The production or consumption of goods is associated with the externalities that is either negative externalities or positive externalities. When the consumption of goods and services create externalities, there is a creation of negative consumption externalities and when the production of goods and services generate externalities such as factories polluting the land and water, there is an occurrence of negative production externalities. Market failure occurs when they fail to supply the socially optimal amount of goods resulting from the failure of the price mechanism to account for the benefits and the cost that is necessary to consume and provide the goods. The effectiveness of the private solutions in addressing the market failures can be evaluated by taking an example. Let us take the example of the negative production externality in the steel market. Negative production externalities occurs when the wellbeing of others is reduced by the production of the firm and such reduction are not compensated by other firm.
The three cost that is considered crucial for discussion is marginal damage, private marginal cost and social marginal cost. Marginal damage is the additional cost due to the production of goods which that particular producers do not pay and are imposed on others. Private marginal cost are the direct cost incurred by the producers for producing an additional unit of output. Social marginal cost on other hand is the sum total of marginal damage and private marginal cost. For instance, the river gets polluted by the steel plant, however, they do not face any regulation and therefore, when deciding on the volume to be produced, they ignore the pollution.
The above graph depicts the negative externalities that resulted in the market failure in the steel market. The production of steel has resulted in generation of negative externality of say $ 100 per unit of steel produced. That is, there is a marginal damage of $ 100 incurred due to the production of steel and such damage has caused the social marginal cost to lie above the private marginal cost. In the above graph, the market equilibrium quantity produced due to the interaction of private marginal benefits and private marginal cost is Q1 at price P1. The production of steel results in the marginal damage which places the social marginal cost above the private marginal cost as it adds up the amount of marginal damage incurred by the steel plant. New equilibrium point is determined at point C where the equilibrium quantity of output is determined at Q2. It is quite evident that the competitive equilibrium quantity is more than the social optimum quantity. Therefore, the gap between the socially optimum output and market equilibrium output represents the dead weight loss to the society and this dead weight loss is represented by the area of triangle ACB.
The application of the Coase theorem can be explained in terms of the individuals enjoying the firms polluting the river. There would be too much of pollution when the individual is ignored by the firms. In the event when individual is owner of the river, then they can charge the firms for polluting the river and the firms would be charged with the amount of marginal damage that is created per unit of the pollution. The reason pollution is priced at marginal damage is that it in the newly created market for pollution, marginal damage is considered as the equilibrium efficient price. On other hand, if the firm owns the river, then individual would be charged by the firm for polluting less and the marginal damage caused per unit of pollution would also be charged by the individual. However, in both the scenario, the finial pollution level will be the same.
The negative externalities produced by the manufacturing of steel has resulted in the creation of dead weight loss and this dead weight loss can be addressed by remedy sought by the private sector.
The above graph depicts the remedy that is opted by the private sector on the generation of negative externality. Suppose the steel plant is charged at $ 100 per unit of the total amount of steel produced by the fisherman. Charging on the amount of steel produced by the fisherman represents an additional cost that is the addition al marginal cost as it is incurred on per unit of steel produced. This would cause an impact on the private marginal cost curve as the private marginal cost increases from PMC1 to PMC2. At the market equilibrium level, the equilibrium quantity produced is represented by the point Q1 with the equilibrium price at P1. With the shift of the private marginal cost, the new equilibrium point is determined at point B. At this new equilibrium point, there is new equilibrium output and price of Q2 and P2 respectively. The equilibrium quantity falls from Q1 to Q2 and this Q2 represents the socially optimal level of output at higher price P2. This negative externality is internalized by this charge imposed by the fisherman and the inefficiency of the negative externalities is removed by the interference of private sector. Therefore, this graph explains quite well how the market failures can be addressed by the effective private solution and hence such solution is effective in dealing with the negative externalities that causes market failure. However, this internalization of the externalities can be useful sometimes.
Hence, it can be inferred that sometimes, private actors would sometimes reach efficient outcomes without the interference of government by effectively addressing the externalities. Nevertheless, it is noteworthy to mention that the fundamental problem is ignored by the approach of Coasian as when there are larger number of individuals on the one or both sides of negotiation, then in such scenario, it becomes hard to negotiate.
