A lesson from chapter 7:
Competitive markets are “efficient” -- they lead to
maximum total surplus.
The price rationing mechanism allocates output to . .
. . . the buyers who value it most highly,
. . . and to the sellers who can produce at
lowest cost.
All units for which WTP of marginal buyer (“marginal
value”) exceeds opportunity cost of marginal seller
(“marginal cost”) are produced and consumed.
“Markets are usually a good way to organize economic
activity.” ( -- one of Mankiw’s 10 “basic principles”)
But “usually” isn’t the same as “always”!
Market failure: A situation in which the market, left on
its own, fails to allocate resources efficiently.
In chapter 10, we look at one cause of market failure:
Externality: the impact of one person’s actions on the
well-being of a bystander.
Bystander impact:
adverse: “negative externality”
beneficial: “positive externality”
Recall:
The demand price (height of the demand curve) at any
quantity measures WTP for the marginal buyer,
hence “marginal value.”
More precisely . . .
. . . “marginal private value”;
that is, the value realized by buyer/consumer alone.
If consumption involves an externality, . . .
. . . “marginal social value” . . .
(the value realized by buyer/consumer
and bystanders)
. . . will differ from marginal private value.
The supply price (height of the supply curve) at any
quantity measures opportunity cost of the marginal
seller, hence “marginal cost.”
More precisely, “marginal private cost” (cost of
producer/seller only).
If production involves an externality . . .
. . . “marginal social cost” . . .
(costs of producer/seller and bystanders)
. . . will differ from marginal private cost.
Here’s the point:
Competitive equilibrium determined by:
marginal private value = marginal private cost.
But efficiency requires:
marginal social value = marginal social cost.
Negative externality in production (no externality on
consumption side):
($/unit)
Marginal social cost
Supply (marginal private
cost)
Demand (marginal private
value . . . and marginal
social value)
Qeff Qmkt
(units/day)
Efficient quant. (Qeff) < market equil. quant. (Qmkt)
Example?
Industrial pollution.
Remedy?
Suppose we imposed an excise tax on the polluters’
product, equal to the external cost per unit.
Supply would shift up by the amount of the tax,
moving Qmkt into equality with Qeff.
An example of “internalizing an externality”:
. . . altering incentives so that people take account of
the external effects of their actions.
Positive externality in production (no externality on
consumption side):
($/unit)
Supply (marginal private
cost)
Marginal social cost
Demand (marginal private
value . . . and marginal
social value)
Qmkt Qeff
(units/day)
Efficient quant. (Qeff) > market equil. quant. (Qmkt)
Example?
Technology “spillover.”
Remedy?
Suppose we imposed an excise subsidy (negative
tax) on the product, equal to the value of the
technology spillover.
Supply would shift down by the amount of the
subsidy, moving Qmkt into equality with Qeff.
Subsidizing “high-tech” industries?
Negative externality in consumption (no externality on
production side):
($/unit)
Supply (marginal private
cost . . . and marginal
social cost)
Demand (marginal private
value)
Marginal social value
Qeff Qmkt
(units/day)
Efficient quant. (Qeff) < market equil. quant. (Qmkt)
Examples?
Driving automobiles . . .
. . . or other consumption activities that
involve burning fossil fuel.
Atmospheric carbon dioxide and global warming.
(http://news.nationalgeographic.com . . .)
Remedy?
Taxes to internalize the externality.
“Carbon tax” (See pp. 216-7)
(http://en.wikipedia.org/wiki . . .)
Positive externality in consumption (no externality on
production side):
($/unit)
Supply (marginal private
cost . . . and marginal
social cost)
Marginal social value
Demand (marginal private
value)
Qmkt Qeff
(units/day)
Efficient quant. (Qeff) > market equil. quant. (Qmkt)
Examples?
Vaccinations.
Education.
Remedy?
Often, the government subsidizes (or provides for
free) goods/services that result in positive
consumption externalities.
So free markets lead to inefficient outcomes if
externalities are present . . .
. . . Not necessarily!!
