Micro-7 / P.

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7 The Problem of Social Cost

I Introduction : Concept of externality

A Examples in classic texts
B Externality : social cost and benefit
II Solutions To Externality
A Traditional approach
B A modern approach
C Property rights and transaction costs
D Coase approach
III Public Goods & Economic Efficiency
A Public goods
B Welfare economics and Pareto optimum
IV Common Property Resources
A Meaning & examples of common property resources
B Over-utilization & dissipation of rent

* * *

I Introduction : Concept of Externality

Externality exists whenever the exchange between two parties causes benefits or costs to the third or
more parties without any equivalent or corresponding gain or compensation.
It is the result of the existence of a difference in cost or benefit between the private exchanging parties
and the society as a whole.
Whenever externality exists, it implies a situation of " getting something for nothing ".

A Examples In Classic Texts

Pigou's Case of Two Roads

Suppose there are two roads, named as Road ABD and Road ACD both leading from A to D. Road ACD is
the longer, wider and more winding road. Road ABD is the shorter, narrower but straight road. At the
beginning, users will go to the "faster" ( i.e. a shorter travelling time ) road ABD.
Congestion on road ABD will increase the time of an extra user as well as on all other users because
traffic is slow down as a result.
Anyone user will impose time cost ( as well as petroleum expense etc. ) on himself as well as on other
users on the road - a social cost.
An possible example is the route from Central to Aberdeen by either Pokfulam Road ( like Road ACD ) or
the Aberdeen Tunnel ( Road ABD ).

Cattle Raiser & Farmer

There are 2 pieces of land lying side by side, one for wheat growing and the other for cattle raising. The
raiser’s cattle eat or damage the farmer’s crops as they stray when there are no fence surrounding the
wheat land.
The cattle gains in weight and the raiser gains the value of meat obtained as a result.
Based on Pigou’s analysis, if the raiser is not liable for the damage on crops, he will simply ignore the crop
loss and run too many cattle.
Conversely, the farmer raises too few crops and external cost is created by the raiser’s cattle.

Orchard & The Bees

An apple grower provides apple trees for the bees to make nectar. If there is a bee-keeper nearby the apple
grower, the bee-keeper benefits from the trees grown by the apple grower.
Since the benefit may not be realised by the apple grower, planting will be too little.
Conversely, the bee-keeper provides a pollination service to the apple grower. Since the service is not paid
by anyone, he doesn’t take into account of this external benefit and too few hives will be established.

The two interested parties are not guided by Adam Smith’s invisible hand to the optimal amount of apples
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and honey production.

In traditional economic theory, such cases are examples of external ( to the exchanging parties )
costs or benefits leading to a question on the efficiency and power of a free market.
Some suggested that it was an indication of “ market failure “.

B Externality : Social Cost & Social benefit

The existence of externality would imply that the private costs or benefits of the exchanging parties are not
the same as the costs or benefits imposed on the society as a whole. The difference is called the external
cost or benefit.

Private Cost & Social Cost

Private cost refers to the highest-valued option forgone of a resource available to a producer or a person
who makes the decision.
Social cost measures the highest-valued option forgone of a resource available to the society.
External cost is the cost inflicted to a third or more parties without compensation. It exists when an act of a
person imposes cost on others, and the person does not need to bear the cost for some reasons. The private
cost and social cost had a divergence.
Social Cost = Private ( Internal ) Cost + External Cost

External benefit is a spillover to a third party without payment.

Social Benefit = Private ( Internal ) Benefit + External Benefit

Divergence Between Private Cost ( Benefit ) & Social Cost ( Benefit )

Divergence In Costs Divergence In Benefit

$ MSC $ MC
D MPC A
A

B B MSB

MPB

0 Q0 Q 0 Q0 Q

II Solutions To Externality

The market mechanism reacts to the private or internal costs or benefits with the forces of demand and
supply. It is criticised that the market fails to take into account of the external costs or benefits so that
efficiency ( i.e. MUV = MSC = MPC ) cannot be achieved.

A Traditional Approach

Pigou’s Two Roads

Pigou argued that if both roads are left free to use by drivers, there will be too many cars on Road ABD
( i.e. congestion ) and too few cars on Road ACD.
Road ABD is said to be over-utilized and Road ACD is under-utilized.
It leads to an inefficient allocation of resources ( roads ).
There is a ( dead-weight ) loss in social welfare.

