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Chapter 12 (1) - Coggle Diagram
Chapter 12 (1)
Unit 4
Another example, when fuel costs are low, more people decide to drive to work rather than taking the train
The effects on the decision-maker are termed private costs and benefits, while the total effects including those inflicted or enjoyed by others, are social costs and benefits.
If the prices of the Weevokil was high enough, there would be no overuse. But the prices of these goods were based on the costs of production, and excluded costs that their use would inflict on others.
Costs inflicted on others are termed external diseconomies or negative externalities, while uncompensated benefits conferred on others are external economies or positive externalities
In taking an action so as to maximize profits the plantation owners did not take account of the external costs they imposed on the fishermen.
While tort law (the law of damages) in most countries covers some kinds of harm inflicted on others (reckless driving) other important external effects of driving your car (such as adding to air pollution or congestion) would not be covered. Here are two further examples:
- A firm operates an incinerator that produces fumes
- You play music loudly at night and disturb the sleep of the people next door
But this is not the case with fumes from the incinerator or loud music at night. In these cases economists say that we have incomplete, missing or unenforceable property rights - or simply incomplete contracts. There is no market within which these external effects can be compensated. So economists also use the term missing markets to describe problems like this
Legal systems also fail to provide compensation for the benefits that one's actions confer on others:
- A firm trains a worker who quits for a better job
- Kim, a farmer, contributes to the cost of an irrigation project while other farmers free ride on her contribution
- A country invests in reducing carbon emissions that lowers the risks of climate change for other countries
Market failures occur in these examples because the external benefits and costs of a persons actions are not owned by anyone
The reason why uncompensated external costs and benefits occur is the same:
- Some information that is of concern to someone other than the decision-maker is non-verifiable or asymmetric information
- Therefore, there can be no contract or property rights ensuring that external effects will be compensated
- As a result, some of the social costs or benefits of the decision-maker's actions will not be included (or will not be sufficiently important) in the decision-making process
Unit 5
Markets typically allocate private goods. But for the other three kinds of good, markets are either not possible or likely to fail. There are two reasons:
- When goods are non-rival the marginal cost is zero
- When goods are not excludable there is no way to charge a price for them
So when goods are not private, public policy may be required to allocate them
Goods in economics are things that people want to use or consume. But there are also bads: things that people dont want, and might be willing to pay to not have.
- Private bads: household refuse or unpleasant smelling drains
- Public bads: air pollution
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Market failure in the case of public goods is closely related to the problems of external effects, absent property rights and incomplete contracts
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Unit 1
The market allocation of the good is unlikely to be Pareto efficient if the decisions of producers and consumers affect others in ways that they do not adequately take into account. This is another cause of market failure
We will analyse the gains from trade in a case where the production of a good creates an external cost: pollution
A competitive market allocation maximizes the total surplus of the producers and consumers and is Pareto efficient, as long as no one else is affected by the production and consumption of the good
To see why this is called an external effect (or sometimes an externality) imagine that the same company owned the banana plantations and fisheries, and hired fishermen and sold what they caught as profit. The owners of the company would decide on the level of pesticide to use, taking account of its downstream effect. They would trade-off the profits from the banana part of their business against the losses from the fisheries
When markets allocate resources in a Pareto-efficient way, we describe this as market failure
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The plantation produces 80 000 tonnes of bananas, at this point price equals MPC
This shows the marginal costs of growing bananas on an imaginary Caribbean island where a fictional pesticide called Weevokil is used. The marginal cost of producing bananas for the growers is labelled as the marginal private cost (MPC). It slopes upward because the cost of an additional tonne of bananas increases as the land is more intensively used, requiring more Weevokil. Marginal social cost (MSC) includes the costs borne by fishermen whose waters are contaminated by Weevokil. The marginal social cost of banana production is higher than the marginal private cost
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We will consider a case in which the wholesale market for bananas is competitive and the market price is $400 per tonne. If the banana plantation owners wish to maximize their profit, we know that they will choose their output so that price is equal to their marginal cost - that is the marginal private cost
When production is 38 000 tonnes it is not possible for the plantation owners and fishermen to both be made better off
If a single company owned both the banana plantations and fisheries, this company would choose to produce 38 000 tonnes, because for the single owner price would be equal to MPC at 38 000 tonnes
Pollutants like Weevokil have negative external effects, sometimes called environmental spillovers.They being private benefits to those who decide to use them, but by damaging the environment they impose external costs on other firms or on households that rely on environmental resources. This is a market failure
The Pareto-efficient level of output is 38 000 tonnes of bananas, price equals MSC
Unit 3
If alternatives to Weevokil were available it would be inefficient to restrict the output ti 38 000 tonnes, because if the plantations could choose a different production method and the corresponding profit maximizing output, they could be better off and the fishermen no worse off.