Private bargaining may bring about efficient outcomes
even with the presence of an externality.
Coase theorem:
If private parties can bargain without cost over the
allocation of resources, they can solve the externality
problem on their own.
(http://en.wikipedia.org/wiki/Coase_theorem)
Example: (involving negative externality in production)
A factory pollutes a river used as a drinking water
source for a downstream town. (Assume no other
bystanders are involved.)
The resource (the river, in this example) has two
potential uses: waste disposal and clean water
source.
To which of these uses will the resource be allocated?
Assume:
The factory values the river’s waste disposal
capacity at $80,000 . . .
. . . the cost of an alternative
non-polluting technology.
The town values the river’s potential as a clean water
source at $100,000 . . .
. . . the cost of a water treatment plant
to remove contaminants.
In this simple case (one resource, only two uses) . . .
. . . efficiency requires that the resource be put
to the higher-valued use.
Efficiency requires: Factory doesn’t pollute
and town gets clean river.
Maybe the outcome depends on the law’s assignment of
“property rights” -- the right to use the resource.
First suppose the law gives the property right to the
factory. (The factory is allowed to pollute for free.)
Will we have the inefficient outcome?
Actually, no . . . because:
The town and the factory will reach a contract
through bargaining:
Town pays factory some amount between
$80,000 and $100,000 and, in return, . . .
. . . the factory doesn’t pollute.
(the efficient outcome)
An example of “Coasian bargaining.”
What about the other possible assignment of property
rights?
Suppose the law gives the town the right to a clean
river. (The town has the legal authority to prohibit
the factory from polluting.)
Is there a possibility of a Coasian bargain in this case?
Can the factory pay the town for permission to pollute?
Factory unwilling to pay more than $80,000 . . .
. . . and town unwilling to accept less than $100,000.
No bargain possible.
Factory doesn’t pollute. (Again, the efficient outcome.)
Notice: In both cases, regardless of the assignment of
property rights . . .
. . . the allocation of the resource was the same.
. . . and it’s the efficient allocation.
(Coase theorem)
The distribution of wealth is affected by the assignment
of property rights, however.
Remember Coase theorem: “If private parties can
bargain without cost . . .”
transaction costs: the costs that parties incur in the
process of agreeing and following through on a
bargain. (legal fees, monitoring costs, etc.)
Go back to factory/town example but suppose the
bargaining process requires the services of a lawyer
to write an enforceable contract.
Attorney fees = $30,000.
Consider each property-right-assignment again.
Law gives factory right to pollute:
To get the factory to agree not to pollute, town
would have to pay at least $80,000 + $30,000.
But this is greater than $100,000. No deal. Factory
pollutes. (the inefficient outcome!)
Law gives town right to clean river:
The factory was unwilling to offer a sufficiently high
payment even without transaction costs. No deal.
Factory doesn’t pollute. (the efficient outcome)
When there are transaction costs . . .
. . . the allocation of the resource can depend
on the assignment of property rights . . .
. . . and it’s not necessarily efficient.
Transaction costs and large numbers of bystanders.
Coasian bargaining in the real world?
Environmental protection groups often engage in it.
Imagine two adjacent plots of land:
Privately-owned.
Development
planned.
Publicly-owned.
Sensitive
wildlife habitat.
Zoning ordinances allow the planned development on
the orange land.
But the development’s externalities threaten the
wildlife habitat on the green land.
Environmental protection group wants to prevent
development . . .
. . . but the “law is against them.”
Some options . . . that amount to Coasian bargaining:
Buy the orange land (and preserve it in
natural state).
Enter a contract with owner of orange land:
Group pays orange land owner $X.
Owner of orange land commits to
specified conservation practices.
Contracts of this nature are called conservation
easements:
a voluntary, legally binding agreement that limits or
prevents certain types of uses or prevents
development from taking place on a piece of property
now and in the future.
Some groups that use conservation easements:
Nature Conservancy (http://www.nature.org/ . . .)
Ducks Unlimited (http://www.ducks.org/ . . .)