ECON 100B Lecture Notes - Lecture 16: Market Failure, Assignment Problem, Kyoto Protocol
Econ 100B Lecture 16 - June 05, 2018
Externalities and Coase Theorem
Externalities
●Arise whenever the actions of one economic agent directly affect another economic agent
outside the market mechanism
●There are four types of externalities
○Negative consumption which leads to overconsumption
○Negative production which leads to overproduction
○Positive consumption which leads to underconsumption
○Positive production which leads to underproduction
●All externalities lead to deadweight loss
●Common property resource
○Example of negative production externality
Can markets account for the externalities
●Private sector solutions to negative externalities
●Ronald Coase (famous Nobel Prize winner economist)
○Externalities can be solved using market mechanism
●Internalizing the externality
○When either private negotiations or government action lead to the price to fully
reflect the externality (positive or negative)
●Private negotiation
○Solution using market mechanism
○Also known as the bargaining solution
●Government action: public goods
Private market solution: Coase Theorem
●Part 1: when there are well defined property rights and costless bargaining, then
negotiations between the party creating the externality and the party affected by the
externality can bring about the socially optimal market quantity
●Part 2: the efficient solution to an externality does not depend on which party is assigned
the property rights, as long as someone is assigned those rights
●Two essential conditions: low transaction costs/costs of bargaining and assignment of
property rights
●Assignment of property rights is essential because it sets the starting point for the
bargaining process
●Example: steel plant polluting a river used by local fishermen
○Parties negotiating: steel plant producer and local fishermen
○Issue of negotiation: optimal level of pollution
Document Summary
Econ 100b lecture 16 - june 05, 2018. Arise whenever the actions of one economic agent directly affect another economic agent outside the market mechanism. Ronald coase (famous nobel prize winner economist) Externalities can be solved using market mechanism. When either private negotiations or government action lead to the price to fully reflect the externality (positive or negative) Part 1: when there are well defined property rights and costless bargaining, then negotiations between the party creating the externality and the party affected by the externality can bring about the socially optimal market quantity. Part 2: the efficient solution to an externality does not depend on which party is assigned the property rights, as long as someone is assigned those rights. Two essential conditions: low transaction costs/costs of bargaining and assignment of property rights. Assignment of property rights is essential because it sets the starting point for the bargaining process. Example: steel plant polluting a river used by local fishermen.
