Unit10 Feb2015 PDF

10
February 2015 beta
MARKET SUCCESSES
AND FAILURES
Courtesy of US Coastguard
WHY MANY, BUT NOT ALL, GOODS ARE BOUGHT AND SOLD IN
MARKETS. HOW MARKETS CAN WORK WELL, BUT SOMETIMES FAIL.
You will learn:

That the functioning of markets depends on the establishment of property rights and
enforcement of contracts by governments.
How market competition provides incentives for innovation.
Market failure arises from a lack of competition, or external effects such as pollution and
knowledge creation.
How these external effects can result in the misallocation of resources.
How private bargaining, government policy, or a combination of the two might improve
this allocation.
That the distribution of income among individuals depends on what they own (including
their skills), and on the prices at which these endowments are traded.
That for moral and political reasons some goods and services are not traded on markets,
but are allocated by other means.
See www.core-econ.org for the full interactive version of The Economy by The CORE Project.
Guide yourself through key concepts with clickable figures, test your understanding with multiple choice
questions, look up key terms in the glossary, read full mathematical derivations in the Leibniz supplements,
watch economists explain their work in Economists in Action and much more.
Funded by the Institute for New Economic Thinking with additional funding from Azim Premji University and Sciences Po
coreecon | Curriculum Open-access Resources in Economics

since the discovery of penicillin in 1928, the development of antibiotics
has brought huge benefits to mankind. Diseases that were once fatal are now
easily treatable with medicines that are cheap to produce. But the World Health
Organisation has recently warned that we are heading for a post-antibiotic era as
bacteria are becoming resistant: Unless we take significant actions to change how
we produce, prescribe and use antibiotics, the world will lose more and more of these
global public health goods and the implications will be devastating.
Not all markets work well. Bacteria become resistant to antibiotics when we use them
too often, in the wrong dosage or for conditions that are not caused by bacteria. In
India, where medicines are easily available over the counter in pharmacies without
a doctors prescription, doctors recognise that leaving the allocation of antibiotics to
the market is having damaging consequences. On the advice of unlicensed private
medical practitioners people use antibiotics when other treatments would be
better. The patients often stop taking the antibiotics to save money when they feel a
little better. This is exactly the pattern of use that will produce antibiotic-resistant
pathogens. But, for the patient, the treatment worked, and the unlicensed doctors
business will prosper. The challenge for the Indian government is how to regulate
the market without denying poor rural communities the chance to get the medicines
they need.
In The Wealth of Nations, Adam Smith explained how the owners of capital (motivated
by their individual desire for profit) and others (through their pursuit of a more
comfortable or pleasant life) would make economic decisions that would benefit
society as a whole. Capital would be invested where it was most productive, and the
consumption of goods and services would economise on societys scarce resources.
He wrote that each individual could be led by an invisible hand to promote an end
[the well-being of others] which was no part of his intention.
He also explained that this was not always the case, and that in many areas, such as
promoting education and limiting the powers of monopolies, government policies
were needed to promote social well-being and to ensure that markets work well.
We have studied a variety of marketsinstitutions in which buyers and sellers
are brought together to trade a good or a service. Smith reasoned that investors,
consumers and others exchange their goods on markets, and that a process of market
competition determines:
1. The prices at which people buy and sell.
2. The profitability of the capital owners investments.
We have studied market competition in Unit 6 where workers compete with each
other for jobs, and where firms compete to make profits by employing labour to
produce goods that they sell. In Units 7 and 8 we studied how firms compete when
selling their goods on markets that may be less or more competitive.
UNIT 10 | MARKET SUCCESSES AND FAILURES

How well markets work in reality, and what role markets should play in an economy,
are questions at the centre of political debate. Many people believe that markets
work well and that, except for special cases, the government should take a handsoff approach. Others think that we should use government policies to modify how
markets work, to ensure that the resulting allocations are fairand do not result in
unwanted side effects such as environmental degradation. Almost everyone thinks
that some things should not be bought and sold on markets, and should be allocated
in some other way.
At any point we see many different markets operating in an economy. We can
evaluate them by applying the criteria of Pareto efficiency and fairness to ask
whether the gains from trade in a particular market are fully exploited and are
fairly distributed. We can also ask whether the economy as a whole leads to a fair
distribution of the burdens and benefits of economic life.
One way to answer these questions is to consider the economy at a particular
moment, taking the existing knowledge, natural environment, technologies, skills,
population, and capital goods as given, and asking: how healthy is the economy
from the perspective of Pareto efficiency and fairness? We call this evaluation static
(meaning without change); it is a snapshot of the economy.
We can also evaluate the economy from a dynamic standpoint. A dynamic evaluation
is more like a film than a snapshot (because dynamic means changing). It draws our
attention to the introduction of new technologieslike the spinning jenny and the
other changes that account for historys hockey stick in Unit 1, such as the resources
devoted to education. A dynamic evaluation also asks if decisions we are making
today will affect the climate and natural environment for future generations.
In the previous unit we also showed that the prices at which goods and services are
bought and sold send messages to buyers and sellers, messages that motivate them
to consume, invest, and innovate in ways that sometimes result in the best use being
made of an economys productive potential. Are the messages sent by market prices
the right messages, ones that lead individuals promoting their own ends to make
decisions in the interest of others, including those who are not yet born?
In this unit we will evaluate different markets, and the workings of the market
system as a whole, demonstrating both successes and failures in the way they allocate
resources, and pointing out some reasons why most people do not support the idea
that everything ought to be for sale.

10.1 PROPERTY RIGHTS AND CONTRACTS
markets might seem to be everywhere in the economy, but this is not the
case. Firms, as we have seen in Unit 6, are organised hierarchically, not as a market.
Families do not allocate resources among parents and children by buying and selling.
Governments use the political process rather than market competition to determine
allocations of resources, such as the public road system.
In the past markets played a far smaller role in the economy. While people have
exchanged goods over long distances for at least 50,000 years, for most of human
history and prehistory there was no market in land or labour, because we didnt have
the conditions we needed to create a market. So what does a market require?
The most important requirement is private property. If something is to be bought
and sold, then it must be possible to claim the right to own it. You would hesitate
to pay for something unless you believed that others would acknowledge (and if
necessary protect) your right to keep it. Owning something, as we have seen in Unit
5, means two things: you can exclude others from using it, and you have the right to
any income that it creates including from the sale of it. Markets in land did not exist
through most of human history simply because individuals could not own land (in
many economies a farmer could exclude others from the land that he traditionally
used, but could not sell that land).
Markets in labour came into existence in two forms. The first was slavery, in which
the labourer himself or herself was sold. In the second and eventually more common
form, labour (meaning the activity of work) is not what is bought or sold. Instead the
employer buys the right to direct the workers activities during a specified period of
time, as we studied in Unit 6. The worker rents a willingness to be directed in this
way.
Therefore markets require a system of property rights, laws preventing theft or other
violations, and a means of enforcing and settling disputes regarding them.
Government has the important role of establishing and maintaining the legal
institutions supporting markets. The courts and police give governments the
ability to control theft, and the courts intervene in cases in which more than one
person claims ownership. Formal legal documents and a system of registration may
guarantee ownership of higher value goods, including land and houses.
If goods are privately owned, the only ways to acquire them are by buying them, or
being given them. Buying low-value tangible goods involves a straightforward swap
for money, but more complex transactions require contracts that can be used in court
as evidence that the parties agreed a transfer of ownership. For example, an author

may sign a contract giving a publisher the sole right to publish a book. Contracts
govern relationships that are to be maintained over a period of time, particularly
employment: in the labour market, a court upholds the right of the worker to work no
more than contracted hours.
Laws and legal traditions can also help markets function when they provide
compensation for individuals who are harmed by the actions of others. Liability
law, for example, ensures that if a firm sells a car with a design fault, and someone
is injured as a result, the firm must pay for the damage. Employers usually have
a duty of care towards their employees, requiring them to provide a safe working
environment.
The definition and enforcement of private property rights are the most essential
conditions for markets to work and governments, in the form of police and the
courts, are essential to provide these conditions.
But threats to the security of your possessions do not come only from other private
individuals. Governments powerful enough to enforce property rights always have
enough power to seize the goods of their citizens. In the 1950s Chinese peasants were
forced to surrender their land, animals and farm implements to collective ownership.
In Unit 1 we mentioned the importance of restraints on governments, so that we may
reasonably expect to enjoy the goods that we own and are able to profit from our
investments. Multinational firms considering investment in other countries factor in
the risk of the government seizing their assets. This is a real problem: the Venezuelan
government expropriated oil projects in the Orinoco Belt in 2007, for example. A
38% share of the projects was transferred from French, Norwegian, British and US
oil companies to the Venezuelan national oil company, giving it a controlling 78%
interest.
DISCUSS 1: PROPERTY RIGHTS AND CONTRACTS IN MADAGASCAR

