Unit 10 Flashcards
What are externalities and what is the relationship between social, private and external costs/benefits?
Externalities are costs or benefits imposed on a third party that is not taken into account by the individual taking the action.
Social cost/benefit = private cost/benefit + external cost/benefit
What is market failure?
When a market system results in a Pareto inefficient allocation (misallocation) of resources. This occurs when people make decisions without taking into account the full social costs and benefits of their actions, so the allocation is not Pareto efficient as there are allocations that would be better for everyone else.
How is the weevokil pesticide e=situation an example of a negative externality?
Banana producers use pesticides to increase crop growth. The pesticides are washed into water sources, killing fish. This reduces the fish yield for fishermen. So the farmers have not taken into account the external effect of pesticides on fishermen.
What does a diagram of marginal social, external and private costs of using weevokil pesticide look like?
The marginal private cost (cost to farmers) is a straight upward sloping line as each additional banana produced requires the same increase in weevokil. The marginal external; cost is n upward sloping curve which increases exponentially as banana production increases. The marginal social cost curve is the same shape as MEC as it is the addition of MEC and MPC.
What level of output would banana farmers choose to produce at?
Banana farmers would produce at the profit maximising level of output, where price is equal to marginal private cost, P=MPC.
What is the Pareto efficient level of output for banana farmers to produce at?
Both banana farmers and fishermen would be better off if banana output was reduced from the level P=MPC. For each ton of banana output reduced, the gain for the fishermen is the marginal external cost of that ton and the loss to the plantation is P-MPC. Whenever MEC>P-MPC, it would be possible for both groups to be better off if the fishermen shared the benefits by making a payment to the plantations.
So the Pareto efficient level of output is P=MSC, since it is better to reduce output when P<MEC+MPC (=MSC)
Because the price of bananas represents what people are willing to pay for them, we can think of this as the marginal social benefit. So the condition for Pareto efficiency is MSB=MSC.
What is Coasean bargaining?
A negotiated settlement aiming to achieve a Pareto-efficient allocation of resources. Ronald Coase argued that when one party is engaged in an activity that causes external effects to another, the two parties often have better information about the effects than the government does, so bargaining is often preferable to government intervention.
Explain an example of a Coasean agreement in the legal trial between Bridgman and Sturges.
Bridgman was a confectioner who used machinery that made noise. Sturges was a doctor who built a consulting room on the boundary of his property near Bridgman’s kitchen.
Coase explained that once the doctor’s right to prevent the use of machinery had been established by the court, the two sides could modify the outcome:
• The doctor would be willing to waive his right to stop the noise in return for a compensation payment greater than the costs it imposed on him.
• The confectioner would be willing to pay if his gain from using the machinery exceeded the payment.
• If the benefit from the machinery was greater than the social cost—the sum of the costs to the two parties—a mutually beneficial payment could be found and the machinery would be used.
• If the benefit were less than the social cost, a Pareto improvement would be impossible and the doctor’s consulting room would remain quiet.
How could Coasean bargaining be used in the pesticide example?
Reducing banana output would reduce banana farmers’ profits but increase net social gain.
If the fishermen had sufficient funds, they would be willing to pay the farmers to reduce output.
The minimum acceptable offer would be a payment exactly equal to the farmers’ loss in profit.
The maximum the fishermen could pay the farmers is equal to the total net social gain.
Coase argued that as long as private bargaining exhausted all the potential mutual gains, the result would be Pareto efficient, independently of which party owned the initial rights.
What are some issues with Coasean bargaining?
- Impediments to collective action - There may be many parties on each side of the external effect, all affected in different ways.
- Missing or asymmetric information - It is necessary to be able to measure the costs of and benefits of everyone involved, in order to calculate how much each party should pay or receive.
- Tradability and enforcement: The bargain involves the trading of property rights, and the contract governing the trade must be enforceable. The legal system must be able to obtain the relevant information if any individual reneges.
- Limited funds: Parties wishing to purchase a property right must have the funds to do so. The fishermen, for example, may not have enough money to pay the plantations to reduce output or find a safer pesticide