Pigou suggested that a government intervention by levying a tax ( toll ) on Road ABD users to discourage
the potential users. Traffic congestion could be avoided with some users drive on Road ACD.
As a result, the external costs are “ internalized “ by the taxation because users of Road ABD have to bear
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the full cost, i.e. social cost = original private cost + tax ( toll charge ).

Cattle Raiser & Farmer

The traditional approach is to minimize the damage or cost rather than to maximize the total gain. In
Pigou’s opinion, the government should intervene by introducing a tax on the cattle raiser and gives a
subsidy to the farmer; or a legal prohibition on the cattle raiser on his cattle to eat the crops.

Orchard & The Bees

The traditional approach would agree to give subsidies to the bee-keeper and the apple-grower because
they provide mutual benefits. The problem lies on the difficulties in pricing and measurement of nectar,
the value of services provided by the bees.

B A Modern Approach
1 Frank Knight argued that the reason for a divergence is not a case that the market fails to work but it
is not allowed to work. If the roads are privately owned, the wealth-maximizing owner will charge a
toll ( similar to a tax ), assuming a very low collection cost. The toll forces the drivers to internalize
the external cost. The problem of externality and misallocation of resources is solved as a result.
2 The effects of social cost on the cattle raiser and farmer are mutual.
The relevant question is not simply : “ How should we restrain A to harm B ? “
The relevant question is : “ Should A be allowed to harm B or vice versa ? “
The appropriate policy is to avoid the more serious harm.
3 The case of orchard and the bees is a typical example of external benefits. The use of taxation and
subsidy is not appropriate and costly.

C Property Rights & Transaction Costs

Property Rights : Rule of The Game

When we purchase some goods, we are indeed buying some rights on the goods from the sellers. These
rights control the ways particular resources that will be used and assign the resulting costs and benefits
arisen from the use of these resources.
Private Property : A good or asset is defined as a private property if, and only if, within well-defined
limits, its owner has these sets of rights.

Inter-relationship Among The Rights

The exclusive right to use implies neither the right to derive income nor the right to transfer. However, a
right to transfer does imply, as least to some extent that a resource is exclusively owned.
Otherwise, no one is willing to pay for it.

David Hume, a famous French writer, wrote ( in A Treatise of Human Nature ) the following in 1740 :
Our property is nothing but those goods, whose constant possession is established by the laws of society;
that is, by the laws of justice... No one can doubt, that the convention for the distinction of property, and
for the stability of possession, is of all circumstances the most necessary to the establishment of human
society, and after that the agreement for the fixing and observing of this rule, there remains little or
nothing to be done towards setting a perfect harmony and concord.

With well-defined and enforced property rights, the owner will put the resources to its highest-valued use.
Efficiency is attained with private costs or benefits equal to social costs or benefits.
A divergence between private cost and social cost ( or benefit ) is attributed to either one or more of the
following :
1 the absence of right to contract ;
2 there is a contract but no complete agreement or stipulation ;
3 there is agreement but inconsistent with the state of : marginal gain = marginal cost because the
enforcement cost ( transaction cost ) is too high.
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Coase’s words on transaction cost : “ ... in order to carry out a market transaction it is necessary to
discover who it is that one wishes to deal with, to inform people that one wishes to deal and on what
terms, to conduct negotiation leading up to a bargain, to draw up the contract, to undertake the
inspection needed to make sure that the terms of the contract are being observed, and so on ... “

The Problem Of Externality

Private Cost + External Cost = Social Cost

It arises because there is no market to trade the goods (or bads).

There is not market to internalize the cost or benefit because :

Property rights are not well-defined. OR Property rights are too costly to enforce.

D Coase Approach : The Coase Theorem

Illustration of The Coase Theorem : The Chemical Factory

A chemical factory discharges poisonous waste into a river which also provides a fishing ground in its
lower part. If both the factory owner and the fishermen have their rights to produce, the factory owner
would simply ignore the damage imposed on fishery. As a result, the amount of fish is reduced by the over-
production of chemicals. There is a divergence between the private and social costs in chemical
production.
A Table Showing The Numerical Values of The Two Sides

Output of MSC Value of Factory Value of Fishery Joint Value of

Factory
MPC MD MPB MPB The Two

0 0 0 0 300 300
1 10 1 90 299 389
2 20 2 170 297 467
3 30 4 240 293 533
4 40 8 300 285 585

5 50 16 350 269 619

6 60 32 390 237 627
7 70 64 420 173 593
8 80 128 440 45 485
9 90 45 450 0 450
10 100 0 450 0 450

Assume : Price of Chemical produced = $100/unit in a price-taking market.

