Chapter 12: Markets, efficiency and public policy
Overuse of antibiotics and pesticides is a social dilemma → unregulated pursuit of
self-interest leads to P areto inefficient outcome → = m arket failure (when markets allocate
resources in a Pareto inefficient way).
Governments provide a system of laws and enforcement to guarantee p roperty rights and
the enforcement of contracts → social norms dictate you respect the property rights.
→p roperty rights: legal protection of ownership, including the right to exclude others and to
benefit from or sell the thing owned.
Paragraph 1: Market failure: external effects of pollution
When analyzing gains from trade we must not only consider c onsumer and p roducer surplus, but
also the costs and benefits that parties other than buyers and sellers may experience.
External cost = positive or negative effect of a p roduction, consumption, or other e conomic
decision on a person that is not specified as a benefit or liability in a contract → external
effect because the effect in question is outside the contract → also called e xternal effect.
Marginal private cost (MPC) = cost for the producer of producing an additional unit of a
good, not taking into account any costs its production imposes on others.
Marginal social cost (MSC) = cost of producing an additional unit of a good, taking into
account both the cost for the producer and the costs incurred by others a ffected by the good’s
production → sum of the m arginal private cost and the marginal external cost.
Marginal external cost (MEC) = cost of producing an additional unit of a good that is
incurred by anyone other than the producer o f the good.
→ at point where both parties cannot be better off at another allocation, price equals MSC.
Pollutants have negative external effects → alsco called environmental spillovers → bring private
benefits to users → by damaging the environment they impose e xternal costs.
Total costs = sum of all marginal external costs.
Paragraph 2: External effects and bargaining
Negotiate a private bargain between owners and workers = C oasan bargaining → preferable
when dealing with external effects by governmental intervention.
Ronald Coase: when one party is engaged in an activity that has the incidental effect of
causing damage to another, a n egotiated settlement between the 2 may result in a
Pareto-efficient allocation of resources → private bargaining ensures Pareto efficiency.
Costs of bargaining also called transaction costs: costs that obstruct the bargaining process o r
the agreement of a contract → include (1) costs of acquiring information about the good to be
traded, and (2) c osts of enforcing a contract.
→ b argaining may fail when: there is a lack of established property rights, and other
impediments leading to high transaction costs, (2) one party regards the o utcome as unfair.
The maximum an industry/firm would pay is the fallback (reservation) option.
Practical obstacles to bargaining may prevent the achievement of Pareto efficiency:
- Impediments to collective actions: private bargaining may be impossible if there are
many parties on both sides of the external effect → difficult to secure.
- Missing info: only with info about origin the exact payment can be calculated.
- Tradability and enforcement: The bargain involves the trading of property rights, and
the contract governing the trade must be enforceable.
- Limited funds: not enough money.
Minimum acceptable payment = loss of surplus.
,Paragraph 3: External effects: policies and income distribution
What can the government do to achieve a reduction in output to the level that takes into account the
costs for sellers? → (1) regulation of the quantity produced, (2) t axation of the production or sale
of a good, (3) enforcing compensation of the sellers for the costs imposed on them.
1. If sellers differ in size and output, it’s difficult to determine and reinforce the right
quota for each one → it reduces the c osts of pollution, but lowers the profits.
2. Tax = MSC - MPC → when a tax is equal to the costs imposed on sellers, it is a
Pigouvian tax (negative external effect): a tax raised on activities that generate negative
external effects to correct an inefficient market outcome → Pigouvian subsidy
(positive external effect): if the marginal social benefit of a decision is greater than the
marginal private benefit → e xternal benefit.
→ c osts of pollution reduced by same amount as regulation, but reduction in profits is
greater → sellers pay taxes and reduce outputs, government receives a tax revenues.
3. Motivates sellers to find the best alternative.
Limits to power government:
- The government may not know the d egree of harm suffered by individuals: can’t
create the best c ompensation policy.
- Marginal social costs are d ifficult to measure: marginal private costs are well known,
but harder to determine social costs, like p ollution costs to individuals and society.
- The government may f avour the more powerful group: Pareto-efficient outcome that
is also unfair.
