Week 3: Externalities - General Info + Private Solutions

Question 1

Externality

Answer 1

When an individual or firm produces something that directly affects others without affecting the market price.

Question 2

Markets affected by externalities result in…

Answer 2

Inefficient resource allocations - levels of prod + expenditures directed at controlling the externality = incorrect

Question 3

Inefficient resource allocation leads to 4 possible outcomes which are…

Answer 3

1. Under-provision of certain goods and services
2. Over-provision of certain goods and services
3. Under-consumption of certain goods and services
4. Over-consumption of certain goods and services

Question 4

Examples of market failure

Answer 4

1. The under-provision of merit goods, such as education and healthcare, as these services would be provided in a market economy only to those who were willing and able to pay.
2. The over-provision of demerit goods such as tobacco, alcohol and gambling due to the absence of government intervention in such markets.
3. The under-provision of public goods (see Chapter 12), such as street lighting and public roads, because producers cannot exclude those who do not pay benefiting from the provision of these services.
4. The abuse of monopoly power (see Chapter 14) by charging customers prices above market equilibrium, and, hence, the inefficiencies associated with a suboptimal allocation of scarce resources.

Question 5

Positive externalities of production and consumption (external benefits)

Answer 5

The actions of an individual or firm confer (uncompensated) benefits on others

Question 6

Negative externalities of production and consumption (external costs)

Answer 6

The actions of an individual or firm confer (uncompensated) costs on others

Question 7

Example of negative production externalities

Answer 7

Steel plant pollutes a river but does not face pollution regulations

Question 8

Example of positive production externalities

Answer 8

Beehives of honey producers have a positive impact on pollination and agricultural output

Question 9

Example of negative consumption externalities

Answer 9

Increased use of antibiotics causing antibiotic resistance, passive smoking

Question 10

Example of positive consumption externalities

Answer 10

Vaccination against a communicable disease such as covid/measles

Question 11

Profit maximisation occurs when…

Answer 11

Marginal Revenue = Marginal Cost

Question 12

Private Benefits

Answer 12

The advantages or gains of production and consumption enjoyed by an individual firm or person.

Question 13

Private Costs of Consumption and Production

Answer 13

The actual expenses incurred by an individual firm or person.

Question 14

Social Benefits

Answer 14

Full benefits of consumption or production, that is, the sum of private benefits and positive externalities

SB = private benefits + positive externalities

Question 15

Social Costs

Answer 15

Full costs of consumption or production, that is, the sum of private costs and negative externalities

SC = private costs + negative externalities.

Question 16

Socially optimal output (allocative efficiency) occurs at…

Answer 16

Marginal Social Benefit = Marginal Social Cost

Question 17

Marginal External Cost

Answer 17

Any additional costs associated with the production of the good that are imposed on others but that producers do not pay

Question 18

Marginal Private Cost (MPC)

Answer 18

The direct cost to producers of producing an additional unit of a good

Question 19

Marginal Private Benefit (MPB)

Answer 19

The direct benefit to consumers of consuming an additional unit of good

Question 20

Marginal Social Benefit (MSB)

Answer 20

Refers to the total gains to society from an extra unit of production or consumption of a particular good or service.

The sum of the benefits for private individuals and the positive externalities to others in society.

The satisfaction experienced by consumers of a specific good

Question 21

Marginal Social Cost (MSC)

Answer 21

The private marginal cost to producers plus the marginal external cost

Question 22

What are the private solutions to combating externalities?

Answer 22

Private solutions - ways private markets can deal with externalities w/out gov assistance

1. Internalise externalities
2. Coase theorem
3. Legal system

Question 23

Define internalising externalities

Answer 23

Forming economic units of sufficient size so that most of the consequences of any action occur within the unit.

Question 24

Give an example of internalising externalities.

Answer 24

Consider a group of neighbouring houses or set of apartments in the same or neighbouring buildings.

The quality of life in this neighbourhood is affected by how each household maintains its property.

