Howdy folks, let's take a crack at
chapter 5 . Chapter 5 is fairly dense, so
I'm going to try to highlight the major
models and conclusions of chapter 5 in a
nutshell.  Chapter 5 is trying to help
acquaint you with market failure.  Markets
as we've dealt with them so far have
always produced equilibriums that
matched up marginal benefit with
marginal cost for the last unit produced,
i.e.,  the last unit that got us to
equilibrium.  Markets are not always going
to be able to do this, and one of the
primary reasons that they fail is
externalities.  This first piece of our
chapter 5 will focus on externalities
and we will talk about spillover costs
and spillover benefits as we develop
this and highlight how in fact the
spillover, or unaccounted-for costs,
result in market failure... and there's at
least the possibility of being able to
avoid market failure,  if private
bargaining can take place.
Okay, let's review briefly.  We've already
established that equilibrium, as
expressed by this Q and this P, maximizes
producer and consumer surplus.  It also
for this last unit has a marginal
benefit of the last unit equal to the
costs of producing it.  I want you to be able
to start thinking about the demand curve
as essentially a reflection of private
marginal benefits and the supply curve
as a reflection of private marginal
costs.  I've expressed that for you here.
To put it in more plain language though,
producers are only willing to produce
the next unit of output if the price is
sufficiently large to cover the marginal
costs of producing that last unit,  so
obviously as the price gets higher more
and more producers are willing to
provide output, hence, the positively sloped
supply curve.  On the demand side you can
think about this in terms of what the
next unit is worth to the folks.  If in fact
you see that prices are rising then that
output had better be valuable in order
to get people to continue to want to
keep buying it so as price rises more
and more folks decide that those last
units of output do not generate a
marginal benefit sufficient to cover the
cost of acquiring that output.  So really
you can think about, uh for any given Q, you
could plug that Q into the supply curve
and you could go and ask what's the
value or the marginal cost of that unit
of output was or you could ask what the
marginal benefit of that unit of output
was.
In essence you can start with a Q like
this one,  and this quantity you plug it
in...you can see what the marginal cost
was of producing that, (right??)...the minimum
price that you'd have to allow them to
charge in order to cover that cost on
the producer side or what it was worth
to the last
interested buyer.  In other words what is
the price that would have to prevail in
order to get folks to demand that last
unit.  Keep this in mind as we're going
forward,  it'll be important for you to
recognize that demand is a reflection of
private marginal benefit and the supply
is a reflection of private marginal cost.
Okay, so we understand that the supply
curve adequately captures private
marginal costs and the demand curve
adequately captures private marginal
benefits.  What they don't do is keep
track of spillover costs or spillover
benefits.  Spillover costs are going to be
refer to as negative externalities and
spillover benefits are going to be
positive externalities.  Here are a few
examples that we can talk through
briefly.  In the positive category we've
got four examples of things that are
quite useful to society at large even
though they generally don't have to pay
for them.  So when your neighbor puts in a nice
yard you get to look at it but you don't
have to pay for it.  The more and more
people that have car alarms and alarms
on their houses thieves have to worry about
getting caught for stealing,  that means
that there's less likely to be a robbery
and theft because of these purchases.  You
benefit from that even if you didn't
purchase one.  Vaccinations,  when
you get vaccinated you actually make it
less likely for everyone around you to
get sick,  but they didn't help you pay
for your vaccinations.... spillover benefit
for them.  When somebody keeps a bunch of
bees they're going to pollinate crops, do
nice things for the environment.  Once
again you didn't have to help pay for
that. Negative externalities, negative
externalities are our spillover costs
and whenever you drive your car around
you pollute, that's a cost that the rest
of society bears.. right??   You're thinking
"Well I paid for my gasoline and it's
nice to drive around."  Yes it is, as you
drive around you impose the cost on the
rest of society. Every time folks overuse
antibiotics they help bacteria build up
immunity and make it more likely that
antibiotics won't work for us in the
future the same way they do now.
Unhealthy food options... as people
continually consume very very high
carbohydrate food they're more likely to
be obese, they're more likely to suffer
from type 2 diabetes, all these things
will drive up medical costs within
society.  It's another negative
externality.... there's a few examples there.
What I want you to recognize is that if
the supply and demand curves do very good
jobs at capturing private benefits and
costs it doesn't mean that they
necessarily capture societal benefits
and costs.  In order to start talking
about societal benefits and costs we're
going to have to add on, essentially, to
both of those curves.  When we're thinking
about negative externalities the supply
curve captures our marginal costs,
private marginal costs... it doesn't
capture however all of our spillover
costs.  The difference between the supply
curve... or your marginal cost curve
and the marginal social cost curve, which
I've just drawn in here, is of course
your negative externality...
and it's the negative externality on
this unit.  So we're gonna have to adjust
our supply curve essentially in order to
capture what's going on here.  Similarly,
when we talk about positive
externalities we're going to have to
adjust our marginal benefit curve or
demand curve, because it is only
capturing private gains.  But when you go out
and you buy that vaccinations you actually
are going to generate benefits beyond
just your marginal benefit.. right?... that's
all that the last buyer captured, but 
they also generated this additional
benefit.   The difference between MSB and MB is the neg...err I'm sorry the positive
externality on that last unit.
