Question

Consider the market for night-time events at Bellerive Oval. To host night-time events the oval must have its large light towers switched on which shine brightly into neighbouring houses disrupting their sleep and night-time recreation
i. What is the externality in this situation and why is it a market failure?
ii. Draw a diagram for night-time events at Bellerive Oval. Clearly identify: the private and social costs curves, efficient equilibrium, the market equilibrium and the deadweight loss.
iii. How might Coasean Bargaining be used to reduce the deadweight loss?

Answer 1

Part i) It is given that the night event negatively impacts the neighbours' sleep (that is, their consumption negatively impacts the consumption of neighbours'). This is the example of the negative externality.

It is a market failure because of the agents' decision in the market of night event negative impacts the neighbours'. That is damage of their decision is bare by others and not the night event consumers. So, their decision will not internalise the marginal external damage. Thus, the private optimum leads to the consumption of the event which is higher than that of the society's optimum consumption level. That is the case of Market failure.

Part ii) The private marginal cost (PMC) that is borne by the private individual. And the social marginal cost (SMC) is the cost that is borne by all the society members. Here it is the case of consumption externality. Thus, the SMC is equal to the PMC. But, the social marginal benefit (SMB) is different from the private marginal benefit (PMB) by the amount of damage, that is SMB = PMB - MD. Here the marginal damage (MD) is capturing disruption neighbours' sleep. The diagram showing the deadweight loss because of externality is shown below-
Part iii) The Coasean bargaining can help the market to achieve efficient equilibrium. Thus, reduce the deadweight loss. This is attained by somehow the external damage to society is internalised in the decision making of the night event consumer. And it will lower the PMB to SMB, that is, efficient equilibrium is achieved.

The property right will also help in achieving the efficient outcome irrespective of the initial right allocated to the victim (neighbours) or to the externality producer. As according to Coase theorem initial assignment property right does not matter as long as an assumption of no transaction cost is satisfied. Then by bargaining, they will reduce deadweight loss. As if the property right is to the victim then he will be compensated for loss and if he does not have right then he will compensate the externality producer to reduce consumption of event to the efficient level. Thus, in both cases, the damage is internalised and thus deadweight loss is reduced by bargaining between the victim and the externality producers.