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 atlowest 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 ofproducer/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):

Marginal social cost($/unit)

(units/day)

Demand (marginal private value . . .

Supply (marginal private cost)

and marginal social value)

Efficient quant. (Qeff) < market equil. quant. (Qmkt)

QmktQeff

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.

($/unit)

(units/day)

Demand (marginal private value . . .

Supply (marginal private cost)

and marginal social value)

Positive externality in production (no externality on consumption side):

Marginal social cost

Efficient quant. (Qeff) > market equil. quant. (Qmkt)

QeffQmkt

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):

Efficient quant. (Qeff) < market equil. quant. (Qmkt)

($/unit)

(units/day)

Demand (marginal private value)

Supply (marginal private cost . . . and marginal

social cost)

Marginal social value

QmktQeff

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 . . .)

($/unit)

(units/day)

Demand (marginal private value)

Supply (marginal private cost . . . and marginal

social cost)

Positive externality in consumption (no externality on production side):

Efficient quant. (Qeff) > market equil. quant. (Qmkt)

Marginal social value

QeffQmkt

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 disposalcapacity at $80,000 . . .

. . . the cost of an alternativenon-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 polluteand 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 innatural 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/ . . .)