If people plant flowers = positive externality

If they let their houses run down = negative externality

Even when each family owns its own apartment, the households may collectively decide that maintenance of the facilities that affect them all—including the external appearance—should be undertaken collectively. They form a cooperative or a condominium association.

Question 25

However, what could potentially be the drawbacks of internalising externalities?

Answer 25

A member of the condominium association might prefer to be a free rider, not paying his or her share of the cost of the maintenance of the common facilities

A member might refuse to maintain his or her apartment in ways that are collectively agreed upon, and that may adversely affect neighboring apartments.

Question 26

Therefore, in order to internalise externalities, what must be made sure?

Answer 26

There should be some way of enforcing the collective agreement that those who purchase a condominium or an apartment in a cooperative sign.

A form of the legal system must be put into use which ensures that the terms of the agreement—by which those living near each other attempt to deal with some of the externalities they impose on each other and to provide what are “public goods” to the group—are adhered to.

Question 27

Define the concept of the Coase Theorem

Answer 27

When one party is engaged in an activity that has the incidental effect of causing damage to another, a negotiated settlement between the two may result in a Pareto-efficient allocation of resources

Question 28

Define property rights

Answer 28

Property rights assign to a particular individual the right to control some assets and to receive fees for the property’s use. E.g goods and services that are typically bought and sold in markets, like food, flights, or houses.

Question 29

Coase’s definition of property rights

Answer 29

Coase forces us to think of other rights like the right to make a noise or to have a quiet work environment—as goods that can be bargained over and traded in return for money.

Question 30

What was the case in Guadeloupe and Martinique regarding pesticides?

Answer 30

1. Pesticide chlordecone was used on banana plantations in the Caribbean islands of Guadeloupe and Martinique = kill the banana weevill
2. Weevill = type of pest
3. This = legal, effective way of reducing costs + increasing plantation’s profits

Question 31

What was the issue then?

Answer 31

1. The chemicals from the pesticide washed off the land into the rivers = contaminated freshwater prawn farms, and the mangrove swamps where crabs were caught and destroyed the rich, coastal spiny lobster fisheries.
2. The livelihoods of fishing communities = destroyed
3. Those who ate the contaminated fish fell sick
4. It has been known for a long time that this pesticide = dangerous for humans as it led to symptoms of neurological damage among US workers who worked in the factory that produced it, leading to its prohibition in 1976.
5. The French government received reports on contamination in Guadeloupe a few years later, but waited until 1990 to ban the substance, and were pressured by banana plantation owners to give them a special exemption until 1993.

Question 32

20 years later…

Answer 32

Fishermen = protesting the slow pace of French gov assistance in addressing the fallout from the contamination demonstrated in the streets of Fort De France (the largest town in Martinique) and barricaded the port

By 2012, the fraction of Martiniquean men suffering from prostate cancer was the highest in the world and almost twice that of the second-highest country

The mortality rate was well over four times the world average.

Neurological damage in children, including cognitive performance, had also been documented.

Question 33

In the context of private bargaining, with the allocation of property rights to farmers, is it illegal to weewill?

Answer 33

No, allocation of prop. rights = owners have a right to use it + produce 80,000 tonnes of bananas.

Question 34

Define reservation option

Answer 34

A person’s next best alternative among all options in a particular transaction

Question 35

What is the reservation option for the plantation owners and fishermen?

Answer 35

The allocation and the associated incomes and environmental effects (what they will get if they do not come to an agreement)

Question 36

In the context of private bargaining, what are the things we have to assume regarding the plantation owners and fishermen?

Answer 36

1. A representative of an association of fishermen sits down to bargain with a representative of an association of banana growers.
2. There are no feasible alternatives to Weevokil, so they bargain only over the output of bananas.

Question 37

Both sides should?

Answer 37

Recognize that they could gain from an agreement to reduce output to the Pareto-efficient level.

Question 38

Explain graph 11.5

Answer 38

1. The situation before bargaining begins is point A, and the Pareto-efficient quantity is 38,000 tonnes.
2. The total shaded area shows the gain for the fishermen (from cleaner water) if output is reduced from 80,000 to 38,000.
3. But reducing banana production leads to lower profits for the plantation owners.
4. The fall in profit is smaller than the gain for the fishermen, so there is a net social gain that they could agree to share.

