economics questions 32

EXTERNALITIES

Adam Smith is famous for his profound insight that competition serves to align the private interest of the individual with the social interest of the community at large. You have encountered this conclusion in your textbook in the discussion on the efficiency of competitive markets. Even though each consumer and each producer intends only his own gain, an equilibrium is reached that is efficient and maximizes the net benefits to society from the production of the good in question.

Does competition always generate this happy outcome? Sadly, no. Under certain circumstances, unfettered self-interest makes the whole community worse off. In the last two decades of the twentieth century the population of beluga sturgeon in the Caspian Sea fell by 90 percent. Today, passing trawlers inadvertently scrape the delicate coral reefs off the coast of Norway. Thailand’s environmentally sensitive mangrove forests are being destroyed by shrimp farms. (Broad, William J. and Revkin, Andrew C., “Has the Sea Given Up Its Bounty?” New York TimesJuly 29, 2003, Late Edition (East Coast): F1.)


Even though these activities are all motivated by producers’ desire to meet the world’s demand for the produce of the oceans, and producers are surely paying for their ships, fuel, and bait, Adam Smith’s conclusion does not apply in any of these examples. The reason is that the producers are not incurring the full cost of their activities.

Every fishing boat contributes to the pollution of the waterways. But no one presents the owners with a bill for their share in the pollution-induced deterioration of the fishery. This cost is external to the owners’ reckoning, and is therefore ignored. Whenever an individual can avoid part of the cost of his or her activities, actions that make the individual better off can harm the collective good, sometimes dramatically. The marginal private cost is less than the marginal social cost. The figure below illustrates the situation in which a fishing boat creates an external cost.

Question 1:

On the figure, identify the following:

a) The equilibrium quantity of fish if the market is unregulated and competitive.

b) The magnitude of the marginal external cost at the unregulated, competitive market equilibrium.


Question 2:

Britain is proud of its National Health Service (NHS). In 1948, the National Health Service Act stipulated that the government would provide virtually free medical care for all citizens. Physicians receive a salary plus a per-patient payment from the government. The NHS embodies the socialist philosophy that profit-driven markets are not the appropriate mechanism for allocating health care.

Markets serve two functions simultaneously: (1) allocation of existing goods and services among competing buyers, and (2) motivation for producers to bring new goods and services to the market. The NHS was established to replace market-determined prices with prioritized waiting lists as the allocation mechanism among competing buyers. Recently, however, the NHS has embraced the profit motive as a mechanism for performing the second function.

The Economist reported that the government has introduced mechanisms to allow hospitals and individual inventors to profit from their innovations. Intellectual property rights will be assigned and protected, allowing the market to reward producers. The Economist predicts an enthusiastic reaction by producers. “In the first year of this new regime, the NHS has earned about £500,000 ($830,000) from about a dozen inventions or new techniques. There is, American experience suggests, plenty of scope for more. One American hospital alone—Massachusetts General in Boston—has an annual licensing income from its doctors’ discoveries of $30m. In 2002, the hospital reckoned it made 213 discoveries, filed 104 patents, and spun out four companies.” (“Healthy Profits.” The Economist October 2, 2003)

a) Imagine a doctor in Britain finds a way to treat stomach ulcers with common kitchen ingredients, replacing a costly prescription medication. The potential marginal social benefit of this discovery would be the amount saved by the NHS on all ulcer patients’ prescriptions, which is tremendous. If there are no intellectual property rights, what is likely to occur?

b) Why might your consumption of medical services confer some external benefits to the people around you?


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