Question

John has lot of issues, both mental and physical. He has a contagious disease that

increases in the probability that those in the same room with him will get diarrhea. Luckily the only people he comes in contact with are his 4747 students. In addition, his mental conditioncauses him to be a jerk.

The good news is there are pills he can take for both conditions and the more he takes the better he is (nicer and less contagious).

The bad news is that the pills are expensive.

Assume he has to take pills in whole: no fractions.

Being an economics professor, he takes, each day, more pills as long as his MPB is greater than or equal to his MPC.

He would likely take more pills if those additional pills were free to him.

First, explain why he might take an inefficient number of pills from the classes’ perspective (the 4747 students and John). Why the word “might” rather than “will”?

Then consider the following plan: the 4747 students correctly figure out how much money is needed to buy the additional pills that would be required to get him to the point where he is

consuming pills up to the point where MSB=MSC. Assume the cost is $X>0

The students then make voluntary contributions to an Edward pill-fund, and the money raised is

used to by the extra pills.

Discuss whether this plan is likely to be efficiency increasing. Discuss whether it is likely that John will end up consuming the efficient number of pills from the classes’ perspective.

Answer 1

Let's try to understand a few concepts before getting in to the discussion.

Marginal Private Benefit (MPB) is the benefits enjoyed by the individual consumers of a particular good. Does not take into account any external benefits or costs arising from a goods consumption.

Marginal private cost (MPC) is the change in the producer's total cost brought about by the production of an additional unit of a good or service. It is also known as marginal cost of production. For example if production costs rise from$1,000 to $1,050 as one more unit of a good is produced the marginal private cost is $50. The metric that quantifies induced consumption, the concept that the increase in personal consumer spending (consumption) occurs with an increase in disposable income (income after taxes and transfers).

Marginal social cost (MSC) is the change in society's total cost brought about by the production of an additional unit of a good or service. It includes both marginal private cost and marginal external cost. For example, suppose it costs a producer $50 to produce an additional unit of a good. Suppose that when the additional unit is produced pollution is emitted which causes $25 worth of damage to the paint on your car. The marginal social cost of production is the producer's cost plus the external cost, or $75.

Marginal social benefit (MSB) is the change in benefits associated with the consumption of an additional unit of a good or service. It is measured by the amount people are willing to pay for the additional unit of a good or service. For example, suppose you are currently consuming two slices of pizza .per day. Assume you would be willing to pay $.75 to consume a third slice of pizza per day. $.75 represents the marginal social benefit of the third, or additional, slice of pizza.

Marginal external cost (MEC) is the change in the cost to parties other than the producer or buyer of a good or service due to the production of an additional unit of the good or service. For example, suppose it costs the producer $50 to produce another unit of a good. Suppose this production results in pollution which causes $60 worth of damage to another company's plant. The marginal external cost is $60.

1. John might take inefficient number of pills by considering the MPB. It is the impact of externalities. 4747 students getting diarrhea is not his concern. Others may be finding him a jerk and not John, personally. This creates inefficiency.

2. The students plan to make voluntary contributions to an Edward pill-fund, and the money raised is used to by the extra pills is likely to increase efficiency and the class's perspective of John consuming efficient number of pills if offered free is right. Let' see why?

It is due to the dynamics of externalities

• Consumers weigh up the costs and benefits to themselves of engaging in a transaction; we call these private costs and benefits.
• Producers weigh up the costs and benefits to themselves of engaging in a transaction (these are also private costs and benefits).
• But neither consumers nor producers are likely to weigh the costs or benefits to others affected by a transaction

We call costs or benefits experienced by people outside the transaction external costs or external benefits or (generally) externalities. When costs or benefits are experienced by people outside a transaction, the actors in the transaction (consumers and producers) don’t take those external costs or benefits into account.

An externality must come from an action, something that somebody does. Good weather is not an example of an externality. Nor is an earthquake. The action could be taken by an individual (say, smoking a cigarette) or a firm (dumping toxic waste into a river). In most cases, the action is associated with production by a firm or consumption by a household.

In John's case, a positive externality arises. i.e Edward pill-fund action by individual students bestows benefits on 4747 students and john. When there is a positive externality, too little of the action is undertaken.

The definition of an externality makes it clear that the fundamental problem is one of behavior, actions by a firm or a household. The behavior reflects a difference between private costs or benefits and social costs or benefits. These observations also point us to a solution. We need to change incentives so as to align private costs or benefits and social costs or benefits. For example, if the private marginal cost of pollution to a firm were somehow equal to the social marginal cost, then a firm acting in its own self-interest would produce the socially optimal amount of pollution. The challenge for policymakers is to find a way to adjust the incentives so that the firm takes into account social marginal costs in addition to private marginal costs.

From this perspective, inefficiency arises because there are no market signals that force the polluter to take into account how its actions are affecting others. The goal of government policy in the presence of externalities is to provide incentives for firms and households to internalize their effects on others. These policies include direct restrictions on what people can do (for example, banning smoking in public buildings), taxes and subsidies that affect prices in an economy, and the introduction of markets that force polluters to pay for the right to pollute. Because externalities involve a divergence between private costs and social costs (or private benefits and social benefits), the goal in all cases is to adjust the incentives so that the actor internalizes the externality.

Before concluding, let me more precise: externalities are a source of inefficiency unless they are compensated for. Think about John and 4646 students who shared a class room. John's actions impose a negative externality on the students. Without any compensating payments, we end up with an inefficient outcome. But when Johb pays the students for the right to use up the healthy environment by accepting charity, we end up with an efficient outcome. Negotiation between Johb and 4747 students in effect creates a market for the clean and healthy classroom. Once this market is in place, the inefficiency disappears.