Initial Value of Fishery without pollution = $300
MPB of factory = $100 – MPC MSB = $100 - MPC - MD = $100 - MSC

1 The traditional analysis would stress the over-production of chemicals killing “ excessive “ fish.
The remedy is to impose a tax on the factory to internalize the external cost into private costs.
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2 Coase suggested a solution by the assignment of rights through the use of contract.
If the right of clean water belongs to the fishermen, the factory owner may pay the fishermen to
buy the right to pollute. The Coase Theorem predicts that a transfer of right is formed to maximize
the potential gain. If the right belongs to the factory owner, he would sell the right (by a certain
amount) to the fishermen.

Coase Theorem

If property rights are well-defined and transaction costs are zero, then :
1 the allocation of resources will be the same, regardless of the initial assignment of property
rights; and
2 the allocation of resources will be efficient, so there is no problem of externality.

External cost ( benefit ) will be internalized when :

Property rights are well-defined. Transaction cost of negotiation among

the parties is not prohibitively high.

A market will be developed and if the terms of exchange can be mutually

acceptable, then mutually beneficial exchanges take place.

Self-interest seekers and wealth-maximizers would finally

come to a state of Pareto Optimum.

The attainment of Pareto optimum does not depend The wealth distribution does depend
on who has been assigned the property rights first. on such assignments.

Summary
1 The assignment of property rights does not affect the allocation of resources.
2 The different assignment of property rights only affects the wealth distribution and the one received
the payment or compensation as a result.
3 Once the private property rights exist and are delineated with sufficiently low transaction cost, the
damage is allowed up to a situation where marginal cost is equal to marginal benefit.
4 The traditional concept of divergence is a wrong concept of cost.
A correct concept on cost could identify the potential gain and a consistent application of the
maximization postulate shows that the divergence is settled by a mutual exchange of rights or market
transactions.
5 A market is able to internalize any external costs/benefits where government intervention or
involvement is not essential to solve the issue of externality.
6 Externality can be eliminated by completely enforced property rights. The market transactions will
guarantee an efficient use of all resources.
Private property rights are a pre-requisite for market transactions.
7 The Coase Theorem is basically a theorem of exchange.
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Whenever transaction costs are sufficiently low and property rights are well-defined, people will
make voluntary exchange for mutual benefits. Exchanges and negotiation of property rights will be
carried out until the marginal gain is equal to the marginal cost. All potential gain is captured at
that situation !

* You should by now understand that there is nothing wrong with the market !

III Public Goods & Economic Efficiency

A Public Good
A public good is any scarce good that can be consumed by many consumers at the same time, without
affecting the amount available to anyone else.
It is a good which is difficult, if not impossible, to exclude non-payers from receiving benefits and whose
benefits are not reduced by any extra users (both payers & non-payers).

Exclusion : Whenever a consumer enjoys a good or service, anyone is deprived of that enjoyment due to
private property rights. Examples are numerous.
Rivalry : When a consumer possesses a good or service, the amount available to anyone is reduced by that
amount held.

In its pure form, a public good carries the characteristics of non-exclusion and non-rivalry.
A pure public good refers to a public good that everyone has an identical amount.
In other words, the cost of supplying a public good to an extra user is zero, but the cost of supplying an
extra unit of public good is not.
Examples of public goods are : lighthouse, street light, roads, local T.V. broadcast, radio broadcast,
national defence, free ( nine years ) education in H.K.

A Table Between Exclusion & Rivalry

Exclusion
With ( Exclusion ) Without ( Exclusion )
Yes Private / Economic Goods Fishing ground
Rivalry No Highways, swimming pools National defence, education, disease.

A Free Rider
1 Due to the property of non-exclusion of public goods, consumers are reluctant to pay for a public
good, resulting in a case of social value greater than the social cost.
These free riders” make the provision of public goods especially by private competitive firms,
very difficult ( though it is not impossible ). It results in a situation under which everyone wants
the good but no one pays for it.

The Vertical Summation of A Demand Curve For A Public Good

$

E MC

0 Q0 Q
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2 Solutions
* To exclude the non-contributors but it is usually inefficient because the costs of exclusion are
normally greater than the benefits resulted.
* The provision and production of public goods are tie-in with some private goods, e.g. the use of
taxation together with a free education.
* To implement government policy to provide the public good, e.g. social security.

The issue of public good arises because property rights cannot be efficiently enforced to the benefits
that the public good generates. If an extra user can benefit from the good at no extra cost to the society,
charging a price would discourage potential users and results in a loss of total benefit to the society.
The provision of public good becomes sub-optimal - thus giving a reason or justification for government
intervention.