Arthur Pigou: using economics for good of society → political freedom and relative status.
→ Pigouvian taxes to ensure that producers face the true social costs of their decisions.
Paragraph 4: Property rights, contracts and market failures
Costs inflicted on others are e xternal diseconomies (or negative externalities): n egative effect
of production, consumption, or other economic decision, not specified as a liability in a
contract.
Uncompensated benefits granted to others are external economies (or positive externalities):
positive effect of production, consumption, or other economic decision, that is not specified
as a benefit in a contract.
Market failure when e xternal benefits and c osts of a person’s actions aren’t owned by anyone.
→ ‘incomplete, missing, or unenforceable property rights’ → i ncomplete contract = contract
that does not specify, in an enforceable way, every aspect of the exchange that affects the
interests of parties to the exchange (or of others) → no market where the external effects can
be compensated.
Missing market = market in which there is some kind of exchange that would be mutually
beneficial → does not occur due to asymmetric o r non-verifiable i nformation.
Uncompensated external costs and benefits occur because:
- Some info that is of concern to someone other than the d ecision-maker is
non-verifiable or a symmetric information: r elevant to the parties in an economic
interaction and known by some but not by others → no contract or property rights
ensuring that external effects will be compensated.
- As a result, some of the social costs o r benefits o f the decision-maker’s actions will not
be included in the decision-making process.
Paragraph 5: Public goods
(1) Public good = use by one person does not reduce its availability to others.
, → examples: irrigation system, national defense, weather forecasting, knowledge → provided
by government rather than m arkets.
→ once the good is available, the MC of making it available to additional people is zero →
non-rival goods: consumption by one person does not diminish its availability for others →
potential users are not in competition ( rival) with each other for the good.
(2) Non-excludable public good = it is impossible to exclude anyone from having access.
→ excluding = copyright: ownershiprights over use and distribution of an original work.
→ opposite from non-excludable is a p rivate good: rival and others can be e xcluded.
(3) Artificially scarce good = public good where it is possible to exclude s ome people from
joining → “club goods” because they function like joining a private club.
(4) Common-pool resource = a r ival good that one cannot prevent others from enjoying →
FEX. fisheries and public roads, that are open to all.
Private bad = non-rival in the sense that a given individual’s consumption of the public bad
does not diminish others’ consumption of it → things people don’t want and willing to pay
not to have → FEX. air pollution.
Rival Non-rival
Excludable Private goods (food, house). Artificially scarce public goods (tollroads).
Non-excludable Common pool resources. Non-excludable goods and bads.
Markets allocate p rivate goods, because: (1) when goods are non-rival, the MC=0, and (2) when
goods are not excludable there is no way to charge a price for them.
Paragraph 6: Missing markets: insurance and lemons
Form of a symmetric info = h idden action: when some action taken by one party to exchange
is not known or cannot be verified by the other → FEX. the employer cannot know (or cannot
verify) how hard a worker actually working → also known as moral hazard: an action affects
the wellbeing of another which the other cannot c ontrol by means of a contract → example of
principal-agent problem.
Form of a symmetric info = h idden attributes: when some a ttribute of person engaging in an
exchange is not known by other parties → FEX. an individual purchasing health insurance
knows own health status, but the insurance company does not → called: a dverse selection.
Market for lemons (worthless cars) is a problem of hidden attributes.
→ if price is equal to MC of average quality products, only producers of poor quality or fake
products would want to sell.
Paragraph 7: Incomplete contracts and external effects in credit markets
Principal-agent problem: hard work to ensure success for which f unds are borrowed and the
repayment of the loan cannot be secured by an e nforceable contract.
Equity = an individual’s own investment in a project → recorded in an individual’s or firm’s
balance sheet as net worth.
Collateral = an asset that a borrower promises to a lender as a security for a loan → if the
borrower is not able to make the loan payments, the lender becomes the owner of the asset.
→ lenders can reduce the m oral hazard problem by requiring e quity or c ollateral, which only
richer people are able to provide.
Poor borrowers may be credit-constrained (individuals who are able to borrow only on
unfavourable terms) or credit-excluded (individuals who are unable to borrow on any terms).
→ form of m arket failure when wealth is very unequally distributed.
