Candidate ID: AD02159
Submission Date: 2nd May 2023
Word Count: 1327
1. Use a diagram of a market with an external cost to show that private
bargaining between the parties involved will result in a Pareto-efficient
allocation, regardless of which party has the property rights (in the
absence of transactions costs). Is the fairness of the allocation reached
affected by which party has the property rights? What are some of the
barriers to this type of private bargaining?
When markets allocate goods in a way which is not pareto efficient, it is called market
failure. These decisions fail to consider the effect of decisions on others, hence, consider the
costs or benefits to parties that are neither the buyer or the seller. When an effect is termed as
‘external’, it refers to something that is not specified as a benefit or liability in the contract.
External cost refers to a negative externality.
To graphically explain this market failure, we consider the market of a mango plantation,
which utilises a harmful pesticide to aid growth of their mangoes. However, these chemicals
flow downstream and affect a village of fishermen. Thus the pollutants have created external
costs in the name of ‘environmental spill overs’, by bringing benefit to the people who utilize
them but ultimately harming the environment and those who rely on these resources. From an
economic point of view, there is market failure as the pesticide is overused and the associated
goods (mangoes) oversupplied.
In a competitive market, a horizontal line will
show the market price as all firms are price
takers, thus, the mango plantation will choose
a price where this line intersects its marginal
private costs, in order to remain profitable.
However, this allocation is pareto inefficient
as the fishermen bear losses equal to the
shaded area in Diagram 1. The pareto efficient
output would be at the point where market
price is equal to the marginal social cost, at
which the quantity of mangoes is reduced.
Both plantation owners and fishermen will be
better off as the fishermen can pay off the
firms with a portion of their savings (as their loss has decreased) and the owners will still be
making a profit as their MPC will still be less than price.
The solution above of paying off the mango
owners to reduce output is called private
bargaining, or Coasean bargaining. Assuming one
individual from each group negotiates and only the
mango output can be changed, both sides should
realise that be reducing it to the pareto efficient
level, both parties can gain. As per Diagram 2, the
gain for fishermen is equal to the loss of profit and
the net social gain when output is reduced.
Reducing output leads to a loss of producer surplus
and profit and finally the net social gain is the total
gain for fishermen minus the loss of profit. Since
clearly the gain for fishermen is greatest, they would be willing to pay off the mango
plantation owners to reduce their output. The minimum acceptable offer from the fishermen
would depend on what the owners would get in the existing situation, which is their
reservation profit, or loss of profit. The maximum the fishing industry would be willing to
pay is determined by their fallback, or reservation option in which they pay their entire gain
off. If this were to happen, owners would get the entire net social gain and the fishermen
would be no better off. The final compensation the two parties agree on, depends on their
bargaining power.
Many may view the pareto efficient level as unfair as the fishermen have to pay to reduce the
owners pollution, however, it is assumed that the plantation has legal rights over the usage of
pesticides. An alternative scenario is one in which it is assumed one of the parties has
property rights over the resources. For example, if the fishermen had legal rights over clean
water, then the plantation owners wishing to use the pesticide would have to propose a
bargain to pay off the fishermen to give up their rights.
In either scenario, market failure tends to get rectifies but the distribution of benefits differ.
However, there are some barriers to this type of bargaining. Firstly, the implications of
collective actions, that is that private bargaining may only be possible if both parties have a
representative body to reflect the beliefs and make agreements for the entire body, this can be
problematic when there are too many people. Secondly, decision a payment scheme requires
measuring the cost of the pesticide for each fishermen affected and also locating the source of
each pollutant which is too time consuming, cost ineffective and tough to achieve with
missing information. Thirdly, the barraging relies on a strong legal framework to protect and
enforce their deal of reducing output or trading property rights, so the government needs to
have clear and final contracts. Lastly, if the fishermen or affected party have limited funds,
they may not be able to pay off the owners to reduce output.
Word Count: 763
5. Use a Lorenz curve diagram to show how labour market segmentation
can lead to increased income inequality. How might the government and
labour unions try to reduce segmentation? Do all workers benefit from
eliminating segmentation?
Labour segmentation is the division of the labour market according to a principle such as
occupation, geography and industry, that cannot be attributed to differences in productivity
alone. For example, in the primary labour market, workers tend to be represented by trade
unions and enjoy high wages and job security. They also have the opportunity to use ‘job
ladders’ to get promoted and increase these benefits. These are the ‘good jobs’. On the other
hand, workers in the secondary market are on short term contracts with limited wages and
security. The majority of these workers tend to be young and from discriminated or minority
ethnic or race groups. There are several informal names given to this section of the economy,
including ‘zero hour contract’, which reflect how there is no commitment by the employer to
provide extended periods of work and pay. In a nutshell. For any given skill or endowment,
the primary workers tends to reap the benefits with higher pay, which ultimately adds to
increasing income inequality.
The Diagram on the left shows the
impact of a reduction in labour market
segmentation. Initially the secondary
labour workers receive just 10% of the
output, whereas, the same proportion of
primary labour workers received 50%
of output. When the segmentation is
removed, all workers, primary or
secondary, receive the same pay and as
a whole receive 60% of the income.
The line (Lorenz curve) is a smooth and
upward sloping. In both scenarios,
unemployed workers receive no income
and the owners receive 40% of total
income. The Gini coefficient, which is
calculated by dividing the area between the Lorenz curve and perfect equality line by the total
area under the perfect equality line, falls from 0.52 to 0.36. This indicates a greater level of
equality within the economy as the absolute value approaches 0. There will be an outward
shift of the curve in the case of increased segmentation, indicating more inequality.
The government contributes to reducing labour market segmentation using pre-redistribution
strategies. This entail affecting the endowments that people have and their value, leading to
reduced inequality as peoples qualities and productivity enhance, leading to less
discrimination based on superficial aspects. It alters a person’s wages prior to taxation. One
such example of a policy is the anti-discrimination policy, this increases the value of the
labour endowment of those targeted by discrimination. Furthermore, there is the minimum
wage act which legally requires employers to pay above a certain amount and prevent
exploitation. This raises the income of poor and targeted groups and reduces income of the
employers, reducing overall inequality.
However, these polices and reduction in segmentation may not benefit all workers. Due to the
increases costs to employers of hiring workers from the secondary labour market, due to acts
such as minimum wages, they may wish to cut back employability in order to cut costs and
increase profits. This may lead to unemployment amongst poorer working class groups.
Furthermore, due to increased costs, firms may have to increase markup on their goods in
order to remain profitable, leading to cost push inflation. This would ultimately eat into the
disposable income of the working class and leave them no better off.
In conclusion, while reduction in segmentation of the labour market may help reduce the
economies overall inequality, there will be people who will be made worse off due to certain
policy implementations.
Word Count: 564
Bibliography:
CORE. (2017). CORE - Economics for a changing world. [online] Available at:
https://www.core-econ.org/.