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ECON 110 Study Guide - Tax Rate, Gdp Deflator, Coase Theorem

50 pages123 viewsWinter 2014

Department
Economics
Course Code
ECON 110
Professor
Oded Haklai

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CHAPTER 16- Market Failure and Government Intervention
Market failure occurs when the market fails to reach a socially optimal outcome. While the
people participating in the deal may be happy, it may not be the best outcome for society as a
whole.
The effects of a deal on people ‘external’ to the transaction are called market externalities.
A negative externality is where the marginal social cost is
greater than the marginal private cost. In other words, the
benefit to society is less than the benefit to the companies
involved. Pollution is a good example: a shoe factory
polluting a river costs society a lot, but the individual
factory isn’t affected and pays little. In this case, we would
like the market to produce less of a good (Q* < Q0).
Q* Q0
A positive externality is the opposite: the marginal social cost is less than the marginal private
benefit. For example, medical research benefits billions of people. The private cost is a lot, but
the social cost is very little. In this case, we would like the market to produce more of a good (QS
> Q).
Review:"Marginal"Rates"
When"you"see"the"word"
marginal,"think"of"the$next$
individual$unit.""
For"example,"when"the"
marginal"cost"of"producing"
books"is"higher"than"their"price,"
it"costs"more"to"produce"the"
next"book"than"the"amount"you"
could"sell"it"for.""
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How do we get markets to produce efficiently and solve this externality problem? There are three
private solutions:
1. Social Norms. A good example of this is littering. The private cost of keeping your
garbage is much higher than just littering. But social pressure and commonly held values
keep you from doing so.
2. Merger of firms linked by an externality. When firms merge, they’ll produce goods more
efficiently (with fewer externalities).
3. Coase Theorem: with costless negotiation the result will be efficient use of the
resources.
Let’s go through an example of the Coase Theorem.
Suppose a coral reef is right near an oil reserve in the Gulf of Mexico. Exxon runs a drilling rig,
while Ocean Tours runs a coral reef adventure tour. The drilling rig (R) is the polluter, while the
coral reef tour (T) is the bearer of the pollution’s costs. R’s preference is to produce at maximum
profits, while T’s preference is that R doesn’t produce at all.
Note that there is also a social benefit to producing oil, considering how central it is in running
our day-to-day lives. There is equilibrium between the two extremes that will provide us with
maximum social benefit with the least social cost. This is considered the efficient production
level.
The most important (and improbable) thing in the Coase Theorem is that in each case, only one of
the companies has the absolute right to the property and can decide their own production.
If R was to decide its production, it would choose produce where its marginal private cost (MPC)
hits the marginal social benefit (MSB) at Qm. The coral reef tour could potentially pay Exxon to
produce less at an efficient production level at Q*. This could be negotiated anywhere between
area B and area B + area A.
- In other words, R will only produce less if its paid at least the profits it would lose (area
B), while T would pay at maximum the total amount it would benefit from less oil
production (area B+A). They can negotiate to some value between B+A and A.
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If T were to decide production, it would choose to produce no oil. Exxon would not be happy
with that arrangement, and so it may negotiate to pay Ocean Tours anywhere between area D and
areas D + C to produce oil at an efficient production level.
- In other words, T will only choose to allow production if paid at least the cost of
pollution (D), while the maximum R would pay is its total benefit from producing oil
(D+C). They can negotiate to some value between B+A and A
Note that efficiency here refers to production at the socially optimum level, where marginal social
cost (MSC) equals the marginal social benefit (MSB) of production. Any other level would cause
dead-weight loss, where MSC is different than MSB, and society would benefit from a change in
production. In these cases, dead weight loss would be area A if the Oil Rig doesn’t reduce oil
production, or C if the Coral Tour doesn’t allow oil production. These areas are where MSC is
higher or lower than MSB.
Three reasons can explain why the Coase Theorem doesn’t always work.
1. Transaction Costs: if they cost more than the potential benefits of negotiation.
2. Bargaining Breakdowns: negotiations fall through
3. Ill-defined Property Rights: who pays who? This also results in bargaining breakdown.
Market failure also occurs when dealing with non-rivalrous and non-excludable goods.
When one person’s consumption of a good leaves it unavailable to others, it is considered
Rivalrous Consumption. TV is an example of a non-rivalrous good, where I can watch TV
without stopping you from watching.
When people can be prevented from consuming a good, it is considered Excludable
Consumption. These goods are in a sense privileges, and people can be charged to gain that
privilege. A non-excludable good would be a public park, which is free for everybody to enjoy.
Excludable
Non-Excludable
Rival
Private Goods
Common Property Resources
Non-Rival
Local Public Goods and Club Goods
Pure Public Goods
Private Goods: usual consumption goods and services. Take a banana: it is rivalrous because
once you eat it, no one else can. And a banana is excludable, because to be able to enjoy it you
have to buy it.
Local Public Goods and Club Goods: like Internet service, cable TV, concerts, and fitness
clubs. When uncongested, these are non-rivalrous. However, they are excludable because
consumers still must pay to take part.
Common Property Resources: like congested roads and bridges, fisheries, air and water.
Congested roads, for example, are free to enter by anyone. But you must compete with other cars
to find space.
These tend to result in a tragedy of the commons, be overused by the market, resulting where
resources are depleted. Fisheries are good examples. While a sustainable level of fishing may be
at maximum profits (where marginal product equals the workers’ wage), fishermen will enter the
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