The Problem of Social Cost

1
The Problem of Social Cost
2
Economicactivity
3
Divergence between private cost and social cost

• Social cost Private cost External cost
• Social benefit Private benefit External
  benefit

• When EC gt 0, SC gt PC
• When EC lt 0 (or EB gt 0), SC lt PC (or SB gt PB)

4
Harmful externality

• EC gt 0 and SC gt PC

DWL

• Over-production and DWL would happen

5
Beneficial externality

• EC lt 0 and SC lt PC

DWL

• Under-production and DWL would happen

6
Pigovian argument

• Economic activity
• Externality not internalized by the actor
• Divergence between PC and SC
• Allocative inefficiency (deadweight loss)
• Market failure
• Government intervention / planning

7
Coasian argument

• Externality is reciprocal in nature

If the factory doesnt exist, no externality.
If the fishermen dont exist, no externality too!
8
Coasian argument

• If we allow the factory to operate, the fishermen
  will be harmed.

• If we restrict the factory to operate, the
  factory owner will be harmed.

• Who is allowed to harm or to be harmed?
• Who has the right to harm?

9
Case 1 Right was not well defined
10
Case 1 Right is not well defined

• Social optimum output is 3
• Social gain is 24 which is maximized

• However, the factory owner who is a wealth
  maximizer would produce the output at which MR
  MPC

11
Case 1 Right is not well defined

• Private optimum output is 6, where MR MPC
• Private gain is 150 which is maximized

• Social gain is - 24 which is not maximized, and
  DWL is 48

12
Case 2 Right is well defined
(Fishermen have the right to a clean river)

• Private optimum output is 3 which is equal to the
  social optimum
• Social gain will be maximized

• The factory will not produce the 4th unit because
  the maximum compensation it is willing to pay is
  smaller than the minimum compensation the
  fishermen are willing to receive.

13
Case 3 Right is well defined
(Factory owner has the right to a clean river)

• Private optimum output is 3 which is equal to the
  social optimum
• Social gain will be maximized

• The factory will not produce the 4th unit because
  the minimum compensation it is willing to receive
  is smaller than the maximum compensation the
  fishermen are willing to pay.

14
Coasian argument

• Economic activity
• Externality not internalized by the actor
• Divergence between PC and SC
• Exchange of property rights
• The externality will be internalized
• Allocative efficiency
• No market failure
• Government intervention is not necessary