Marcel Fafchamps and Bart Minten studied grain markets in Madagascar in 1997,
where the legal institutions for enforcing property rights and contracts were weak.
Despite this, they found that theft and breach of contract were rare. The grain
traders avoided theft by keeping their stocks very low and, if necessary, sleeping
in the grain stores. They refrained from employing additional workers for fear of
employee-related theft. When transporting their goods they paid protection money
and travelled in convoy. Most transactions took a simple cash and carry form. Trust
was established through repeated interaction with the same traders.
1. Do these findings suggest that strong legal institutions are not necessary for
markets to work?
2. Consider some market transactions in which you have been involved. Could
these markets work in the absence of a legal framework? How would they be
different?
3. Can you think of any examples of transactions where repeated interaction helps
to facilitate market transactions? Why might this be important even when a legal
framework is present?
Source: Fafchamps, M. and Minten, B. 2001. Property Rights in a flea market economy, Economic
Development and Cultural Change, 49(2), pp. 229-267.
10.2 MARKET FAILURE
where property rights exist, it is possible for markets to function. But, for a
market to function well, the messages that prices send must be the right ones. That
is, prices must measure the true scarcity of a good.
When prices send the wrong messages we have what is called a market failure. One
cause is a lack of competition. Competition among many buyers and sellers is an
essential part of Adam Smiths reasoning and, when it is absent or limited, the
invisible hand will not work.
We examined the implications of competition in Units 7 and 8. Firms facing little
competitionmonopolists or those producing differentiated goodsset their prices
above marginal cost. The price at which the good is sold then sends the wrong
message: the high price overstates the real scarcity of the good as indicated by its
marginal cost. The resulting allocation is not Pareto efficient: too little is sold, so
there is a deadweight loss. In contrast, firms in competitive markets are price-takers:
they produce where price is equal to marginal cost and the allocation maximises the
total surplus of the buyers and sellers.
But we also noted in Unit 8 that, even if a market is competitive, the allocation of
the good may not be Pareto efficient if the decisions of the buyers and sellers also
have costs or benefits for other people. Such an effect is known as an external cost or
external benefit, or simply an externality (you may also see externalities referred to as

external diseconomies and external economies for reasons like this), and this is a second
possible cause of market failure. Specifically, market failure occurs if consumers or
firms account for the direct costs and benefits to themselves when making decisions,
but not those imposed or conferred on others.
There are many economic decisions that have external effects:
If you use a car to travel to work, you contribute to traffic congestion for other
road users.
A firm that operates an incinerator produces fumes that lower the surrounding air
quality.
If you play music loudly at night, you disturb the sleep of your neighbours.
If a firm trains a worker, it may benefit from the workers increased skills; but if
the worker quits a different firm may receive the benefit.
When you are employed at a fixed wage, working harder brings no benefit to you,
but increases your employers profits.
When Kim (the farmer in Unit 4) contributes to the cost of an irrigation project,
other farmers will also benefit.
A country that invests in reducing carbon emissions helps to lower the risks of
climate change for other countries.
Several of these problems have the character of the social dilemmas we studied in
Unit 4. If you are a considerate person you probably care about your neighbours
sleep. But whenever the decision-maker does not take account of external effects
there is likely to be a misallocation of some resource. We have already seen in Unit
4 that if Kim takes into account only the costs and benefits to herself she will not
contribute to the irrigation project. The allocation of irrigation will not be Pareto
efficient.
As the list above illustrates, external costs or benefits arise in different contexts and
for different reasons. Climate change is a major social dilemma. An irrigation project
is a public good. Roads are (usually) a common property resource to which we all
have free access. The external effect of work effort arises because labour contracts
are incomplete. In other cases the externality seems to be an incidental side-effect.
The potential solutions for these problems differ too, but what they all have in
common is that the contracts, property rights, laws, markets and prices in the
economy do not provide incentives for individual consumers and firms to take into
account all the relevant costs and benefits of their decisions. Therefore some costs
and benefits are not reflected in market prices, resulting in a Pareto inefficient
allocation: there is a market failure.

10.3 MARKET FAILURE: POLLUTION EXTERNALITIES
when we analyse the gains from trade in markets for consumer goods such
as cars, books, clothes, or washing machines using the methods in Units 7 to 9, we
measure the gains to the buyers and sellers using consumer and producer surplus.
We must also include the external costs or benefits if others are affected by the
consumption or production of the good. We will use this approach to analyse the case
in which the production of a good creates an external cost in the form of pollution.
In the Caribbean islands of Guadeloupe and Martinique (both part of France), the
pesticide Chlordecone was used on banana plantations from 1972 until 1993 to
kill banana weevil, reducing costs and boosting the plantations profits. As the
chemical was washed off the land into rivers that flowed to the coast it contaminated
freshwater prawn farms, the mangrove swamps where crabs were caught, and coastal
fisheries.
To investigate the implications of this kind of externality, Figure 1 shows the
marginal costs of growing bananas on an imaginary Caribbean island where a
fictional pesticide called Weevokil is used. The purple line is the marginal cost for
the growers, which we label as the marginal private cost (MPC). It slopes upward
because the cost of an additional tonne increases as the land is more intensively used,
which requires more Weevokil. The orange line shows the marginal cost imposed
by the banana growers on fishermenthe marginal external cost (MEC). This is the
cost of the reduction in quantity and quality of fish caused by each additional tonne
of bananas. Adding together the MPC and the MEC, we get the full marginal cost
of banana production: the marginal social cost (MSC). This is the brown line in the
diagram. The orange shaded area in the figure shows the costs imposed on fishermen
by plantations using Weevokil. At each level of production this is the difference
between the marginal social cost and the marginal private cost.
900
Marginal social cost
800
Costs imposed on
fishermen by plantations
using Weevokil
700
Costs, $
600
500
Marginal private cost

Marginal external cost
400
300
200
100,000
90,000
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
100
Q, quantity of bananas (tonnes per year)
Figure 1. Marginal costs of banana production using Weevokil.
INTERACT
Follow figures click-by-click in the full interactive version at www.core-econ.org.
To focus on the essentials, we will consider a case in which the wholesale market for
bananas is competitive, and the market price is $400 per tonne. Then, if the banana
growers wish to maximise their profit, we know that they will choose their output
so that price is equal to marginal costthat is, marginal private cost. Figure 2 shows
that total output will be 80,000 tonnes at point A.
Although 80,000 tonnes maximises profits for banana producers, this does not
include the cost imposed on the fishing industry. You can see in Figure 2 that for
the first 38,000 tonnes, the price is greater than the MSC. Thinking about the
joint surplus of plantations and fisheries, we can see that this amount of banana
production is socially beneficial, even accounting for the pollution it causes. But
for every tonne of production above 38,000 the marginal cost to plantations and
fisheries together is greater than the revenue of $400 that the banana company
receives, decreasing the social surplus. It would be better to reduce production to
38,000.
900
800
Costs imposed on
using Weevokil
700
600
Costs, $
$ 270
500
400

Price
300
200
100,000
90,000
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
100
0
10
Figure 2. The choice of banana output.

In other words, production of 80,000 tonnes, when price equals MPC, is Pareto
inefficient. To see this, suppose that output was reduced by 1 tonne. This would
hardly affect banana profits (since price is equal to MPC) but fishermen would gain
$270. If the fishermen paid the plantation owners $135 (say) to reduce output by 1
tonne, everyone would be better off. They could do better still by reducing output
more. The Pareto efficient level of output would be 38,000 tonnes of bananas, at
which price equals MSC, and there are no further joint gains to be made.
10.4 EXTERNALITIES: POLICY AND DISTRIBUTION
the banana plantations use too much Weevokil and produce too many
bananas from a social point of view because they dont take account of the costs
imposed on fishermen. How can a society resolve such a problem? We shall see in the
next section that it may be possible to create conditions under which the fisherman
and the plantations can resolve it for themselves. Alternatively, a government might
intervene directly. There are several policies that could achieve the Pareto efficient
choice of pesticide and level of output, although they differ both in practicality and
their implications for the two industries.
Suppose that the government wants 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.

1. Regulation. The government could cap banana output at 38,000 tonnes, the Pareto
efficient amount. This looks like a straightforward solution. On the other hand, if the
plantations differ in size and output it may be difficult to determine and enforce the
right cap for each one.
This policy would reduce the costs of pollution for the fishermen, and it would
lower the plantations profit: they would lose their surplus on each tonne of bananas
between 38,000 and 80,000.
2. Taxation. At the Pareto efficient quantity the marginal private cost is $295. The
price is $400. If the government puts a tax on each tonne of bananas produced equal
to $400 - $295 = $105, then the after-tax price received by plantations will be $295.
The light blue line in Figure 3 shows the after-tax price. Now, if plantations maximise
their profit they will choose point P1 where the after-tax price equals the marginal
private cost, and produce 38,000 tonnes.
900
800
Costs imposed on
using Weevokil
700
Costs, $
600
500
400
Tax
300

Price
After tax price

received by
plantation
P1
200
100,000
90,000
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
100
Pareto efficient
quantity
Figure 3. Using a tax to achieve Pareto efficiency.