Overuse of antibiotics and pesticides is a social dilemma → unregulated pursuit of
self-interest leads to P areto inefficient outcome → = m arket failure (when markets allocate
resources in a Pareto inefficient way).
Governments provide a system of laws and enforcement to guarantee p roperty rights and
the enforcement of contracts → social norms dictate you respect the property rights.
→p roperty rights: legal protection of ownership, including the right to exclude others and to
benefit from or sell the thing owned.
Paragraph 1: Market failure: external effects of pollution
When analyzing gains from trade we must not only consider c onsumer and p roducer surplus, but
also the costs and benefits that parties other than buyers and sellers may experience.
External cost = positive or negative effect of a p roduction, consumption, or other e conomic
decision on a person that is not specified as a benefit or liability in a contract → external
effect because the effect in question is outside the contract → also called e xternal effect.
Marginal private cost (MPC) = cost for the producer of producing an additional unit of a
good, not taking into account any costs its production imposes on others.
Marginal social cost (MSC) = cost of producing an additional unit of a good, taking into
account both the cost for the producer and the costs incurred by others a ffected by the good’s
production → sum of the m arginal private cost and the marginal external cost.
Marginal external cost (MEC) = cost of producing an additional unit of a good that is
incurred by anyone other than the producer o f the good.
→ at point where both parties cannot be better off at another allocation, price equals MSC.
Pollutants have negative external effects → alsco called environmental spillovers → bring private
benefits to users → by damaging the environment they impose e xternal costs.
Total costs = sum of all marginal external costs.
Paragraph 2: External effects and bargaining
Negotiate a private bargain between owners and workers = C oasan bargaining → preferable
when dealing with external effects by governmental intervention.
Ronald Coase: when one party is engaged in an activity that has the incidental effect of
causing damage to another, a n egotiated settlement between the 2 may result in a
Pareto-efficient allocation of resources → private bargaining ensures Pareto efficiency.
Costs of bargaining also called transaction costs: costs that obstruct the bargaining process o r
the agreement of a contract → include (1) costs of acquiring information about the good to be
traded, and (2) c osts of enforcing a contract.
→ b argaining may fail when: there is a lack of established property rights, and other
impediments leading to high transaction costs, (2) one party regards the o utcome as unfair.
The maximum an industry/firm would pay is the fallback (reservation) option.
Practical obstacles to bargaining may prevent the achievement of Pareto efficiency:
- Impediments to collective actions: private bargaining may be impossible if there are
many parties on both sides of the external effect → difficult to secure.
- Missing info: only with info about origin the exact payment can be calculated.
- Tradability and enforcement: The bargain involves the trading of property rights, and
the contract governing the trade must be enforceable.
- Limited funds: not enough money.
Minimum acceptable payment = loss of surplus.
,Paragraph 3: External effects: policies and income distribution
What can the government do to achieve a reduction in output to the level that takes into account the
costs for sellers? → (1) regulation of the quantity produced, (2) t axation of the production or sale
of a good, (3) enforcing compensation of the sellers for the costs imposed on them.
1. If sellers differ in size and output, it’s difficult to determine and reinforce the right
quota for each one → it reduces the c osts of pollution, but lowers the profits.
2. Tax = MSC - MPC → when a tax is equal to the costs imposed on sellers, it is a
Pigouvian tax (negative external effect): a tax raised on activities that generate negative
external effects to correct an inefficient market outcome → Pigouvian subsidy
(positive external effect): if the marginal social benefit of a decision is greater than the
marginal private benefit → e xternal benefit.
→ c osts of pollution reduced by same amount as regulation, but reduction in profits is
greater → sellers pay taxes and reduce outputs, government receives a tax revenues.
3. Motivates sellers to find the best alternative.
Limits to power government:
- The government may not know the d egree of harm suffered by individuals: can’t
create the best c ompensation policy.
- Marginal social costs are d ifficult to measure: marginal private costs are well known,
but harder to determine social costs, like p ollution costs to individuals and society.
- The government may f avour the more powerful group: Pareto-efficient outcome that
is also unfair.
Arthur Pigou: using economics for good of society → political freedom and relative status.