There are limits to how well governments can implement Pigouvian taxes, regulation and compensation - often for the same reasons as for Coasean bargaining:
- The government may not know the degree of harm suffered by each fisherman
- Marginal social costs are difficult to measure
- The government may favour the more powerful group
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What can the government do to achieve a reduction in the output of bananas to the level that takes into account the costs for the fishermen? There are three ways this might be done:
- Regulation of the quantity of bananas produced: The government could cap total banana output at 38 000 tonnes the Pareto Efficient amount. If the plantations differ in size and output it may be difficult to determine and enforce the right quota for each one
- Taxation of the production or sale of bananas: At the Pareto-efficient quantity (38 000 tonnes) the MSC is $400 and the MPC is $295. The price is $400. If the government puts a tax on each tonne of bananas produced, equal to $400 - $295 = $2015 (the marginal external cost) then the after tax price received by plantations will be $295. When the plantations are producing 38 000 bananas the tax is exactly equal to the cost imposed on the fishermen. This approach is known as Pigouvian tax. The costs of pollution for fishermen are reduced by the same amount, but the reduction in banana profits is greater, since the plantations pay taxes as well as reducing output, and the government receives the tax revenue.
- Enforcing compensation of the fishermen for the costs imposed on them: The government could require the plantation owners to pay compensation for costs imposed on the fishermen. The compensation required for each tonne of bananas will be equal to the difference between the MSC and the MPC which is the distance between the green and purple lines in the figure. The fishermen are fully compensated for pollution, and the plantations profits are equal to the true social surplus of banana production. The effect of this policy on the plantations profits is similar to the effect of the tax, but the fishermen do better because they rather than the government receive payment from the plantations
Unit 2
Initially it is not illegal to use Weevokil: the allocation of property rights is such that the plantations have the right to use it, and choose to produce 80 000 tonnes of bananas. This allocation and the associated incomes and environmental effects represent the reservation option of the plantation owners and fishermen. This is what they will get if they do not come to some agreement
So lets imagine that a representative of an association of fishermen sits down to bargain with a representative of an association of banana growers. They bargain only over the output of bananas
The fishermen and the plantation owners could negotiate a private bargain. Solutions of this type are often called Coasean bargaining
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To demonstrate that the market allocation of bananas (producing 80 000 tonnes using Weevokil) is not Pareto efficient, we showed that the fishermen could pay the plantation owners to produce fewer bananas and both would be better off.
The situation before bargaining begins is point A, and the Pareto efficient quantity is 38 000 tonnes. The total shaded area shows the gain for the fishermen if output is reduced from 80 000 to 38 000. Reducing banana production will lead to lower profits for the plantations. 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.
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. The minimum acceptable offer from the fishermen depends on what the plantations get in the existing situation, which is their reservation profit (blue area). If plantation owners agreed to this minimum payment to compensate them for their loss of profit, the fishing industry would achieve a net gain from the agreement equal to the net social gain, while plantations would be no better and no worse off. The maximum the fishing industry would pay is determined by their fallback (reservation) option
Practical obstacles to bargaining may prevent the achievement of Pareto efficiency:
- Impediments to collective action: private bargaining may be impossible if there are many parties on both sides of the external effect. The individuals representing the two groups would be performing a public service that might be difficult to secure
- Missing information
- Tradability and enforcement: the bargain involves the trading of property rights, and the contract governing the trade must be enforceable
- Limited funds