The distributional effects of taxation are different from those of regulation. 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; in addition, the government receives tax revenue. The tax corrects the price
message, so that the plantations face the full social marginal cost of their decisions.
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 a Pigouvian tax, after the
economist who advocated it.
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PAST ECONOMISTS
ARTHUR PIGOU
Arthur Pigou (1877-1959) was one of the first neoclassical economists to focus on
welfare economics: the analysis of the allocation of resources in terms of the wellbeing of society as a whole. Born in Ryde on the Isle of Wight, Pigou won several
awards during his studies at Cambridge in history, languages and moral sciences
(there was no dedicated economics degree at the time). He became a disciple
and protg of Alfred Marshall, and eventually succeeded him as professor of
Political Economy after Marshall manipulated the process in his favour. Although
Pigou was an outgoing and lively person when young, his experiences as a
conscientious objector and ambulance driver during the first world war, as well
as anxieties over his health, turned him into a recluse who hid in his office except
for lectures and walks.
Pigous economic theory was mainly focused on using economics for the good of
society, which is why he is sometimes seen as the founder of welfare economics.
His book Wealth and Welfare (1912) was described by Schumpeter as the greatest
venture in labour economics ever undertaken by a man who was primarily a
theorist, and provided the foundation for Economics of Welfare (1920). Together,
these works built up a relationship between a nations economy and the welfare
of its people. This was very much focused on happiness and well-being; concepts
such as political freedom and relative status were recognised as important
factors.
Pigou believed that reallocation of resources was necessary in the event of
what we would today call externalities, where the interests of a private firm or
individual had diverged from the interests of society. To solve this problem, Pigou
suggested the use of taxes, which now bear his name: Pigouvian taxes ensure that
producers face the true social costs of their decisions.
Pigou also wrote extensively on the labour side of welfare, such as the link
between short-run involuntary unemployment and labour demand, as opposed to
the effects of real wages (which he found to be less important than psychological
factors).
Despite both being heirs to Marshalls new school of economics, Pigou and
Keynes did not see eye-to-eye. Keyness The General Theory of Employment,
Interest and Money contained a critique of Pigous The Theory of Unemployment,
and Pigou felt that Keyness material was becoming too dogmatic and turning
students into identical sausages.
Although overlooked for much of the 20th century, Pigou paved the way for much
of labour economics and environmental policy. Pigouvian taxes were mostly
unrecognised until the 1960s but they have become a major policy tool for
reducing pollution and environmental damage.
3. Enforcing compensation. The government could require the plantation owners

to pay compensation for costs imposed on fisherman. 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 brown and purple lines in the diagram.
Once compensation is included the MPC will be equal to the MSC, so plantations will
maximise profit by choosing point P2 in Figure 4 and producing 38,000 tonnes. The
grey area shows the total compensation paid. The fishermen are fully compensated
for pollution, and the plantations profits are equal to the true social surplus of
banana production.
900
800
700
Costs, $
600
500
P2
400

Price
300
100,000
90,000
80,000
70,000
60,000
50,000
40,000
30,000
Total
compensation paid
20,000
100
10,000
200
Pareto efficient
quantity
Figure 4. The plantations compensate the fishermen.

The effect of this policy on the plantations profits is similar to the effect of the tax,
but the fisherman do betterthey, rather than the government, receive payment
from the plantations. Using calculus LEIBNIZ 20, part A, explains how the market
equilibrium fails to be Pareto efficient in presence of externalities. Part B shows how
a Pigouvian tax can re-establish Pareto efficiency.
13
14
LEIBNIZ
For mathematical derivations of key concepts, download the Leibniz boxes from
www.core-econ.org.
TEST YOUR UNDERSTANDING

Test yourself using multiple choice questions in the full interactive version at
www.core-econ.org.
When we identified 38,000 tonnes as the Pareto efficient level of output, we

implicitly assumed that growing bananas inevitably involves Weevokil pollution.
But that was not the case in Guadaloupe and Martinquethere were alternatives
to Chlordecone. If alternatives to Weevokil were available it would be inefficient to
restrict output to 38,000 tonnes, because if the plantations could choose a different
production method and the corresponding profit-maximising output, they could be
better off, and the fishermen no worse off.
The root of the problem was the use of Chlordecone, not the production of bananas.
The market failure occurred because the price of Chlordecone did not incorporate
the costs that its use inflicted on the fishermen, and so it sent the wrong message
to the firm. Its low price said: use this chemical, it will save you money and raise
profits, but it should have said: think about the downstream damage, and look for
an alternative way to grow bananas.
Of the three policies we considered, requiring the plantations to compensate the
fishermen would give them the incentive to find less polluting production methods,
and could in principle achieve an efficient outcome. But, for the other policies, it
would be better to regulate or tax the sale or the use of Chlordecone rather than the
production of bananas, to motivate them to find the best alternative to intensive
Chlordecone use.
If the tax on a unit of Chlordecone was equal to its marginal external cost, the price of
Chlordecone for the plantations would be equal to its marginal social costit would
be sending the right message. They could then choose the best production method
taking into account the high cost of Chlordecone, which would involve reducing

its use or switching to a different pesticide, and determine their profit-maximising
output. As with the banana tax, the profits of the plantations and the pollution costs
for the fisherman would fall; but the outcome would be better for the plantations,
and possibly the fisherman also, if Chlordecone rather than bananas were taxed.
Unfortunately, none of these remedies was used for two decades in the case of
Chlordecone, and the people of Guadaloupe and Martinique are still living with
the consequences. In 1993 it was finally recognised the social marginal cost of
Chlordecone use was so high that it should be banned altogether.
DISCUSS 2: POLICIES FOR POLLUTION

Which of the policies do you think should have been implemented? Which additional
facts you would like to know to answer this question? Evaluate the strengths and
weaknesses of each policy from the standpoint of Pareto efficiency and fairness.
10.5 EXTERNALITIES, BARGAINING AND PROPERTY RIGHTS
the economist ronald coase challenged the assumption that external costs
like those suffered by the fishermen require government intervention, arguing that
compensation can be negotiated privately.
Lets see how a private bargain might solve the problem of banana pesticide. Initially
it is not illegal to use Weevokil: the plantations have the right to use it, and they
produce 80,000 tonnes of bananas. This allocation and the incomes, environmental
effects and other outcomes represent the reservation position of the plantation
owners and fishermen. This is what they will get if they do not come to some
agreement.
For the fishermen and the plantation owners to negotiate, they would each have to be
organised so that a single person (or body) could make agreements on behalf of the
entire group. So lets imagine that a representative of an association of fishermen sits
down to bargain with a representative of an association of banana growers. To keep
things simple we will assume that, at present, there are no feasible alternatives to
Weevokil; so they are bargaining over the output of bananas.
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16

PAST ECONOMISTS
RONALD COASE
Ronald Coase (1910-2013) had the insight
to argue that when one party is engaged in
an activity that has the incidental effect of
causing damage to another, a negotiated
settlement between the two would result in
a Pareto efficient allocation of resources. He
used the legal case of Sturges v. Bridgman to
illustrate his argument. The case concerned
Bridgman, a confectioner (candy maker) who
for many years had been using machinery
that generated noise and vibration.
This caused no external effects until his
neighbour Dr Sturges built a consulting room
on the boundary of his property, close to the
confectioners kitchen. The courts granted
the doctor an injunction that prevented
Bridgman from using his machinery.
Source: By Ionel141 (Own work) [CC-BY-SA-3.0

(http://creativecommons.org/licenses/bysa/3.0)], via Wikimedia Commons.
Coase pointed out that, once the doctors right to prevent the use of the machinery
had been established, the two sides could modify the outcome. The doctor would be
willing to waive his right to stop the noise in return for a compensation payment. The
confectioner would be willing to pay if the value of his annoying activities exceeded
the costs that they imposed on the doctor. Also, the courts decision would make no
difference to whether Bridgman continued to use his machinery. If the confectioner
had been granted the right to use it, the doctor would have paid him to stop if and
only if the doctors costs were greater than the confectioners profits.
In other words, private bargaining would ensure that the machinery was used if and
only if its use along with a payment to compensate the doctor made both better
off. Private bargaining would ensure that its use was Pareto efficient. Bargaining
is simply a way to make sure that the candy-maker takes account of not only the
private marginal costs of producing candy but also for the external costs imposed
on the doctor, that is, on the entire social costs. To the candy maker, the price of
using the annoying machinery (or using it during the doctors visiting hours) would
now send the right message, for it would include not only the costs of powering the
machine, wear and tear and so on, but also the costs of compensating the doctor.
Private bargaining could thus be a substitute for liability law in ensuring that those
harmed were paid compensation, and that those inflicting harm would make every
effort to avoid doing so.
As long as private bargaining exhausted all the potential mutual gains, the result
would (by definition) be Pareto efficient, whatever the court decided. One could
object that the courts decision resulted in an unfair distribution of profits, but not
that the outcome was Pareto inefficient.
But Coase emphasised that this conclusion was of limited practical relevance
because of the costs of bargaining and other impediments to the parties exploiting
all possible mutual gains. For example, when there are a large number of parties
affected by decisions made by other individuals bargaining between the two sets of
parties will often be impossible unless they are organised into groups. These costs of
bargaining are sometimes called transaction costs and in their presence the outcome
of bargaining will not be Pareto efficient.
Coase also noted that the decision on who has rights has an impact on the incentives
to compromise. For example, the confectioner might have had to cease producing,
when it would have been relatively easy for the doctor to change his consulting
hours or improve the sound insulation and vibration resistance of the wall.
Coases analysis suggests that a lack of established property rights, and other
impediments leading to high transaction costs, can prevent the resolution of
externalities through bargaining. If there were a clear legal framework in which
one side initially owned the rights to produce (or to prevent production of) the
externality, and if these rights were tradable between the two parties in a market for
the externality, then there would be no need for further intervention. While this can
be a useful insight we also need to recognise, as he did, that establishing tradable
property rights is not easy, because of transaction costs.
Bargaining can fail for other reasons. Sometimes in Unit 4 players in the Ultimatum
Game failed to come to an acceptable agreement, both parties walking away empty
handed, when the Proposer claimed too large a slice of the pie.
Both sides should recognise that they could gain from an agreement to reduce output
to the Pareto efficient level. In Figure 5 the situation before bargaining begins) is
point A, and the Pareto efficient quantity is 38,000 tonnes. The gain for fishermen
(from cleaner water) if output is reduced from 80,000 to 38,000 is shown by the total
shaded area. The lost profit for plantations is the blue area, so the net social gain is
the remaining yellow area. The fishing industry could pay the plantations to reduce
output.
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900
800
700
600
Costs, $
500
Net social gain
400
Loss of profit

Price
300
200
100,000
90,000
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
100
0
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Pareto efficient
quantity
Figure 5. The gains from bargaining.

