Coase Theorem

SUBMISSION QUESTION 7

EXTERNALITIES AND COASE THEOREM

(a) Explain what is meant by “externalities”?

(b) Consider an industry whose production process emit a gaseous pollutant into the atmosphere. Use the simple supply and demand model to demonstrate that, in the absence of any regulation, this industry’s production will result in allocative inefficiency in the use of society’s resources.

Externalities is cost or benefit from production or consumption of commodity that flow to external parties but not taken into account by market (Bajada, 2012).

The impact of externalities is the distortion in allocation of resources. Externalities will cause individual to pursuit based on their self-interest. Hence, it will cause commodity not produced at the socially optimal level and output become inefficient (Frank, Jennings and Bernanke, 2009).

There are two types of externalities:

(1) Externalities cost

Externalities cost happens if production or consumption of commodities inflict cost to external parties without compensation (Bajada, 2012). When externalities costs occur, producers shift some of their costs onto community making their production costs lower than otherwise, thus the commodity become underprices and over-allocation of resources (Bajada, 2012).

The example of externality cost is industry whose production process emits gaseous pollutant into atmosphere. The pollution will impose higher medical or health costs to the society nearby the industry area. The producers should include the pollution costs to their products since they are not implementing process to refine the waste.

Source : Wikipedia.com | The curve shows that the market equilibrium is at price Pp and Quantity Qp. In the absence of any regulation, the equilibrium price will be underpriced because the industry did not include social cost of industry’s pollution. Furthermore, the quantity equilibrium is too high because over-allocation of the resources...