B Welfare Economics & Pareto Optimum

1 Welfare economics refers to a branch of economics dealing with the evaluation on the desirability
of different decisions on resource allocation.
For example, the arguments on the use of sales tax against direct taxes in the case of HK; the
various means of budget financing in HK; the most effective policy to deal with car thefts in HK.
The value judgement that is central to welfare economics is that any change that improves the well-
being of one individual without reducing the well-being of anyone else is a desirable change.

2 Efficiency & Pareto Optimum

An Italian economist, Vilfredo Pareto (1848-1923) suggested the so-called Pareto optimality
criterion :
Any change that makes at least one individual better off and no one worst off is an
improvement in social welfare. A situation in which it is impossible to make anyone better off
without making someone worst off is called a Pareto optimum.

Traditional Concept On Efficiency

Perfect competition guarantees the attainment of three states of efficiency :
* Consumptive efficiency :
For any two goods X & Y; MRS of a person = MRS of another = MRS of ...
* Productive efficiency :
For any two inputs L & K; MRTS of a firm = MRTS of another firm = MRTS ...
* Allocative efficiency :
For any two goods; MRS = MRTS.
In a modern terminology, MUV = P = MC of a good.

However, the market fails to attain Pareto optimum or allocative efficiency due to some cases.
The market fails because MUV  P and MUV  MC.
The cases include : the existence of monopoly ; the existence of externality ; the presence of
natural monopoly ; the presence of public goods ; risk and uncertainty leading to imperfect
information.

3 Modern Concept On Efficiency

In reality, there is always a cost in using the market - the transaction cost. So the more powerful
analysis by economic theory is the application of transaction cost rather than a comparison between
the reality and perfect competition.
To attain Pareto optimum or efficiency, transaction cost must be zero. Once transaction cost is zero,
it also implies that property rights must be well-defined.
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We then explain human behaviour with this concept.

To take the example of externality, the correction of externality is not costless. Many people often
ignore the existence of huge costs and external side-effects of the correction itself. The costs may
outweigh the benefits.
It follows that a divergence between private and social costs may not be inefficient ( because we
cannot be better than the present situation - Pareto optimum ).
As a result, externality needs not be eliminated by government intervention.

IV Common Property Resources

A Meaning & Examples Of Common Property Resources

Common property resources refer to any resources without well-defined property rights. Once the property
rights of these resources are well-defined, they become private properties.
No one has a right to exclude others from using it and any person is free to compete (if it is also scarce)
for its use.
A common property resource may be a free good like air or a scarce good like ocean life such as blue
whales, sharks; wildlife such as elephants, tigers ; and also the atmosphere.

B Over-utilization & Rent Dissipation

1 Common property resources, with common rights, will encourage everyone to acquire them without
bearing the full cost. The resource-takers tend to over-utilize the resources. In other words, in the
absence of private property rights, these resources are excessively exploited.
Without exclusive rights to use the resource (or an exclusive claim to the value of it) its use will
invite competition. Finally, every competitor can earn no more than the alternative earning of his
own factor inputs required in the exploitation of that property resource.

2 This competing use of a common property will reduce its economic rent or net value of the income
earned to zero. This exclusive income or rent is said to be completely dissipated because the cost of
inputs used to get this formerly common property matches the amount of income earned at the
margin.
The condition is described as rent dissipation.

3 With the lack of exclusive use rights, the competition of a common property will lead to rent
dissipation which implies :
- over-exploitation or excessive use, e.g. over-fishing; over-hunting; or
- under-exploitation, e.g. fruit trees in the New Territories.
However, complete rent dissipation is also rare. People will restrict the use of that common property
by regulations or information costs, e.g. marine fishing with licences, size restriction on fish and
marine life etc.

* * *

An Overview Of Microeconomics

1 This topic begins by an introduction of the concept of externality. Then, the traditional concepts
of market and government intervention are explained. This is followed by the modern approach
on externality, emphasizing on Coase ideas and solutions.

2 The real problem of social cost lies on an understanding of the nature and application of
transaction cost and property rights.
These two concepts can explain what is really the problem of social cost and externality.
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3 These two constraints give us more powerful theories to explain human behaviour.
The problem of social cost also lies on these two concepts.

4 The role of market and price, accompanied with transaction cost and property rights, forms the
fundamental framework in microeconomic theory and analysis.

End of Microeconomics