The minimum acceptable payment is determined by what the plantations get in
the existing situation: their reservation profits. This would be the blue area, to
compensate them for loss of profit. If this minimum payment were the deal they
struck, the fishing industry would achieve a net gain from the agreement equal to the
net social gain, while plantations would be no better off.
The maximum the fishing industry would pay is (as in the case of the plantations)
determined by their fallback (reservation) position, and it is the sum of the blue and
yellow areas; in that case the plantations would get all of the net social gain, while
the fishermen would be no better off. Unit 5 showed us that the compensation they
agree on between these maximum and minimum levels will be determined by the
bargaining power of the two groups.
You may think it unfair that the fishermen need to pay for a reduction in pollution.
At the Pareto efficient level of banana production, not only is the fishing industry
still suffering from pollution, but it also has to pay to stop it getting worse. This
happens because we have assumed that the plantations have a legal right to use
Weevokil. An alternative legal framework could give the fishermen a right to clean
water. If that were the case, the plantation owners wishing to use Weevokil could
propose a bargain in which they paid the fishermen to give up some of their right to
clean water to allow the Pareto efficient level of banana production, which will be a
much more favourable outcome for the fishermen.
We have reached the same conclusion as for the doctor and confectioner. Pareto
efficiency can be achieved irrespective of the initial allocation of property rights
including the right to pollute; although only in the unlikely event that there are no
transaction costs or other impediments to bargaining. But the initial allocation has a
big effect on the distribution of income.

Coase knew that in practice there are always obstacles to bargaining. Transaction
costs are likely to be high in this case. Coase focused on externalities involving just
two parties; here many plantations and fisherman are involved. Each side needs
to appoint someone they trust to bargain for them, and agree how payments will
be shared within each industry. Secondly, it must be possible to measure the costs,
which is difficult when we are discussing pollution. Thirdly, the contract must be
enforceable. Having agreed to pay thousands of dollars, the fishermen must be able
to rely on the legal system to back them if a plantation owner does not reduce output
as agreed.
A further problem in the case of the fisherman is that they may not be able to afford
to pay a large sum to the plantations to persuade them to reduce output. They will
eventually have higher incomes if pesticide use is curtailed, but if they cannot pay
until this happens (or borrow the money) the difficulties of writing an enforceable
contract are exacerbated. We will see in Unit 11 why they are unlikely to obtain a
loan.
The pesticide example illustrates that, although the resolution of externalities
through bargaining does not require direct government intervention, the
government still has an important role. It needs to establish the initial allocation
of property rights, to determine the reservation position of each side, and a legal
framework for enforcing contracts so that property rights are tradable. And in
determining their reservation positions it has a big influence on the relative
incomes of the banana and fishing industries: both sides have an incentive to lobby
for a favourable allocation of property rights. In Guadeloupe and Martinique, the
plantation owners had close relationships with the local government; which perhaps
explains why the right to use Chlordecone persisted for so long.
DISCUSS 3: BARGAINING POWER

What do you know about this problem that might affect the bargaining power of the
plantation owners and the fishermen? Think of other things that might plausibly
affect their bargaining power.
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DISCUSS 4: EXTERNALITIES AND MARKET POWER

Imagine that, in contrast to our example, there is a single banana plantation with a
large amount of market power (similar to the monopolies in Unit 7). Use the analysis
of firms with market power in Unit 7, and the analysis of external environmental
effects in this unit, to make a case for and against:
1. Making the banana market more competitive by breaking up the single
plantation into a large number of smaller producers (supposing this is possible).
2. Taxing the sale of bananas.
10.6 FAIRNESS: ENDOWMENTS, INCOME AND INEQUALITY
when we analyse the distributional consequences of an individual market, we

measure what individuals gain as a result of participatingtheir surplus. We have
seen, for example, that a firm with market power can increase its own surplus and
reduce that of consumers by setting a high price. But what determines the extent of
inequality in the distribution of resources in the market economy as a whole?
Imagine a country, Econesia, in which there are many islands. On each island
the natural resources and the skills of the population are suitable for one kind of
economic activity. The residents of Wheat Island grow grain and make bread, Goat
Island produces milk and meat, Coal Island is populated by miners, on Cotton Island
people grow cotton and make clothes, and so on. There are no firms; each family
owns the land and other resources for its work. At the weekly market (on Market
Island), people from all over the country buy and sell their produce. Each family
obtains income from selling its own produce, and uses it to buy other goods in the
market.
For every type of good produced there are many buyers and sellers; all markets are
perfectly competitive with the market prices equal to the marginal cost of producing
the good. And there are no externalities: no pollution, noise or traffic congestion. In
fact the allocation of goods in Econesia is Pareto efficient: there are no further trades
that could make anyone better off without making someone worse off.

The distribution of income in Econesia is very unequal. On some islands most people
have low incomes and consequently a low standard of living. All Econesians work
hard, but there are other islands where the residents have much higher incomes.
Some people describe the life of the rich Econesians as ostentatious, and think that
they have more than they need. Others say that they are entitled to do what they like
with the fruits of their labour.
Why are some islands rich and others poor? The main difference in income comes
from the prices at which they can sell their produce in the market. There is a small
island that produces chocolate, which is in high demand all over Econesia. Since
there are relatively few suppliers, the equilibrium price is high and the expert
chocolate producers enjoy a high standard of living. Miners are poor, however;
although they are skilled workers, coal is abundant, and an alternative source of
energy is available from Oil Island. So the price of coal is low.
There is inequality between people who live on the same island, too. On Cotton Island
some families own extensive plantations. Others scrape a living on a tiny plot of land.
Should we attribute inequality in Econesia to the market system? Some people think
that the market prices are unfair: after all, miners work just as hard as chocolate
makers. But the prices reflect how much people all over Econesiarich and poor
value the products. There is little that producers of less-valued goods can do about
this, although an advertising campaign might help. The difference in the wealth
which residents have before they enter the market is the underlying source of
inequality. Each person has an endowment, consisting of the land and productive
resources inherited from their parents, together with their skills; they use their
endowment to produce an income. Some families are endowed with more land or
larger workshops than others. Some were lucky enough to be born on islands with
the resources and skills to produce highly-valued goods; others have endowments
that are worth far less, because people dont want to buy what they produce, or
because there are many others with similar endowments.
The story of Econesia illustrates that an important source of inequality in income
is the endowments that people can use to generate that income. For most people
in the world, their endowment consists mainly of their skills, which are enhanced
by education or vocational training, and they generate income by working for
an employer. Nevertheless the same mechanisms are at work: those whose skill
endowments can be used to produce goods and services that people value will
earn higher incomes, provided that they have access to a workplace with the other
resources required in production. Those who own these resources will also have
higher incomes.
Of course, this is not the only source of inequality; unlike those in Econesia, most
markets are not perfectly competitive. We know from Unit 5 that the institutions in
a society determine the distribution of bargaining power, and that those with more
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bargaining powerlike the proposer in the Ultimatum Game in Unit 4 or the real
world plantation owners in Guadeloupe and Martiniquecan use it to take a large
share of the gains from trade.
Econesia has a democratic government. The government sets the rules under which
Market Island operates, ensuring that ownership rights and contracts are respected.
The government is considering a change in the distribution of income by regulating
the prices of some goods. We know from Unit 9 that this is likely to lead to excess
supply or demand. For example, if the government raises the price of coal above its
market clearing level, some miners may be unable to sell their output. An alternative
policy might be for the government to tax the sales of some goods (chocolate,
perhaps). This would probably raise the price of chocolate and reduce sales; however,
the tax revenue could be used to supplement the incomes of people on the poorest
islands. Or, since the fundamental source of inequality is the distribution of
endowments, it might be better to address it directlyby taxing more productive
land, for example.
But Econesia has competitive markets, no externalities and complete contracts.
Prices are sending the right messages to allocate goods efficientlychanging the
prices would distort the messages. If the people of Econesia care about the welfare
of others and want to reduce inequality and poverty there is an alternative policy
focusing on the fundamental source of the problemthe government could change
the distribution of endowments. The assets of Cotton Island could be shared more
equally between the residents: some of the land on the larger plantations could
be reallocated to those with smaller plots. Some of the productive land on Wheat
Island, which generates high incomes for the residents, could be redistributed to the
struggling miners.
Redistributing the endowments in Econesia could achieve a more equal society while
maintaining the efficiency of Econesias markets.
DISCUSS 5: INEQUALITY AND COMMUNITY