Okay so we understand that we can adjust
supply and demand in order to capture
spillover costs and spillover benefits. 
When we put all that information to good
use we now have a reflection of total
social costs and total social benefits...
and as you might imagine we're gonna aim
for this intersection right here. This
quantity will refer to as Q optimal and
at Q optimal we are essentially going to
follow a version of our golden rule.  The
last unit that we created generated a
social benefit on the margin that was
equal to the marginal social cost of
creating it.  In other words we've made
sure that we're not only paying
attention to private costs and benefits
on the margin but we're also accounting
for all of the social spill overs that
might be happening.  When we can get a
market to MSB equals
MSC (here),  then this is of course
efficient level of production. This is
where a market needs to be in order to
not fail.
Okay,  so markets need to get to a
quantity that has MSB equal to MSC and if
they're not accounting for externalities
they're unlikely to do that.  However,
there's a gentleman by the name of Coase
and Coase argued that there's no real
reason that folks can't overcome
externalities as long as they have
reasonable expectations, can chat with
each other,  and have a pretty good sense
of the costs and benefits of the
activities involved.  I've highlighted all
these down here at the bottom.  The Coase
theorem in a nutshell , basically is that
private bargaining allows folks to pay
each other off in order to reach
efficient outcomes. 
So we can walk through a couple of quick
examples here.  In example one, you've got
a situation where your neighbor might be
mowing the lawn very early every
Saturday morning.  You might prefer that
they not do that.  Even if they have the
right to do it that doesn't mean it's
efficient,  and if you were to approach your
neighbor and offer to pay them off so
that they wouldn't do it,  then you'd
actually have to just figure out between
the two of you who valued silence, so to
speak,  more.  If you were willing to pay
$50, your neighbor might be willing to
not mow their lawn.  In that case you
clearly value the silence more than they
value getting the lawn mowed early and
it would be a bargain that both of you
would be happy to make.  In other words
you're efficiently using the "resource".  Shared space and noise
level is also a similar thing you might
imagine or you might relate to if you've
ever had to share a room, a dorm room or
a room with a sibling.  This example here,
you might imagine that you have a
sibling who is continually practicing
karaoke for the voice because  they're
convinced that they are going to be the
next you know reality TV star.  You might,
on the other hand, want to be able to
study... and of course if mom tells you
that they have the right to practice
karaoke in preparation for fulfilling
their dreams, then they have a legal
right... but that doesn't mean that you
might not be able to get them to stop
doing.  It's going to depend on rather not
you value the silence more than they
value the karaoke practice time. I'm sure
all of you at one point or another have
probably bribed the dorm roommate or a
sibling to get them to stop doing
something. 
In that case you're actively bargaining
towards a more efficient use of the
space.  To put this into a slightly more
realistic, or maybe not even more
realistic.... a larger scale let's say.. you
can think about a factory that has legal
rights or at least it's not breaking the
law when they pour off wastewater into a
stream... and if in fact if that is not
illegal,  then you're going to have to
live with that....
unless you value the clean water and
stream more than they value the cheap
way of getting rid of waste.... so even if
they're not breaking the law,  Coase would
suggest that the town and all of the
affected parties essentially go in
together to memorialize an agreement with
the factor that basically sets up a
payment system where they will be paid
not to pollute.  And of course this is a
good outcome for both of you, because if
you were willing to pay off the firm to
engage in a more expensive method of
getting rid of their waste and you end
up with clean water to boot,  then this is
a good deal for you particularly if you
still value the clean water more than
you had to pay for it.  In other words
you'd have some consumer surplus...you
might think about it that way.
So there's three quick examples that I
hope give you the flavor of the Coase
theorem,  and I want you to reflect on the
fact that in order to get any of these
solutions to work it relied on the
ability of people to get the
information they needed cheaply,  that
they were both reasonable in terms of
their expectations... they weren't going to
lie about how much stuff was actually
going to cost or about how much it was
worth to them...,  and they had a good sense
of the costs and benefits that were
involved.  Oftentimes those things aren't
that easy to come by,  and if they're not
easy to come by,
well, markets may end up failing and
there may be a clear role for government
to step in and try to fix things.  We'll
pick that up in our next presentation.