Question 39

Explain graph 11.6 (blue shaded area)

Answer 39

Reducing output from 80,000 to 38,000 tonnes reduces the profits of plantations.

The lost profit is equal to the loss of producer surplus, shown by the blue area.

Question 40

Explain graph 11.7 (remaining green shaded area)

Answer 40

The net social gain is the gain for the fishermen minus the loss for the plantation owners, shown by the remaining green area.

Question 41

Now, explain how private bargaining can be used to solve the pesticide problem.

Answer 41

Since the gain to the fishermen would be greater than the loss to the plantation owners, the fishermen would be willing to pay the banana growers to reduce output to 38,000 tonnes if they had the funds to do so.

Question 42

What would be the minimum acceptable offer from the fishermen?

Answer 42

Depends on what the plantations get in the existing situation, which is their reservation profit (shown by the blue area labelled ‘loss of profit’)

Question 43

The maximum the fishing industry would pay is determined by…

Answer 43

Determined by their reservation option, as in the case of the plantation owners.

It is the sum of the blue and green areas.

In this case, the plantation owners would get all the net social gain, while the fishermen would be no better off.

Question 44

The compensation the plantation owners and fishermen agree on between these maximum and minimum levels is determined by…

Answer 44

The bargaining power of the two groups.

Question 45

The legal framework affects…

Answer 45

Who benefits from solving the market failure

Question 46

Can it be considered unfair that the fishermen need to pay for a pollution reduction?

Answer 46

Yes, because even at the Pareto-efficient level of banana production, the fishing industry is still suffering from pollution (shown by the fact that the MSC is above the MPC), & it must pay to stop the pollution from getting worse.

Question 47

Why is it unfair for the fishermen?

Answer 47

Because we have assumed that the plantation owners have a legal right to use Weevokil.

Question 48

What would an alternative legal framework look like in this case?

Answer 48

1.The fishermen have a right to clean water.

2. The plantation owners wishing to use Weevokil could propose a bargain in which they paid the fishermen to give up some of their right to clean water to allow the Pareto-efficient level of banana production.
3. This = a much more favourable outcome for the fishermen

Question 49

Therefore, Coase’s bargaining process…

Answer 49

The bargaining process would result in a Pareto-efficient allocation independently of whether the initial rights were granted to the plantations (right to pollute) or to the fishermen (right to unpolluted water).

But the two cases differ dramatically in who gains and who loses when the market failure is solved.

Question 50

Why might private bargains not work? (list the reasons)

Answer 50

1. Impediments to collective action
2. Missing information
3. Tradability and legal enforcement
4. Limited funds

Question 51

Impediments to collective action

Answer 51

1. Private bargaining may be impossible if there are many parties on both sides of the external effect, for example, many fishermen and many plantation owners.
2. Each side needs to find someone they trust to bargain for them, and agree how payments will be shared within each industry.
3. The individuals representing the two groups would be performing a public service that might be difficult to secure.

Question 52

Missing information

Answer 52

Devising the payment scheme makes it necessary to measure the costs of Weevokil, not just in aggregate, but to each fisherman.

also need to establish the exact origin of the pollutant, plantation by plantation.

Only when we have this information can we calculate the size of the payment that each fisherman must pay, and how much each plantation should receive.

Easy to see that it is far harder to make a polluting industry accountable for the damage it does than to calculate the liability for damage done

Question 53

Tradability and legal enforcement

Answer 53

The bargain involves the trading of property rights + the contract governing the trade must be enforceable.

Having agreed to pay thousands of dollars, the fishermen must be able to rely on the legal system if a plantation owner does not reduce output as agreed.

This may require the fishermen and the courts to discover information about the plantation’s operations that are not publicly known or available.

Question 54

Limited funds

Answer 54

The fishermen may not have enough money to pay the plantation owners to reduce output to 38,000 tonnes