Week 3 - ECONOMICS, EXTERNALITIES AND INSTITUTIONS Flashcards
What are the two different perspectives on externalities?
A.C. Pigou’s perspective supports government intervention, while Ronald Coase critiques Pigou and advocates for a market-oriented approach.
Both perspectives offer a more nuanced approach than commonly suggested by textbook treatments.
Define negative externalities.
Negative externalities arise when the activities of one economic agent directly affect the welfare or production possibilities of others without market mediation.
Example: Pollution from a power station affecting fishermen.
What is the essence of Pigou’s argument regarding externalities?
One person A renders services to person B while also inadvertently affecting others, leading to unaccounted costs or benefits for third parties.
This is described in Pigou’s ‘Wealth and Welfare’.
What is a missing market in the context of externalities?
A missing market occurs when there are no competitive markets for goods like clean air, resulting in an inefficient allocation of resources.
People cannot trade for goods like clean air, leading to inefficiencies.
How does Pigou describe the divergence in costs related to negative externalities?
There exists a divergence between the marginal private cost and the marginal social cost of activities that generate negative externalities.
Example: Power generation imposes costs on society that are not reflected in the production costs.
What is the Pareto inefficient outcome in the context of electricity production?
Too much electricity is produced, as society values the last units less than the resources needed for their production.
This leads to a deadweight loss in the market.
What is the Pigovian solution to negative externalities?
The government imposes a tax equal to the external damage caused by production to internalize the externality.
This tax aligns the marginal private cost with the marginal social cost.
What is the marginal social cost of electricity?
The marginal social cost is the additional cost incurred by society from the production of an additional unit of electricity, including all resources used up.
It is calculated as marginal private cost plus marginal external cost.
What does Pigou argue regarding state intervention?
He argues that the effectiveness of state intervention depends on various factors, including the competence and integrity of government officials.
He emphasizes a comparative institutional approach.
Define positive externalities.
Positive externalities occur when the benefits of an action accrue to parties other than the one who undertook the action, leading to underinvestment from a societal perspective.
Example: Employer training that benefits other firms when workers leave.
How does the Prisoners’ dilemma relate to training in firms?
The dilemma illustrates that if firms do not train, they all suffer from a shortage of skilled labor, leading to a Pareto inefficient outcome.
This situation results from firms not accounting for the positive externalities of training.
What are positional goods?
Positional goods are those whose utility depends on comparative consumption levels among individuals, leading to negative consumption externalities.
Example: Luxury items that provide status based on their scarcity.
What is the Pigovian policy response to consumption of positional goods?
Taxing the consumption of luxury positional goods to internalize negative consumption externalities and reduce consumption to a Pareto efficient level.
This aligns private consumption with social costs.
What is the Coase theorem?
The Coase theorem states that if property rights are well-defined and transaction costs are negligible, resources will be allocated efficiently regardless of the initial distribution of rights.
It suggests that parties can negotiate solutions to externality problems.
How does Coase critique Pigou’s view on externalities?
Coase argues that Pigou’s view oversimplifies the situation by portraying it as a one-way harm from polluter to victim, ignoring the reciprocal nature of externalities.
He emphasizes the conflict of interest over resource use.
What is the significance of well-defined property rights in the Coase theorem?
Well-defined property rights allow for mutually beneficial bargaining between parties to resolve externalities without government intervention.
This hinges on the assumption of zero transaction costs.
What is the Coase theorem?
If property rights are well-defined and transactions costs are zero, resources will be allocated efficiently regardless of the initial distribution of rights.
What are the conditions under which informal bargaining can correct misallocations due to externalities?
Property rights must be well-defined, and transaction costs must be negligible.
True or False: According to the Coase theorem, government intervention is always necessary to resolve externalities.
False
What is a Pareto efficient level of pollution?
A level of pollution where it is possible to make some individuals better off without making others worse off.
Fill in the blank: For Coase, externalities arise when property rights are _______ or poorly enforced.
ill-defined
What must exist for bargaining to happen according to the Coase theorem?
An initial assignment of property rights over the relevant resources.
What are transactions costs?
Costs incurred in carrying out market transactions, such as discovering who to deal with and negotiating terms.
What happens when transactions costs exceed potential gains?
Bargaining may not take place, leading to market failure.
What is a challenge of reaching satisfactory solutions through the market when many people are involved?
The process of negotiation may be too difficult and time-consuming.
What is free-riding in the context of Coasean bargaining?
When individuals benefit from the contributions of others without contributing themselves.
What does asymmetric information imply in bargaining situations?
One party knows things that the other parties do not, which can lead to failed agreements.
What does Coase suggest about the real cause of the externality problem?
The existence of transactions costs.
What is meant by comparative institutional analysis?
Identifying the institutional solution (state, market, etc.) that best addresses a specific externality problem.
In what scenario might Coasean bargaining be the best approach?
When transactions costs are positive but low.
What is a non-state hierarchical solution to externalities according to Coase?
Firms that internalize costs by owning both the source of pollution and the affected resources.
What is a direct government regulation approach mentioned by Coase?
Pigovian taxes and subsidies.
What might be a case for doing nothing about an externality?
When the costs of allowing the externality to persist are lower than the costs of addressing it.
Overall lesson regarding externalities?
Consider each case to determine the best institutional solution for the specific context.
