

Answer 8

· Gross benefit = avoided social cost (area ABCD)
· Cost = deadweight loss = losses in rents (area ABD)
· Net benefit = Gross benefit - cost (area BCD > 0)
· Tax income = transfer (6 x DA)

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Question 9

What is the difference between the consumer and the producer surplus?

Answer 9

Consumer surplus: the difference between what a consumer is willing to pay and what they paid for a product.
Producer surplus: the difference between the market price and the lowest price a producer is willing to accept to produce a good.

Question 10

Private solutions to the externality issues

Answer 10

· Moral conventions and social sanctions
· Non-profit organisations
· Integration of different business models
· Bargaining between generators of externalities and the parties affected by the external effects: Coase Theorem.

Question 11

Assumptions of Coase theorem

Answer 11

1. No transactions costs
2. Perfect communication
3. Perfect information

Question 12

Coase theorem

Answer 12

Private bargaining between individuals can correct externality problems and lead to efficient markets.
A solution involves creating property rights for either the victim or the generator. Either assignment will lead to an efficient outcome.
Two things that are not being claimed:
1. The outcome will be the same in both cases.
2. Either way of assigning property rights necessarily promotes equity.

Question 13

Possible outcomes of the Coase theorem

Answer 13

1. B gets the property rights.
   There is an M reduction of (M M*) and A pays B an amount equal to the area of triangle b (the money value of B’s suffering)
2. A gets the property rights.
   there is an M reduction of (M M) and B pays A an amount equal to the area of triangle d (the money value of A’s loss).
   In neither case is M the bargaining outcome. The outcomes are different in the two cases.
   Both outcomes are efficient, because in both cases MB = MEC,
   but they involve different levels of M.

Question 14

Why does the free market does often not provide an efficient outcome concerning external effects and public goods?

Answer 14

1. Activities of economic agents can have direct positive or negative consequences for other economic agents (externalities).
2. Certain goods would not be sufficiently produced in perfect competition (public goods).
3. There are also ethical or economic-political goals (e.g. fair distribution).

Question 15

Define the term «public good» and public resource.

Answer 15

Public goods are non-excludable and non-rival
Public resources are non-excludable and rival.

▪ Public goods are non-excludable and non-rival in consumption.
▪ Problem: markets cannot supply them
▪ Examples of public goods:
* lighthouse
* national defence
* fundamental research
* social system
* wilderness resource
* climate system

Question 16

Explain the free rider problem and public goods

Answer 16

A free rider benefits from the provision of a good, without paying for/contributing to it.
Crucial problem with the provision of public goods as a result of the non- excludability characteristic.
Possible solution: government to provide public goods.

Question 17

What are possible solutions to solve the Prisonner’s dilemma?

Answer 17

Dominant strategy: Strategy with the best pay-off, regardless of the other person (i.e. confess, abate).
Strategy in static equilibrium: Both confess / co-operate / abate.

Question 18

Sources of market failure

Answer 18

Market failure can occur for three main reasons, linked to
1. The nature of the market - monopoly, oligopoly,
monopsony, monopolistic competition
2. The nature of the good - public good, common goods, externalities
3. The nature of the exchanges within the market -
transaction costs, information asymmetry

Question 19

Suppose that A and B live in adjacent apartments. A is a saxophone player, who enjoys practicing a lot. B does not like music and can hear A practicing.

Let M represent an hour of saxophone music
The marginal benefit function for A playing music is: MB = 100 – 10M
The marginal external cost borne by B is: MEC = 5M

• If A does not have to pay anything for the noise, how much will A practice?
• What is the total benefit of playing saxophone to A at this level?
• What is the efficient level of M?
• If B is given the legal right to a domestic environment that is not noise polluted, which level of M will be realized?

Answer 19

→ A will practice until MB=0 i.e. 10 hours
→ The total benefit is the area under the MB curve.
(10010)/2 = 500
→ Efficient outcome achieved where MB = MEC which is at 100/15 ≈ 6.7 hours
→ The outcome will be 6.7 hours. A will not increase M beyond M because the compensation that would be necessary to pay B would be greater than the worth of the small increase to A.