Price Theory Handout #10

Market failure: situations in which the market, absent government intervention, leads to inefficiencies (specifically, losses in wealth, or Kaldor-Hicks inefficiencies).

Nirvana fallacy: the error of condemning a situation because it fails to meet an impossible ideal.

Comparative institutional analysis: looking at all the different institutional options (market, various forms of government intervention) and comparing their advantages and disadvantages.

Externality: a cost or benefit for a party not directly involved in a transaction. Externalities can be negative, if a cost is imposed on a third party, or positive, if a benefit is accrued by a third party.

Social cost = private cost + external cost.

Marginal social cost = marginal private cost + marginal external cost, or MSC = MPC + MEC. In general, the MPC is represented by the market supply curve. The MSC curve lies above the supply curve, representing the addition of external costs.

Pigou tax: a tax that charges a polluter a per-unit fee equal to the marginal external cost of the (Q*)th unit, where Q* is the optimal amount of the good to produce.

Pollution permits: a tradable permit granting the holder the right to create a certain amount of pollution.

Tort liability: being held responsible in court for damages caused to the person and property of others.

Marginal social benefit = marginal private benefit + marginal external benefit, or MSB = MPB + MEB. In general, the MPB is represented by the market demand curve. The MSB curve lies above the demand curve, representing the addition of external benefits.

The Coase Theorem: In an externality situation, agents will voluntarily negotiate to an efficient outcome privately, if three conditions hold:

· property rights are well defined

· property rights are transferable

· transaction costs are zero or close to zero

Tragedy of the commons: refers to the fact that many situations of negative externalities and overuse of resources are attributable to the existence of an open-access resource, also known as a commons.

Open-access resource: a resource that many people can use and cannot be excluded from using.

Public good: a good characterized by a kind of extreme positive externality situation. Technically, a public good must have both of the following features:

· Non-excludability: non-payers cannot be excluded from consuming it.

· Non-rivalry: one person's consumption of the good/service does not diminish anyone else's consumption of it.