How likely are Econesians to implement measures reducing inequalities?
In a 2000 article (LINK) Alberto Alesina and Eliana La Ferrera suggest that group
homogeneity is a key determinant of successful collective actions. Using US group
membership survey data, they show that individual participation in church, local
services and political activities is more likely in communities characterised by a
higher degree of racial homogeneity and less income inequality.
Source: Alesina, A. and La Ferrara, E. 2000. Participation in Heterogeneous Communities. Quarterly
Journal of Economics, pp. 847-904.
You may have wondered how things got to be the way they are in Econesia, and
whether they will stay that way if the government does not intervene. The original
settlers just took the land they wanted, so both luck and the use of force played a
part in determining todays distribution of income. The miners have only been poor
since the discovery and settlement of Oil Island; perhaps in future they will find new
production techniques and develop new products or skills to increase their incomes.
One problem in Econesia is that people cannot move from a poor island to a richer
one (unless the government redistributes land): the miners cannot go elsewhere to
work because they dont own land on other islands (and no one wants to buy their
land). In reality, although it may be costly for workers to change industries, they
can develop new skills through education and training. New opportunities arise as
a result of innovation and technological change, because products and markets are
continually evolving.
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10.7 PUBLIC GOODS
markets are not the best way to determine the allocation of many kinds of goods
or services. We saw in Unit 6 that, within firms, tasks are assigned and resources
allocated by the command of management, not by the working of supply and
demand. As Coase pointed out, for the things that are done within firms, markets
are not the least-cost way to allocate resources. There is another large class of goods
and services for which this is also true. These are called public goods and they include
such things as a system of justice, national defence and weather forecasting, services
that are typically provided by governments rather than the market. Other examples
are the knowledge of the rules of multiplication or the view of the setting sun.
The defining characteristic of a public good is that if it is available to one person it
can be available to all at no additional cost. For a view of the setting sun, one more
person enjoying it does not deprive anyone else of enjoyment. This means that, once
the good is available at all, the marginal cost of making it available to additional
people is zero. Goods with this characteristic are sometimes called non-rival goods.
Pure public goods are non-rival goods from which others cannot be excluded.
Examples include a view of a lunar eclipse, knowing the time of day, and publically
broadcast signals such as weather forecasts or the news, for people in a particular
area.
For some public goods it is possible to exclude additional users, even though the
cost of their use is zero. Examples are satellite TV, the information in a copyrighted
book, or a film shown in an uncrowded cinema; it costs no more if an additional
viewer is there, but the owner can nonetheless require than anyone who wants to
see the film must pay a price. The same goes for a quiet road on which tollgates have
been erected. Drivers can be excluded (unless they pay the toll) even though the
marginal cost of an additional traveller is zero. Public goods from which people may
be excluded are sometimes called artificially scarce goods or club goods (as long as the
golf course is not crowded, adding a member costs nothing).
The opposite of public goods are private goods. Like the loaves of bread, dinners in
restaurants, pesetas divided between Ana and Beatriz, and boxes of breakfast cereal
that we have used as examples so far, private goods are both rival (more for Ana
means less for Beatriz) and excludable (Ana can prevent Beatriz from taking her
pesetas for herself).
There is a fourth kind of good that is rival, but not excludable. Examples include
fisheries open to all: what one fisherman catches cannot be caught by anyone else,
and anyone who wants to fish can do so. Figure 6 summarises the four kinds of
goods.
RIVAL
NON-RIVAL
EXCLUDABLE
Private goods (food,

clothes, houses)
Public goods that are artificially

scarce (subscription TV,
uncongested toll roads,
knowledge subject to intellectual
property rights, Unit 19)
NON-EXCLUDABLE
Common-pool
resources (fish stocks in
a lake, common grazing
land, Units 4 and 17)
Pure public goods and bads (view

of a lunar eclipse, public
broadcasts, rules of arithmetic or
calculus, national defence, noise
and air pollution, Units 17 and 19)
Figure 6. Private goods and public goods.

As can be seen from the examples, whether a good is private or public depends not
only on the nature of the good itself, but on legal and other institutions. For example,
knowledge that is not subject to copyright or other intellectual property rights would
be classified as a pure public good; but when an author has a monopoly on the right
to reproduce the work it is a public good that is artificially scarce. Another example:
common grazing land is a common-pool resource; but if the same land is fenced to
exclude other users, it becomes a private good.
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:
1. When goods are non rival the marginal cost is equal to zero and so setting a price
equal to a marginal cost (as is necessary for a Pareto efficient market transaction)
will not be possible unless the provider is subsidised.
2. When additional users cannot be excluded there is no way for the provider to
charge a price for the good or service.
It is not easy for governments to create public policy to achieve both Pareto efficient
and fair outcomes in cases where goods are not private. In the next section of this
unit and in Unit 20, we examine knowledge and intellectual property rights, and in
Unit 18 we return to common-pool resources and public bads.
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DISCUSS 6: RIVALRY AND EXCLUDABILITY

For each of the following goods or bads, decide whether they are rival, and whether
they are excludable, and explain your answer. If you think the answer depends on
factors not specified here, explain how.
1.
2.
3.
4.
5.
6.
A public lecture given at a university.

The noise produced by aircraft around an international airport.
A public park.
A forest used by local people to collect firewood.
Seats in a theatre.
Bicycles available for hire to the public to travel around a city
10.8 MARKETS AND INNOVATION
the television programme Dragons Den gives inventors three minutes to

pitch an idea for a new product to potential investors. They hope the investors will
back them with the finance needed to set up in business. We know more about the
successes, such as Reggae Reggae Sauce (created in 2007 by an entrepreneur called
Levi Roots, real name Keith Valentine Graham) and the ideas that had no hope of
being funded (a glove for drivers to wear on one hand to remind them which side
of the road to drive on) than about the credible investments that later failed. But
innovation almost always involves risky investments with uncertain returns, because
a new product or a new method of production typically requires new machinery, a
new way of organising sales or production, and other startup costs.
So far in our discussion of markets we have adopted a static viewpoint: given the
markets, firms, goods and workers that we observe in the economy now, are resources
allocated fairly and efficiently? But economies are continuously evolving and we
can also ask whether markets provide incentives for innovation and investment, to
improve the living standards of individuals and society in the future.
Successful innovation can contribute to rising living standards by expanding the set
of products available to consumers, and reducing the prices of existing products.
Many people in the world now have mobile phones, household appliances like
washing machines and vacuum cleaners, and access to entertainment such as films

and recorded music, all of which were unimaginable 100 years ago. Developments
in healthcare and pharmaceuticals have immeasurably improved the quality of life.
But innovation can be painful too. In Unit 2 we saw how the invention of the spinning
jenny contributed to the Industrial Revolution in England, but the first spinning
jennies were destroyed in attacks by workers who were worried that technology
would eliminate their jobs. As new products and industries are established, new
skills are needed, and workers with obsolete skills may suffer. The economist Joseph
Schumpeter (see Unit 2), who studied the role of the entrepreneur in society, called
the process of innovation and changing markets creative destruction.
We know that, in markets where many firms compete to sell identical or very similar
products, competition has the effect of reducing the price and expanding the
amounts produced so that the price approximates the marginal cost of production.
This is good for consumers because more goods are sold at a lower price; but it
lowers the profits of firms. A firm would prefer to be a monopolist or at least to sell a
differentiated good with unique characteristics not possessed by other products on
the market.
Competition thus gives firms the incentive to innovate. There are two ways in which
research and development (R&D) can create monopoly power. It might create a new
product, as attractive to consumers and as different from its competitors products
as possible. Toyotas hybrid car, the Prius, was a successful product innovation.
Alternatively a firm may find a better production process for an existing product.
If it can produce more cheaply than its competitors, profits will increase; if the cost
reduction is large it may even be able to set a price that other firms cannot match ,
and become a monopolist.
There is a catch, however. Monopoly power might not last long. Other firms will copy
a successful new product or process, increasing competition and reducing profits
again. For a firm to decide to invest in the R&D needed for successful innovation, it
must expect to be able to gain enough monopoly power, for long enough, to obtain a
return on its investment.
The problem for a firm is good news for the rest of us. For consumers and other firms,
this process of copying innovation reduces prices and makes desirable commodities
available. Since the 1980s competition between the worlds top mobile phone
companies such as Samsung (South Korea), Nokia (Finland), and Apple (US) has
stimulated a continuous process of product innovation and improvement in design
and capabilities, and further price competition. In 1996 Nokia combined a mobile
phone and Personal Digital Assistant in a single device and the smartphone was
born. Other companiesEricsson, Palm, Blackberry and NTT Docomodeveloped
the idea further, followed by Apples touchscreen device, the iPhone, in 2007. In 2013
world smartphone sales reached 1 billion.
The spinning jenny was a major process innovation. One worker operating a spinning
jenny could replace 12 spinsters with spinning wheels. Since wages in England were
high, it greatly reduced the costs of spinning cotton. Its inventor, James Hargreaves,
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spent several years perfecting his machine, with the backing of a businessman
called Robert Peel. Their incentive was clear: together they hoped to go into textile
production, and if they had been able to prevent others from using their invention
they would have made high profits. But this part of the plan failed, and other textile
manufacturers quickly adopted the jenny. If copying is easy, new technology will
spread fast and consumers can benefit from cheaper goods, but the rents available to
innovators disappear faster and this may slow down the pace of innovation.
Hargreaves experience illustrates the risks of R&D. If copying is easy, new
technology will spread fast and consumers can benefit from cheaper goods, but the
economic rents available to innovators disappear faster and this may slow down the
pace of innovation. The innovator may not capture enough of the return to make
the investment worthwhile. We can think of knowledge as a public good. Once
a new product or process is known, others can profit from it, free riding on the
original investment. Governments can address free riding by granting a patent to
the innovator. A patent is a right of exclusive ownership of an idea, which lasts for
a specified length of time (typically 20 years). During this time it effectively allows
the owner to be a monopolist or exclusive user. Although this did not protect the
spinning jenny (Hargreaves discovered that he had invalidated his patent by selling
some early jennies) there are many examples of successful use of patents, such as the
prolific inventor Thomas Edison (1847-1931), who made a fortune in telegraphy and
electric power distribution .
DISCUSS 7: PATENTS
Knowledge is a public good. Once produced, it can be made available to everyone
without further cost: think of calculus or the ideas of Ronald Coase. Patents are a
way to reward a knowledge-producing company by granting it the exclusive right to
exploit the knowledge commercially for a fixed period.
Surprisingly, the chief executive of Tesla Motors (a US-based electric car company)
decided last June to make public all the patents its company owned. Technology
leadership is not defined by patents, which history has repeatedly shown to be small
protection indeed against a determined competitor, but rather by the ability of a
company to attract and motivate the worlds most talented engineers, he wrote in a
blogpost: LINK.
Do you understand Teslas decision? Do you think executives in pharmaceutical firms
would be willing to do similarly?