The market failure is addressed by various types of private solutions such as moral codes, business mergers or contract and charities. Under contracts or business mergers, two business that offers positive externalities to each other can enter into the contract that would make but the parties better off. Furthermore, the behaviour of individual is guided by the moral codes and they might provide an incentive to refrain from doing anything that is unethical or is not in the interest of the individual or the society as a whole. Lastly, charities are other private solution that is intended to limit the behaviour that results in promotion of behaviour that generates negative externalities.
The theorem states that the problem of externalities can be solved by the private economic actors amongst themselves by arriving at their own solution. It is argued by the Coase theorem that in the event of existence of externalities, as long as the cost of transaction is low that is when the negotiation cost is low by allowing the individuals to negotiate and assigning of the property rights, then it is possible to reach the efficient cost. Regardless of the parties who is assigned the property rights, the efficient cost can be reached. Hence, it is stated by Coase theorem that bargaining between the parties for conflicting property rights would result in generation of efficient outcome irrespective of the party that is awarded with the property rights as long as the negotiation can be done on the bargaining transaction cost. The property rights is explained in two theorems by making certain assumptions. In first theorem, a socially optimal market quantity can be produced by the negotiations between the parties affected by and creating the externality and this happens when there are costless bargaining and property rights that are well defined. Another theorem is that the party to which, the property rights is assigned do not form the basis of efficient solution to externality and this happens as long as the rights is assigned to someone.
In accordance with the Coase theorem, the private bargaining among the effected parties can help in eliminating the market failure due to property rights. It is pointed out by the theorem that there can be optimum allocation of resources by the perfectly competitive economy even under the conditions of externality. This can happen when the transaction and marketable cost are zero and property rights are defined clearly. When there is transaction cost, there exist the opportunities when choice of one person impacts the choice of others.
In addition to this, the theorem helps in providing natural links between law and economics and deciding on the rules of external liability by offering an efficiency rationale. The liability rules of the theorem helps in achieving optimality when the information is imperfect and bargaining is costly. It also states that the party that have to incur least cost in dealing with the externality harmful effects are responsible for paying the cost.
It is signified by the coarse theorem that economic efficiency is promoted by marketable and well defined property rights and Pareto optimality can be achieved using the mechanism of market despite the externalities are present. This is so because the externalities can be removed by devising a private bargaining solution. The institutional base do not matter if in the real world, the transaction costs are similar. Hence, distribution and efficiency will be impacted differently by the different institution and therefore it is indispensable to make comparative institutional analysis. Furthermore, the final outcome under the Coase theorem is significant in the absence of transaction cost and given an assignment property rights.
The success of Coasian solution is limited by the number of solutions and the limitations of the theorem has been found in assigning the holdout problems, property rights, free rider problem and transaction cost that is higher than zero. Coase theorem is based on the zero transaction cost adequacy that acts as a proxy for the perfect competition. It is unlikely that the monopoly marketer such as Railway Company will act like competitive market despite the fact that the contrary is claimed by the theorem. The bargaining process for the legal entitlement will be thwarted by the imperfect competition and this would lead to a situation of Prisoners dilemma.
It is not possible for many externalities to internalize as many externalities has the characteristics that make unfeasible competitive market. The initial allocation of the property rights form the basis of forms the basis of demand for goods and services. This is so because there is distribution consequences of wealth because of initial allocation of entitlement irrespective of the inadequacies of the approximation of zero transaction costs. As a consequence of this, the initial legal decision forms the basis of efficient outcome.
In a situation, involving few parties and it is possible to assign the property rights, there is a likelihood of seeing a solution that is similar to the one suggested by Coase. This can be explained with the help of an example, say, neighbour of a person owns a property that has a steep hill which is perfect for climbing. The neighbour built a fence because he is afraid that anyone being injured would be liable to him and it will not be socially efficient. This is so because the climbers would not receive any benefits from climbing. In such scenario, there exist a room for negotiation as the rock climbers might be willing to pay for climbing the rock. In turn, the neighbours might be willing to accept the payment for hedging a risk when the neighbour is found liable when the climber is injured. However, if the no liability contract is signed by the neighbour with the hill owner, then it is possible to reach a similar Coasian solution. In this situation, in order to gain from the benefits of climbing the rock as some values are getting exchanged. The negative externalities created by the pollution can be dealt in the cap and trade markets by viewing the permits as the property rights assignment. The outcome of Coasian can be seen in such types of market.
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