unit10_feb2015.pdf

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10MARKET SUCCESSES AND FAILURES

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.

February 2015 beta

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.

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coreecon | Curriculum Open-access Resources in Economics 2

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 3

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 hands-off 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.


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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.


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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.

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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.


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 well-being 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.

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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.


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.


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.

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.

PAST ECONOMISTS

Source: By Ionel141 (Own work) [CC-BY-SA-3.0 (http://creativecommons.org/licenses/by-sa/3.0)], via Wikimedia Commons.


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.

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.


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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.


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 poorvalue 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


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.


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.


EXCLUDABLE

RIVAL NON-RIVAL

NON-EXCLUDABLE

Private goods (food, clothes, houses)

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)

Public goods that are artificially scarce (subscription TV, uncongested toll roads, knowledge subject to intellectual property rights, Unit 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.


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. A public lecture given at a university.2. The noise produced by aircraft around an international airport.3. A public park.4. A forest used by local people to collect firewood.5. Seats in a theatre.6. 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,


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


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.


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

Figure 7. Keeping up with the Joneses.


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.


MARKET FAILURE (MISALLOCATION OF RESOURCES)

TYPE OF PROBLEM

HOW IT AFFECTS OTHERSTHE DECISION

COST OR BENEFIT?

PUBLIC GOOD

PUBLIC BAD

NEGATIVE EXTERNALITY (EXTERNAL DISECONOMY)

POSITIVE EXTERNALITY (EXTERNAL ECONOMY)

COMMON PROPERTY RESOURCE

INCOMPLETE CONTRACT

An employee on a fixed wage decides how hard to work

You travel to work by car

A firm trains a worker

A firm uses a pesticide that runs o into waterways

You take an international flight

A firm invests in R&D

Hard work increases her employers profits

Congestion for other road users

Another firm benefits if the worker quits

Damage to the fishing industry

You increase global carbon emissions

Other firms can exploit the innovation

On-the-job eort is too low

Over-use of public roads

Too little training

Over-use of pesticide and over-production of bananas

Over-use of aeroplanes

Too little R&D

External benefit

External cost

External benefit

External cost

External cost

External benefit

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 goodsknowledge 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. You buy an item of luxury designer clothing.2. You inoculate your child with a costly vaccination against an infectious disease.3. You use money that you borrow from the bank to invest in a highly risky project.4. 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


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 giv