The socially optimal output level is the level where the costs to society in producing that quantity are balanced against the benefits to society from its consumption. However, various sources of market failure such as externalities result to the market failing to supply the socially optimum output. The private optimum level of output is where the marginal private costs equal marginal private benefits. That is, the marginal private costs equal the price. When a positive externality occurs, the marginal social benefit will be higher than the marginal private benefit (price) and thus the private optimal output will be lower than the social output. On the other hand, when a negative externality occurs the marginal social cost will be higher when compared to the marginal private cost and hence the private optimal output level will be higher than the output level that is socially optimal.
The only circumstance under which the private optimum levels of output becomes larger than the socially optimal output level is when a negativeproduction externality occurs. Anegative production externality usually results to the marginal social cost being higher than the marginal private cost (the price)and thus the private optimal level of output becomeshigher than the output level that is socially optimal.A real life example of when the private optimal level of output is larger than the socially optimaloutput level can be seen in the context of construction of a dam. The construction of a dam would prevent fish from swimming upstream, consequently destroying the fishing industry in the towns located upstream. However, if the fishermen are recompensed by the constructors of the dam for the full value of their loss, no negative production externality exists.
Government intervention is needed to internalize externalities in production and consumption decisions of individuals so that socially optimal output levels and private optimal output levelswill be the same. Pigou suggested that the government taxes or subsidies the externality according to the marginal damage or gain incurred. Consumer surplus would be maximized at such a solution.In the real life example presented, in order to correct the negative production externality and bring down the production to optimal levels, the government can intervene through the imposition of a tax on the benefiting firm. A tax based on per unit of production can be imposed. This will result to a shift of the MPC curve upwardstowards the MSC curve and thus resulting to a reduction in output and bringing it closer to the socially optimal level of output.
The Coase theorem presents a case against government intervention to solve negative externalities. The theorem states that private bargaining will overcome negative externalities, without the necessity for government involvement or intervention regardless of how proportional rights are allocated (Olmstead & Keohane, 2007, p. 127).The theorem maintains that when there are no transactional costs the assignment of legal rights has no effect upon the allocation of resources among economic enterprises. That is, the allocation of property rights has no bearing on how economic resources are used. The Coase theorem argues that under certain conditions private bargainingbetween the owners of an externality the expected victim might overcome a negative externality.
The major assumptions of the Coasetheorem whichalso act as major weaknesses of this theorem is the assumption that bargaining is easy and inexpensive, and that deals are easy to enforce(Olmstead & Keohane, 2007, p. 127).The theorem also assumes that transactions are costless and that damages are accessible and measurable(Thomas & Callan, 2012, p. 71).
A real life example of the Coase theorem is the Durham church and residents case. In this case, nearby residents of a church in Durham complained about the church’s service being too loud and noisy, however, they settled their dispute.Residents of the hills in south Durham complained about the amplified music and thumping base from the nearby New Hope church, which they stated can be heard inside their homes. Representatives of the church stated that they had made several attempts to minimize and reduce the sound emanating form their service since 2011, involving engaging sound engineers to run tests that concluded the sound from the church were well within the limits set by the city. The church also had installed sound-absorbing materials inside and planned to conduct major renovations that would include lining offices along exterior walls in an attempt to reduce noise levels outside. Lawyers from both parties informed the Judge that the two parties had come to a “mutual satisfactory” resolution to the disagreement and dispute. With terms that were acceptable to and by both parties. This case is a real life example where bargaining resulted to little transactional costs, economic efficiency and application of the Coase theorem.
Brent, R. J. (2007). Applied Cost-benefit Analysis, Second Edition (Revised ed.). Edward Elgar Publishing.
Figart, D. M., Dolfsma, W., & Clary, B. J. (2006). Ethics and the Market: Insights from Social Economics. New York: Routledge.
Olmstead, S. M., & Keohane, N. O. (2007). Markets and the Environment. Washington, DC: Island Press.
Thomas, J., & Callan, S. (2012). Environmental Economics and Management: Theory, Policy, and Applications (6 ed.). New York: Cengage Learning.
Tongzon, J. L. (2002). The Economies of Southeast Asia: Before and After the Crisis (Revised ed.). Edward Elgar Publishing.
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