→ Pigouvian taxes to ensure that producers face the true social costs of their decisions.
Paragraph 4: Property rights, contracts and market failures
Costs inflicted on others are e xternal diseconomies (or negative externalities): n egative effect
of production, consumption, or other economic decision, not specified as a liability in a
contract.
Uncompensated benefits granted to others are external economies (or positive externalities):
positive effect of production, consumption, or other economic decision, that is not specified
as a benefit in a contract.
Market failure when e xternal benefits and c osts of a person’s actions aren’t owned by anyone.
→ ‘incomplete, missing, or unenforceable property rights’ → i ncomplete contract = contract
that does not specify, in an enforceable way, every aspect of the exchange that affects the
interests of parties to the exchange (or of others) → no market where the external effects can
be compensated.
Missing market = market in which there is some kind of exchange that would be mutually
beneficial → does not occur due to asymmetric o r non-verifiable i nformation.
Uncompensated external costs and benefits occur because:
- Some info that is of concern to someone other than the d ecision-maker is
non-verifiable or a symmetric information: r elevant to the parties in an economic
interaction and known by some but not by others → no contract or property rights
ensuring that external effects will be compensated.
- As a result, some of the social costs o r benefits o f the decision-maker’s actions will not
be included in the decision-making process.
Paragraph 5: Public goods
(1) Public good = use by one person does not reduce its availability to others.
, → examples: irrigation system, national defense, weather forecasting, knowledge → provided
by government rather than m arkets.
→ once the good is available, the MC of making it available to additional people is zero →
non-rival goods: consumption by one person does not diminish its availability for others →
potential users are not in competition ( rival) with each other for the good.
(2) Non-excludable public good = it is impossible to exclude anyone from having access.
→ excluding = copyright: ownershiprights over use and distribution of an original work.
→ opposite from non-excludable is a p rivate good: rival and others can be e xcluded.
(3) Artificially scarce good = public good where it is possible to exclude s ome people from
joining → “club goods” because they function like joining a private club.
(4) Common-pool resource = a r ival good that one cannot prevent others from enjoying →
FEX. fisheries and public roads, that are open to all.
Private bad = non-rival in the sense that a given individual’s consumption of the public bad
does not diminish others’ consumption of it → things people don’t want and willing to pay
not to have → FEX. air pollution.
Rival Non-rival
Excludable Private goods (food, house). Artificially scarce public goods (tollroads).
Non-excludable Common pool resources. Non-excludable goods and bads.
Markets allocate p rivate goods, because: (1) when goods are non-rival, the MC=0, and (2) when
goods are not excludable there is no way to charge a price for them.
Paragraph 6: Missing markets: insurance and lemons
Form of a symmetric info = h idden action: when some action taken by one party to exchange
is not known or cannot be verified by the other → FEX. the employer cannot know (or cannot
verify) how hard a worker actually working → also known as moral hazard: an action affects
the wellbeing of another which the other cannot c ontrol by means of a contract → example of
principal-agent problem.
Form of a symmetric info = h idden attributes: when some a ttribute of person engaging in an
exchange is not known by other parties → FEX. an individual purchasing health insurance
knows own health status, but the insurance company does not → called: a dverse selection.
Market for lemons (worthless cars) is a problem of hidden attributes.
→ if price is equal to MC of average quality products, only producers of poor quality or fake
products would want to sell.
Paragraph 7: Incomplete contracts and external effects in credit markets
Principal-agent problem: hard work to ensure success for which f unds are borrowed and the
repayment of the loan cannot be secured by an e nforceable contract.
Equity = an individual’s own investment in a project → recorded in an individual’s or firm’s
balance sheet as net worth.
Collateral = an asset that a borrower promises to a lender as a security for a loan → if the
borrower is not able to make the loan payments, the lender becomes the owner of the asset.
→ lenders can reduce the m oral hazard problem by requiring e quity or c ollateral, which only
richer people are able to provide.
Poor borrowers may be credit-constrained (individuals who are able to borrow only on
unfavourable terms) or credit-excluded (individuals who are unable to borrow on any terms).
→ form of m arket failure when wealth is very unequally distributed.
