Notes of lecture 2.
How to solve the problem (inefficient outcome) caused by market failure
(Externalities and Public goods/bads) ?
An externality exist when the consumption or production choices of one agent enters the
utility or production function of another agent without that agent’s permission or
There is no price on the externality, the externality is nonexcludable!
We cannot demand a price from the producer for being exposed to pollution.
When there are externalities in production, the private cost do not correspond to the
social cost of production.
PUBLIC GOODS (Non-rival goods):
A person’s consumption does not reduce the amount available to others.
Is the externality an excludable or nonexcludable good ?
Is the externality a rival or non-rival good (public or private good) ?
An externality is often a public bad! For instance polluting the air.
Correction of market failure:
1. Make a nonexcludable, rival good excludable through well – defined property rights.
Let the market fix the rest !
What about non-rival goods ? Problems with private information and free-riding
2. Introduction of administered prices for pollution - Pigovian fees)
1. Well defined property rights:
Well defined property rights mean you have the right to not be exposed to the pollution
(Clean air), or you have the legal right to pollute. These rights can be traded in the
market, as with ordinary goods.
Coase Theorem: As long as negotiation costs are negligible and affected consumers can
negotiate freely with each other, the court can allocate the entitlement to either party, and
an efficient allocation would result.
(1) perfect information
(2) consumers and producers are price takers
(3) costless court system
(4) profit max. producers, utility max. consumers
(5) no income or wealth effect
(6) no transaction costs.
If (1) to (6) holds, the initial assignments of property rights regarding the externalities
does not matter for efficiency
Example with two agents.:
Externalities in consumption.
Figure .
But, well defined property rights may not solve the problem if the commodity is a nonrival good (with many agents involved). Free –rider and private information.
Government intervention- pricing pollution – Pigovian fees.
Efficient level of pollution is where marginal benefit of emission (marginal savings
form emission) equals aggregate marginal damage cost of pollution.
A pigovean fee is a fee paid by the polluter per unit of pollution exactly equal to the
aggregate marginal damage caused by the pollution when evaluated at the efficient
level of pollution from pollution.
Fees versus subsidies
Market failure - imperfect competition