Innovation involves a delicate balancing act for government policy. In established
markets competition lowers prices and increases gains from trade. Although change
may not benefit everyone, innovation can eventually raise our well-being. But
incentives for research and development (R&D) depend on solving the free rider
problem, perhaps by allowing monopoly power. In Unit 20 we will investigate how we
use patents in the trade-off between competition and monopoly.
Important innovations have emerged from combinations of public and private sector
R&D. The technology used to create the glass of iPhone screens is derived from
military research. In India, agricultural productivity has grown rapidly due to the
introduction of new seed varieties. Until the development of genetically modified
(GM) hybrids, research was conducted mainly by public sector organisations: private
companies could not profit from selling new varieties because once released, farmers
could produce new seed for themselves. But GM hybrids require repeat purchase
because second- generation seeds have low yields. This is one of the reasons why
private seed producing companies like hybrids. In the last 20 years competition
between plant biotechnology companies has led to the development of many new
hybrid seed varieties. Revolutionary insect-resistant cotton hybrids developed
through biotechnology have led to a boom in cotton exports. This is another example
of the delicate balance between monopoly power and R&D: the market power of
domestic and multinational biotech companies, and corporate control over seeds,
have caused concern, both about farmers dependence on multinational corporations
and environmental sustainability, but the new varieties have boosted the incomes of
Indian farmers.
While markets are powerful engines of innovation, there are some innovations
with large impacts on human well-being worldwide for which we need nonmarket
institutions, either to solve the free rider problem, or because the potential market is
small or lacks funding .
Consider, for instance, the case of vaccines. Using vaccines to eradicate a disease like
polio is both feasible and highly desirable. But this is almost impossible to achieve
through market mechanisms alone. No matter what the price of vaccination, there
will always be some people who are unable or unwilling to pay for them. This is
especially the case if the disease is rare, and the likelihood of contraction is perceived
to be low. Eradication needs a concerted global effort to vaccinate children without
exception and without charge. Historically, this has required coordinated action by
national governments and international agencies, sometimes with the assistance of
private foundations.
Here is a striking example. In 2009, there were 741 cases of polio in India, nearly
half the total number of reported cases. But on 13 January 2014, India marked three
years since its last reported polio case, and on 28 March 2014 it was officially declared
free of polio by the World Health Organisation. The eradication of polio in India
required 2.3 million vaccinators, and a large financial commitment by the national
government, the World Health Organisation, the Centres for Disease Control, the
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United Nations Childrens Fund, Rotary International and the Gates Foundation. Polio
is now endemic only in Pakistan, Afghanistan, and Nigeria, although international
travel allows the virus to be transmitted across their borders.
Without commitments like this by nonmarket institutions, we might not even have
the vaccines. In 1955 the virologist Jonas Salk (1914-1995) developed the earliest
polio vaccine deemed safe for human use at the University of Pittsburgh School of
Medicine. He relied on funding from the National Foundation for Infantile Paralysis
(now known as The March of Dimes Birth Defects Foundation). The vaccine was never
patented, and Salk made no money from it.
10.9 POSITIONAL EXTERNALITIES
some goods, such as cars and clothes, may act as status symbols. Their owners
value them partly because they rank them above other people.
Perhaps one of your motives when you buy a car, or a coat, is to demonstrate your
wealth and superior style. Or perhaps you settle for a cheaper second-hand coat while
feeling envious, or embarrassed, or disadvantaged at a job interview. The economist
and sociologist Thorstein Veblen (1857-1929) described the former as conspicuous
consumption: buying luxury items as a public display of social and economic status.
Goods that are valued more because they are expensive are known as Veblen goods.
Veblen goods are an example of a larger class called positional goods. They are
positional because they are based on status or power, which can be ranked as high or
low. Our positions in this rank, like the rungs of a ladder, may be higher or lower. But
there is only a fixed amount of a positional good to go around. If Maria is on a higher
rung of the ladder because of her new coat, somebody must now be on a lower rung.
The effect of positional goods on other people is a negative externality. To see its
implications, consider the case of Maria and her sister, moving with their families
to a new town. Each family has a choice between buying a luxury house or a more
modest one. Their payoffs are represented in Figure 7. Since both families have
limited funds they would be better off if both bought modest houses than if both
bought luxury ones, squeezing the rest of their budget. But, we already know that
Maria is status-conscious, and the two families are competitive when it comes to
lifestyle: if the Smiths buy a modest house, the Joneses can benefit from feeling
superior if they choose a luxury house. The Smiths, in turn, will feel miserable.
Figure 7. Keeping up with the Joneses.
You can see that this problem has the

structure of a Prisoners Dilemma.
Whatever the Joneses do, the Smiths are
better off with a luxury house. For both
couples, choosing Luxury is a dominant
strategy. They will achieve a payoff
of 1 each, and the outcome is Pareto
inefficient, because both would be better
off if they bought modest houses. The
root of this problem is the external cost
that one family imposes on the other by
choosing a luxury house. The price of the
luxury house that Marias family will buy
does not include the positional externalities
that purchasing it inflicts on her sisters
family. If it did, Maria would not buy the
luxury house, given the payoffs in the
table.
What can they do to avoid the Pareto inefficient outcome? We know from Unit 4 that
altruism would help, but these families are not altruistic about houses. Following
Coases advice, they could agree in advance that if one family has a better house
they will compensate the other, with a payment chosen to make Modest a dominant
strategy. However, courts might be unwilling to enforce a contract like this.
The keeping up with the Joneses problem that Maria and her sister face arises
because people care not only about what they have, but also about what they have
relative to what other people have. This is sometimes called a Veblen effect.
Veblen effects help to explain two facts about modern economies:
1. People work longer hours in countries in which the very rich receive a larger
fraction of the income. For example, the US has both higher hours of work and
a higher income share of the very rich than Germany, France, Sweden and the
Netherlands. The rich are the Joneses who people want to keep up with. To do
this, they work longer hours if the Joneses are richer. A century ago American
workers worked fewer hours than workers in any of the countries just named.
But over the past century the share of income going to the very rich declined in
all these countries. Sweden, for example, went from one of the most unequal
countries (by this measure) to one of the most equal.
2. As a nation gets richer, its people sometimes do not become happier or more
satisfied with their lives. Economists measure happiness by a persons answer to
survey questions such as Taken altogether, how would you say things are these
days? with responses from 1 (not too happy) to 3 (very happy). Between 1973 and
2004 the per capita real average income almost doubled in the US, but average
happiness barely moved, at a little better than 2. It is not that Americans had lost
interest in money. In the US, as everywhere, when people get a rise in their wages
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or lose their job it has a big effect on reported happiness. But economists have
also found that a change in our income has a much smaller effect if most of our
acquaintances have experienced the same change. When an entire nation gets
richer, the effect on individual happiness is modest, if there is one at all.
This is a Veblen effectjust as Maria being happier with a modest house if her sister
has one too. When Veblen effects are present the conspicuous consumption of the
well-off is a positional good and a public bad: it is experienced by everyone, reducing
their satisfaction with their own situation .
DISCUSS 8: VEBLEN EFFECTS AND POLICY

Veblen effects result in a market failure. Do you think that the government should
adopt policies to address this market failure, and if so, what might they be?
10.10 EVALUATING MARKETS
anything that we care about can be called a good (or if we dislike it, a bad).
Economics is about how goods (and bads) are allocated between people, and one
means of allocation is trade in a market. Imagine this scene, in which two economics
students are discussing what they have learnt about markets in Units 6 to 10:
Student A: If everything we cared about was allocated by trade in a perfectly
competitive market, the allocation of goods would be Pareto efficient. What we
need to do is make sure that there are property rights for all goods.
Student B: But thats not much use. We know that most markets arent perfectly
competitive. Firms can set prices.
Student A: Well, yes. But still, if goods are traded in markets the prices give at least
an indication of scarcity, and that helps to make sure they are allocated in the
right way. And markets give people incentives to innovate and producer better or
cheaper goods.
Student B: Problem is, there are lots of goods that cant be traded in markets at all.
Think about the fishermenthey care about the quality of the water in the sea,
and theres no market for that. And that means there are externalities. And what
about R&D? You need a market for new knowledge, but that wont work because
its a public good.

Student A: Yes, but thats where Coase comes in. Where there isnt a market to
do the job you establish property rights so that, when the allocation of goods is
inefficient, people can bargain and write contracts to sort out the problem.
Student B: I suppose that might work for some things. But it isnt always possible
to write complete contractsand its hard to imagine solving road congestion that
way. I suppose youd argue that roads ought to be privately-owned.
Student A: Maybe. But people find other ways of solving social dilemmaslike
irrigation systems or writing open source software. Perhaps markets arent always
the answer. Anyway, I think weve forgotten something important.
Student B: Fairness?
Student A: Yes. Its great if markets and property rights help us allocate goods
efficiently, but they wont help us distribute them fairly. Maybe thats the biggest
social dilemma of all.
At this point, the two students have reached some agreement. We know from the
story of Econesia that looking at the markets in the economy can help us understand
why some people are rich and others are poor, but if some people have valuable
endowments and others dont, markets will not address the problem of inequality. We
will return to this problem in Unit 19.
But the conversation above illustrates a device that economists often use. We
imagine an ideal world (perhaps a nightmare world) in which everything we care
about is allocated in markets (preferably competitive ones) or, where markets are not
possible, we can still exchange goods for money by writing contracts enforceable in
court. This can be a useful exercise: not because such a world is feasible or desirable,
but because it helps us understand the problems of market failure associated with
the allocation of individual goods. This may be a lack of competition or some kind of
external cost or benefitand that helps us to think about what solutions are feasible.
For example, what Student B says about the fisherman is true: one way of
interpreting an externality is to say that, if there were a market in which fisherman
and plantation owners could trade rights to clean water, it would solve the problem.
In the case of Caribbean fisherman that probably isnt feasible, but we will see in
Unit 20 that new markets have been established to address the problem of carbon
emissions.
Figure 8 illustrates some cases of market failure. We have encountered these
examples before, except for the case of a public bad: just as a public good benefits
every member of a group in the same way, a public bad is costly for everyone. In
these examples the fundamental problem is not a lack of competition. Instead
there is some kind of external cost or benefit which individuals making economic
decisions ignore. Where people dont take account of an external cost, as in the case
of the banana growers, the private marginal cost of their decision is below the social
marginal cost and this leads them to buy too much of the costly good (bananas, or
Weevokil) from a social point of view. We can interpret external benefits similarly:
when the private benefit of a good is below the social benefit, people buy too little.
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34
TYPE OF
PROBLEM
THE DECISION
HOW IT AFFECTS
OTHERS
COST OR
BENEFIT?
MARKET FAILURE
(MISALLOCATION
OF RESOURCES)
PUBLIC GOOD
A firm invests
in R&D
Other firms can

