LECTURE 4 Flashcards
MARKET FAILURE VIOLATES WHICH THEOREM?
1ST WELFARE THEOREM - any market equilibrium should be PE.
Externalities arise when…
One agent’s actions directly affect another agent outside the market mechanism.
What kind of benefits/costs do agents account for?
Private costs and benefits only - not social.
3 main causes of externality market failure
Lack of property rights
Jointness in production and consumption
Information failure
Production externality =
effect of externality on profit relationship
Consumption externality =
effect of externality on utility level.
-VE production externalities =
when a firm’s production reduces well being of others not compensated by the firm.
PMC=
direct cost to the firm of producing an additional unit.
Marginal damage =
any additional costs associated with the production of an additional unit that are imposed on others but the producer does NOT pay.
-VE production externality SMC and PMC relationship
SMC = PMC + MD
SMC > PMC
The DWL triangle always…
Points to the SOCIAL optimum
How does -ve production externality affect market outcome?
Free markets overproduces compared to social optimum.
-VE consumption externalities =
when an individual’s consumption reduces well being of others not compensated by the individual.
PMB =
direct benefit to the consumer of consuming an additional unit.
Marginal damage for consumption =
any additional costs associated with the consumption of an additional unit that are imposed on others but the consumer does NOT pay.
-VE consumption externality PMB and SMB relationship
SMB = PMB - MD
SMB < PMB
How does -ve consumption externality affect market outcome?
Overconsumption
+VE production externalities =
when a firm’s production increases well being of others, but the firm is not compensated by those others.
+VE production externality SMC and PMC relationship
SMC = PMC - MB
SMC < PMC
Effect of +ve production externality on outcome
Underproduction
+VE consumption externalities =
when an individual’s consumption increases well being of others, but the individual is not compensated by those others.
+VE consumption externality SMC and PMC relationship
SMB = PMB + MB
SMB > PMB
Effect of +ve consumption externality on outcome
underconsumption
Individual optimisation to show consumption externality –> suboptimal outcome.
Max individual utility (which depends on others consumption) s.t. individual resource constraint s.t. aggregate resource constraint too.
FOC for individual optimisation with consumption externality. What does this mean?
U’(yi) = 1
PMB = PMC of additional unit of good y.
Each consumer doesn’t account for other’s consumption of good y despite the externality.
How do we find PE allocation for consumption externality
Maximise total utility of society s.t. aggregate resource constraint.
FOCs for PE allocation for consumption externality
u’1(y1) + v’2(y1)=1
u’2(y2) + v’1(y2)=1
Account for other’s consumption of the good st the externality.
If the consumption externality is positive, what does this mean for v’1 and v’2 and how do free market and PE allocation compare?
v’1(y2) > 0, v’2(y1)>0
This means u’1(y1) and u’2(y2) LOWER for PE
Lower MU = higher Y1 and Y2 by diminishing MU.
SO: free market = underconsumption.
If the consumption externality is negative, what does this mean for v’1 and v’2 and how do free market and PE allocation compare?
v’1(y2) < 0, v’2(y1)<0
This means u’1(y1) and u’2(y2) HIGHER for PE
Higher MU = lower Y1 and Y2 by diminishing MU.
SO: free market = overconsumption.
What’s the rat race problem? What’s the NE and PE outcomes?
A competition for relative position.
Gain advantage over rivals by competing harder than they do.
But if everyone competes hard the extra effort cancels out.
NE = both high effort
PE = low effort - account for -VE externality on others
Tragedy of the commons arises from…
common right of access to a resource.
F(B) shows how the number of fish each fisherman catches depends on the total number of boats. What is the sign of F’(B) and how can we show there is overfishing in market?
F’(B) < 0 -VE externality
ME: F(B)- c = w
PE: F(B) - c + BF’(B) = w
Since F’(B)<0, F(B) higher in PE and so B lower in PE than ME.
What are the 2 aims of Coase theorem?
- Establish property rights
2. Internalise the externality
What does internalising an externality mean?
When government action or private negotiation leads the price to the party to fully reflect external costs/benefits of their actions.
COASE THEOREM I
When there are: well defined property rights & costless bargaining, negotiations between the party creating the externality and the party affected can –> SOCIAL OPTIMUM.
COASE THEOREM II
The efficient quantity for a good producing an externality does NOT depend on which party is assigned the property rights, as long as one of them is.
Conclusion of coarse theorem: in a competitive economy with….
complete information and zero transaction costs, the allocation of resources will be efficient and invariant wrt to legal rules of entitlement.
How can the social optimum be reached if individuals own the river that is being pollute by a firm?
Individual can charge the firm for polluting the river.
Sell permits to give the firm the right to pollute.
What’s the optimum charge if individuals own the river?
Optimum charge per unit of pollution = MD
If charge > MD, incentive for individuals to sell more pollution permits = supply rises = price falls.
How can the social optimum be reached if the firm owns the river that it is polluting?
Firm can charge individuals for polluting less.