exploit the
innovation
External
benefit
Too little R&D
PUBLIC BAD
You take an
international
flight
You increase
global carbon
emissions
External
cost
Over-use of
aeroplanes
NEGATIVE
EXTERNALITY
(EXTERNAL
DISECONOMY)
A firm uses a
pesticide that
runs off into
waterways
Damage to the
fishing industry
External
cost
Over-use of
pesticide and
over-productio
n of bananas
POSITIVE
EXTERNALITY
(EXTERNAL
ECONOMY)
A firm trains a
worker
Another firm
benefits if the
worker quits
External
benefit
Too little
training
COMMON
PROPERTY
RESOURCE
You travel to
work by car
Congestion for
other road
users
External
cost
Over-use of
public roads
INCOMPLETE
CONTRACT
An employee
on a fixed wage
decides how
hard to work
Hard work
increases her
employers
profits
External
benefit
On-the-job
effort is too low
Figure 8. Some examples of market failure.

There are several ways of interpreting the problems in Figure 8. They all arise
because people do not take appropriate account of the effect of their actions on
others. We could say that this happens because there is no market for some goods
knowledge or effort, for example. This means that someone who produces knowledge
or exerts effort confers an uncompensated benefit on others. But we know from Coase
that markets are not essential for efficient allocation. So we could say instead that
the problems arise when the contracts that govern our exchanges are missing,
incomplete or incompletely enforced. A firm that undertakes R&D lacks a contract
with other firms to protect its profit from innovation.
In case of an external cost, the person who inflicts the damage is not held liable in
the way that a person who caused a fire that destroyed his neighbours house would
be held liable. Liability law establishes that if my actions have an adverse effect on
you, you can sue for compensation. If the judicial process works efficiently and is not
expensive, the relevant contract is complete. But there are many economic activities
that are not covered by liability law. Firms can adopt technologies that inflict noise
on their neighbours and acid rain on downwind regions. If it is not regulated by
zoning or environmental regulations, the firm will find it more profitable to ignore

the costs that it imposes on others. In this case the price at which the firm is selling
its product sends the wrong message: the price understates how costly it is to
produce the good because it does not include the costs imposed on neighbours and
downwind regions.
DISCUSS 9: MARKET FAILURE

Construct a table like the one in Figure 8 to analyse the possible market failures
associated with the decisions below. In each case can you identify what markets or
contracts are missing or incomplete?
1.
2.
3.
4.
You buy an item of luxury designer clothing.

You inoculate your child with a costly vaccination against an infectious disease.
You use money that you borrow from the bank to invest in a highly risky project.
A fishing fleet moves from the over-fished coastal waters of its own country to
international waters.
5. A city airport increases its number of passenger flights by allowing night-time
departures.
6. You contribute to a Wikipedia page.
7. A government invests in research in nuclear fusion.
10.11 MARKETS, MORALS AND POLITICS
markets are institutions conforming to rules determined by convention,

or by governments, and the market system has expanded as the institutions that
make markets possible have developed. Sometimes goods are not traded in markets
because it is not feasible, but sometimes we make moral and political judgements
that trade should not be allowed, even if it were feasible. Societies differ in the
kinds of contracts and property rights that they permit and support. Goods could
be allocated according to need, or by queuing or lotteries, rather than price. Where
should the boundaries of the market system be?
Lending money at interest was prohibited in several religious traditions including
Judaism, Christianity, and Islam. One ethical justification is that rich lenders were
more powerful than poor borrowers. According to the Catholic theologian (and later
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36

saint) Thomas Aquinas (1225-74): A man paying interest on a loan isnt doing it
voluntarily but under pressure; he is forced by his need to borrow from lenders who
wont lend except at interest. He would not have approved of the professors at the
University of Bologna at the time who lent money at high rates of interest to their
students to buy books.
Usury, as it was known, was widely regarded as sinful in medieval Europe, which
presented problems for the merchants of Florence, Venice, Genoa and other
prosperous Italian cities who traded in wool, cloth, hides, wheat, metals, jewels,
pictures, and spices throughout Europe and the Mediterranean. Payments had to be
transmitted over long distances, and goods could take six months or more to arrive
at their destination. Merchants needed loans to continue trading while waiting for
payment, but there was no incentive to supply them. They developed institutions
and financial instruments to make trade easier, the origin of modern banking and
insurance companies. One way of circumventing usury laws was a bill of exchange: a
letter promising that the drawer (borrower) would pay a specified amount of money
on a particular date, which could be bought and sold at any agreed price. Another
was to give the lender a specified stake (called an interest) in an investment project,
or a share in the profits.
There are some goods that are held in common, rather than as private property.
For example land has been held in common throughout most of human history.
Commonly-owned resources can have the characteristics of a public good: that is
to say, giving more people access does not increase costs. We saw in Unit 4 that
communities can successfully manage shared resources such as forests, grazing
land or irrigation projects. There is normally public access to the road network, and
roads are built and maintained by local and national government. International
agreements guarantee free access to the sea beyond coastal areas (we call this
international waters), and specify rights and responsibilities in the exploitation of fish
stocks and mineral resources.
Healthcare and education are not public goods in the same sense, but in most
countries primary education is provided free to all children (usually compulsorily)
by the public sector. Economists and philosophers argue that access to education is
a right; it should be provided equally for all, and should not depend on willingness
or ability to pay. This is an example of what the economist James Tobin (1918-2002)
called specific egalitarianism: the view that some goods should be more equally
distributed than income for ethical reasons. These goods are sometimes called merit
goods.
Healthcare is more contentious. In some countries there is a clear public consensus
that access to healthcare should depend on need rather than ability to pay. In others
it is treated primarily as a private service, to be paid for in the same way as a haircut
or a car repair.

There are some transactions and markets that we prohibit by law, because we find
them unacceptable, though our attitudes may change. Mediaeval Italian merchants
had serious doubts about lending money at interest, but they had no such qualms
about the slave trade . The slave market was then an established institution; today
it is illegal throughout the world. Article 4 of Universal Declaration of Human Rights
states: No one shall be held in slavery or servitude; slavery and the slave trade shall
be prohibited in all their forms.
This not only outlaws kidnapping and people trafficking; it means you cannot
voluntarily sell yourself into slavery. You own your human capital, but you cannot sell
it. You can rent it to an employer, but you cannot transfer control of it permanently;
you retain the right to terminate the contract. Employment laws provide safeguards
against contracts that are so difficult to get out of that they are effectively slavery..
DISCUSS 10: VOLUNTARY SLAVERY

Suppose that a well-informed, sane adult, with an adequate income, decides that he
would like to sell himself to become the slave of another person, and that he finds
a buyer willing to pay his asking price. (The aspiring slave will give the price paid by
the buyer to his children to further their education.) The would-be slave owner will
be bound by the law and will not engage in beating or harsh treatment of the slaveto-be. If the would-be slave sells himself, would the result be Pareto efficient? Do you
think that such transactions should be legal?
Buying and selling babies is a different case. There are well-established institutions
allowing parents to voluntarily give up a baby for adoption, but laws typically prevent
parents from selling their children, and most people feel that adoption should not
be a monetary transaction. Most people think the same about the sale of human
organs for transplant. But why should such transactions be prevented, if both parties
enter into them voluntarily? One reason might be that we think they may not be
truly voluntary: that people might effectively be forced by poverty into a transaction
they would not otherwise consider, and might later regret. A second reason would
be a belief that to put a price on a baby, or a body part, violates a principle of human
dignity. It corrupts our attitudes towards others.
The moral philosophers Michael Walzer and Michael Sandel have discussed the
moral limits of the markets. Some market transactions conflict with the way we value
humanity; others with principles of democracy, such as allowing people to sell their
votes. Another example is a company that hires homeless people to stand in line to
gain for access to US Congressional hearings on behalf of lobbyists. The line-standing
companies charge up to $60 an hour for their services, of which the standers receive
37
38

between $10 and $20. Although this may make both the homeless person and the
lobbyist better off, Sandel argues that it might create unfair access to democratic
institutions and (in the words of the Washington Post) may be demeaning to
Congress. Perhaps thats why Congress does not sell tickets itself.
We have seen some of the advantages of allocating resources using markets and the
price system; in that analysis we implicitly assumed that exchanging the good for
money did not affect its intrinsic value to the buyer and seller. But parents attitudes
to babies, and voters appreciation of their democratic rights might both be altered
if they were bought and sold. When we consider whether it would be beneficial to
introduce a new market, or monetary incentives, we should think about whether this
might crowd out other social norms or ethical preferences. We saw an example in
Unit 4, where introducing fines for parents who arrived late to collect their children
from a daycare centre increased lateness; it seemed to change a parents valuation
of a carers time, or to shift the parents thinking from it is really not right that I
inconvenience the carer to being late is just another good with a price, and its low
enough so Ill buy a little.
DISCUSS 11: CAPITALISM AMONG CONSENTING ADULTS

Should all voluntary contractual exchanges be allowed among consenting adults?
What do you think about the following (hypothetical) exchanges? You may assume in
each case that the people involved are sane, rational adults who have thought about
the alternatives and consequences of what they are doing. In each case, decide
whether you approve, and whether you think the transaction should be prohibited.
1. A very complicated medical procedure has been discovered that cures a rare
form of cancer in patients who would otherwise certainly die. Staff shortages
make it impossible to treat all those who would benefit, and the hospital has
established a policy of first come, first served. Ben, a wealthy patient who is at
the bottom of the list, offers to pay Aisha, a poor person on the top of the list,
$1m to exchange places. If Aisha dies (which is very likely), then her children will
inherit the money. Aisha agrees.
2. Melissa is 18. She has been admitted to a good college but does not have any
financial aid and cannot get any. She signs a four-year contract to be a stripper
on the internet and will begin work when she is 19. The company will pay her
tuition fees.
3. Space Marketing Inc. announces plans to launch giant billboards made from
mylar sheets into low orbit. Companies would pay more than $1m dollars to
display advertisements. Logos, about the size of the moon, will be visible to
millions of people on earth.
4. You are waiting in line to buy tickets for a movie that is almost sold out. Someone
from the back of the line approaches the person in front of you and offers her $25
to let him in front of her.
5. A politically apathetic person, who never votes, agrees to vote in an election for
the candidate who pays him the highest amount.
6. William and Elizabeth are a wealthy couple who give birth to a baby with a minor
birth defect. They sell this baby to their (equally wealthy) neighbours and buy a
child without any birth defects from a family who need the money.
7. A care home for elderly people advertises for nurses, saying Jamaicans
Preferred. The director justifies it by saying that, in their experience, Jamaican
nurses are the most efficient.
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40

10.12 CONCLUSION
we have evaluated the role that markets play in an economy from both static
and dynamic standpoints. It is not possible, or desirable, for all goods to be bought
and sold. But, if property rights and markets are established, we can assess how well
they allocate resources. Figure 9 summarises our results.
Figure 9. The invisible hand in the short and long run.
UNIT 10 KEY POINTS
1. The functioning of markets depends on a system of property rights and contracts to

protect ownership and transfer of ownership.
2. In competitive markets prices send the right message, if there are no externalities.
3. Market failure can arise from a lack of competition, or when individual decisionmakers do not take account of external effects, which arise in cases such as pollution,
public goods, and common property resources.
4. When the social marginal cost of production is greater than the private marginal
cost (as in the case of pollution) the externality leads to over-production.
5. Inequality of income results from inequality in the endowments that people have
and the prices at which people trade the goods and services resulting from these
endowments.
6. Market competition stimluates R&D and innovation, and the spread of new methods
of production; but competition also limits the temporary economic rents that provide
incentives for innovation.
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42

UNIT 10: READ MORE
10.1 PROPERTY RIGHTS AND CONTRACTS
Institutions and economic performance

Douglas North argued that not only were institutions necessary for the good
functioning of the economy but they are also the fundamental cause of long-run
growth.
North, D.C. 1990. Institutions, Institutional Change, and Economic Performance. New York:
Cambridge University Press.
Daron Acemoglu and James Robinson present an institutional theory of growth. They
also provide evidence based on the European colonial history and the division of
Korea.
Acemoglu, D., Johnson S., Robinson J. A. 2005. Institutions as a Fundamental Cause of
Long-Run Growth, In: Philippe Aghion and Steven N. Durlauf, Eds, Handbook of Economic
Growth, Volume 1, Part A, pp. 385-472.
Their book Why Nations Fail is a comprehensive review of Acemoglu and Robinsons
arguments on growth.
Acemoglu, D., Robinson, J. A. and Woren, D. 2012. Why nations fail: the origins of power,
prosperity, and poverty. Crown Business, New York.
10.6 FAIRNESS: ENDOWMENTS, INCOME AND INEQUALITY
Participation in heterogenous communities

Alberto Alesina and Eliana La Ferrera suggest that group homogeneity is a key
determinant of successful collective actions: LINK.
Alesina, A. and La Ferrara, E. 2000. Participation in Heterogeneous Communities.
Quarterly Journal of Economics, pp. 847-904.
Are skyscrapers green?
Edward Glaeser explains why deciding to live in cities rather than in the country in
the US reduces negative environmental externalities: LINK.
Glaeser, E. 2009. The Lorax Was Wrong: Skyscrapers Are Green. The New York Times,
Economix, 10 March.
10.8 MARKETS AND INNOVATION
The entrepreneurial state

Mariana Mazzucato, an economist who specialises in innovation, argues that few
of the technological breakthroughs that we often attribute to the genius of IT
entrepreneurs would have been possible without heavy support from the state: LINK.
Mazzucato, M. 2011. The entrepreneurial state. London: Demos.
10.9 POSITIONAL EXTERNALITIES
Consumption tax
Robert H.Frank explains why taxing household consumption can be a powerful tool
to reduce inequalities and conspicuous consumption:LINK.
Frank, H. R. 2011. The Progressive Consumption Tax. Slate, Moneybox, 7 December.
John Stuart Mill was arguing in favour of such tax in 1848: LINK.
Mill, J. S. 1848. Principles of political economy: with some of their applications to social
philosophy. London: John W. Parker.
Arthur Pigou made a similar point in 1920: LINK.
Pigou, A. C. 1920. The economics of welfare. London: MacMillan.
Hours of work and Veblen effects
Oh, S., Park, Y. and Bowles, S. 2012. Veblen Effects, Political Representation and the 20th
Century Decline in Working Time. Journal of Economic Behavior & Organization, 83(2), pp.
218-48.
Schor, J. 1993. The Overworked American: The Unexpected Decline of Leisure. New York
City: Basic Books.
Relative happiness
Clark, A. E., Frijters, P. and Shields, M. 2008. Relative Income, Happiness, and Utility: An
Explanation of the Easterlin Paradox and Other Puzzles. Journal of Economic Literature,
46, pp. 95-144.
This work is licensed under the Creative Commons Attribution-NonCommercialNoDerivatives 4.0 International License. To view a copy of this license, visit http://
creativecommons.org/licenses/by-nc-nd/4.0/ or send a letter to Creative Commons,
444 Castro Street, Suite 900, Mountain View, California, 94041, USA.
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How market competition provides incentives for innovation.

How these external effects can result in the misallocation of resources.

coreecon | Curriculum Open-access Resources in Economics

UNIT 10 | MARKET SUCCESSES AND FAILURES

coreecon | Curriculum Open-access Resources in Economics

UNIT 10 | MARKET SUCCESSES AND FAILURES

DISCUSS 1: PROPERTY RIGHTS AND CONTRACTS IN MADAGASCAR

coreecon | Curriculum Open-access Resources in Economics

10.2 MARKET FAILURE

UNIT 10 | MARKET SUCCESSES AND FAILURES

coreecon | Curriculum Open-access Resources in Economics

UNIT 10 | MARKET SUCCESSES AND FAILURES

Marginal social cost

Marginal private cost

Q, quantity of bananas (tonnes per year)

Figure 1. Marginal costs of banana production using Weevokil.

coreecon | Curriculum Open-access Resources in Economics

Marginal social cost

Marginal private cost

Q, quantity of bananas (tonnes per year)

Figure 2. The choice of banana output.

10.4 EXTERNALITIES: POLICY AND DISTRIBUTION

UNIT 10 | MARKET SUCCESSES AND FAILURES

Marginal social cost

Marginal private cost

After tax price

Q, quantity of bananas (tonnes per year)

Figure 3. Using a tax to achieve Pareto efficiency.

coreecon | Curriculum Open-access Resources in Economics

UNIT 10 | MARKET SUCCESSES AND FAILURES

3. Enforcing compensation. The government could require the plantation owners

Marginal social cost

Marginal private cost

Q, quantity of bananas (tonnes per year)

Figure 4. The plantations compensate the fishermen.

coreecon | Curriculum Open-access Resources in Economics

TEST YOUR UNDERSTANDING

When we identified 38,000 tonnes as the Pareto efficient level of output, we

UNIT 10 | MARKET SUCCESSES AND FAILURES

DISCUSS 2: POLICIES FOR POLLUTION

10.5 EXTERNALITIES, BARGAINING AND PROPERTY RIGHTS

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Source: By Ionel141 (Own work) [CC-BY-SA-3.0

UNIT 10 | MARKET SUCCESSES AND FAILURES

coreecon | Curriculum Open-access Resources in Economics

Marginal social cost

Net social gain

Marginal private cost

Q, quantity of bananas (tonnes per year)

Figure 5. The gains from bargaining.

UNIT 10 | MARKET SUCCESSES AND FAILURES

DISCUSS 3: BARGAINING POWER

coreecon | Curriculum Open-access Resources in Economics

DISCUSS 4: EXTERNALITIES AND MARKET POWER

10.6 FAIRNESS: ENDOWMENTS, INCOME AND INEQUALITY

when we analyse the distributional consequences of an individual market, we

UNIT 10 | MARKET SUCCESSES AND FAILURES

coreecon | Curriculum Open-access Resources in Economics

UNIT 10 | MARKET SUCCESSES AND FAILURES

DISCUSS 5: INEQUALITY AND COMMUNITY