What’s the optimum charge if the firm owns the river?
Optimum charge per unit of pollution = MD
If charge > MD, individuals not wtp to reduce pollution.
If charge < MD, firms would rather pollute than receive money.
How does charging MD per unit of pollutin in Coase theorem affect -ve production externality graph?
Charge MD per unit = PMC shifts UP so that PMC=SMC.
State 3 problems with Coase theorem (don’t explain yet)
- Assignment problem
- Holdout problem
- Transaction costs & negotiation problems
Whats the assignment problem of Coase theorem? When is this a greater problem?
Hard to know who is responsible e.g. for global warming.
Greater problem if many agents, lesser problem if small, local externality.
Whats the holdout problem of Coase theorem? When is it amplified?
Shared ownership if property rights give each owner power over all the others since they must all agree to th Coasian solution. The final individual could holdout and ask for charge > MD so won’t reach the optimum. Amplified when many parties.
Whats the transaction costs/negotiating problems of Coase theorem?
Hard to negotiate when many individuals on one or both sides. Preferences must be aggregate for negotiation. Assumption of costless bargaining unrealistic.
Optimum pigouvian tax for -VE production externality sets…
t = MD
to correct the wedge between PMC and SMC and shift PMC up.
3 cons of Pigouvian
- Exact level of MD unknown
- Unintended consequences for other markets (only part equilibrium model)
- Tax evasion
How does reg and control differ to pigouvian?
Its quantity, not price regulation - firms have to cut down pollution to a certain level or face legal sanctions.
How does outcome of regulation compared to Pigouvian?
Same outcome: both restrict output o social optimum and push up PMC to SMC.
2 pros of reg
- Easy to enforce, administer and monitor.
2. Quickly reduce pollution to meet a target.
2 cons of reg
- Discourages innovation
2. Inefficient when heterogeneity in costs of pollution reduction across firms.
What problem with regulation do pollution permits solve?
Solution when heterogeneity in costs of pollution abatement
Tradable pollution permits are…
Permits give firms the right to pollute.
Firms can trade permits on a market among themselves.
Set total number of pollution permits to…
SOCIAL OPTIMUM level of pollution.
What 2 types of efficiency do pollution permits achieve?
- allocation: p=mc
2. productive: min AC
In equilibrium, which firms buy/sell more pollution permits?
Firms with HIGH MC of reducing pollution BUY the most.
Firms with LOW MC of reducing pollution SELL the most.
What are the PE FOCs for pollution reduction where we have a high and low cost firm?
FOC: MC of pollution reduction = MD of pollution.
Can the social optimum level of pollution reduction be achieve with pigouvian?
Yes - set t=MD of pollution and get same FOCs
Can the PE level of pollution reduction be achieved through tradable permits? Does it matter what the initial levels of pollution reduction are?
YES - independent of initial allocations as firms trade to reach PE.
Each firm maximises own profits
WEITZMAN’S INSIGHT on price and quantity regulation
When there is uncertainty about MB/MC, price and quantity regulations may not longer be equivalent.
What market do we analyse to look at Weitzman’s insight?
The market for pollution reduction - NOT good’s market.
In the market for pollution reduction, what do PMC and SMC curves look like?
PMC=SMC
Slope upwards - becomes more and more costly to reduce pollution due to diminishing returns to inputs.
In the market for pollution reduction, what do PMB and SMB curves look like?
In absence of policy, PMB = 0
SMB is a horizontal line = MD of pollution i.e. MD not incurred.
What is private optimum I market for pollution abatement?
PMC=PMB at 0 so no pollution reduction.
Why when a tax is set is there a +VE PMB of pollution abatement? What’s its Lebel?
PMB = MD = t
i.e. the tax not incurred by reducing pollution
To analyse Weitzman’s insight, we assume regulators are uncertain about…
MC of pollution reduction.
Why can we have SMB of pollution reduction sloping down?
Initially when pollution is high, high MB from reducing it. As we get closer to very little pollution, additional benefit from more reduction small.
Example of when SMB=MD curve is quite flat i.e. elastic
global warming
Whats the PE pollution reduction FOC again?
MC = MD
When regulators think MC pollution reduction is lower than it actually is, how does this affect outcome with a tax?
Set tax too low.
Not enough pollution reduction.
SMB > actual MC = should reduce pollution more = DWL
When regulators think MC pollution reduction is lower than it actually is, how does this affect outcome with quantity regulation?
Mandate pollution reduction where SMB = perceived MC
At this quantity, actual MC > SMB = should reduce pollution less = DWL
SO: when the SMB=MD curve is FLAT and the regulator gets the wrong MC, does price or quantity reg lead to a bigger DWL?
DWL quantity > DWL price.
SO: when the SMB=MD curve is STEEP and the regulator gets the wrong MC, does price or quantity reg lead to a bigger DWL?
DWL quantity < DWL price.
Example of when SMB=MD curve is quite steep i.e. inelastic
Nuclear leakage
