Efficient Wage TheoryExternalitiesProperty RightsCommon Property ResourcesCite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY]. 1 1 Efficient Wage Theory 14.01 Principles of Microeconomics, Fall 2007 Chia-Hui Chen December 10, 2007 Lecture 34 Externalities, Market Failure and Government Outline 1. Chap 17: Efficient Wage Theory 2. Chap 18: Externalities 3. Chap 18: Property Rights 4. Chap 18: Common Property Resources 1 Efficient Wage Theory Use the efficient wage theory to explain the presence of unemployment. Suppose the wage is w, and workers can choose to work or shirk provided a benefit of S. The unemployment rate is u, and the workers get caught and fired with a pro bability p. If a worker shirks, he can get S + (1 − p)w + p(1 − u)w = S + w(1 − pu), if a worker does not shir k, he gets w. Therefore, a worker will work if w � S + w(1 − pu), that is, S w � . pu This is ca lled nonshirking constraint. Without information asymmetry, the market wage is wC , and full employ-ment exists at LC . With information asymmetry, the nonshirking constra int and the demand of labor determine the wage w ∗ and labor L∗ (see Figure 1). With greater asymmetric information, the probability that shirking is de-tected, P decreases , and thus the nonshirking constraint rises. The wage and ′ labor are w and L ′ respectively (see Figure 1). TherebyCite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY]. 2 2 Externalities w 10 9 8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 8 9 10 w* L* LCL’ w’ wC DL SL Nonshirking Constraint L Figure 1: Unemployment in a Shirking Model. • ∗ w > wC , L ∗ < LC ; • ′ ∗ w > w , ′ L < L ∗ . 2 Externalities Externalities are the effects of production and consumption activities not di-rectly reflected in the market. They can be negative or p ositive. Negative Externalities. Action by one party imposes a cost on another party. Example (Pollution). Pollution is not reflected in market because at mar-ket, residents do not demand firm pay for that cost. Positive Externalities. Action by one party benefits another party. Example (Beautiful Garden). If your neighbor has a beautiful garden, you are happier, but you do not pay your neighbor.Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY]. 3 2 Externalities 0 1 2 3 4 5 6 7 8 9 10 P MSC q* q1 Negative Externality An example is steel plant dumping waste in the river as it makes steel. That imposes cost on fisherman downstream. Marginal external cost (MEC) is the increa se in this cost for each a dditional unit of steel production. Marginal social cost (MSC) is M C plus M EC. Given the market price P , a firm chooses to pro duce q1, but if taking external cost into account, a firm should produce a t q ∗ (see Figure 2). MC 0 1 2 3 4 5 6 7 8 9 10 Q Figure 2: A Firm with Negative Externality. In a competitive market, the equilibrium price and quantity are P1 and q1, but the efficient outcome should be P ∗ and q ∗ (see Figure 3). The failur e to incorporate external cost creates deadweight loss. Positive Externality Landscaping generates externa l benefits to the neighbors . Like the example above, the marginal social benefit (MSB) is the sum of private benefit (which is the demand) and the ma rginal external benefit (MEB). The quantity q1 consumed in the market is less than the efficient level q ∗ (see Figure 4). Solution to Externality Here are some solutions with government intervenes.10 9 P MSC 8 DWL 7 6 MC P* 5 4 P1 3 2 1 qq* 1 0 D 0 1 2 3 4 5 6 7 8 9 10 Q 0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10 Q PMC MSB q*q1 D P1 Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY]. 4 2 Externalities Figure 3: The Whole Industry with Negative Externality. Figure 4: External Benefits.Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY]. 5 3 Property Rights • Tax each unit produced by M EC. The marginal cost of the firm is M C + T = M C + M EC = M SC, then the firm will choose efficient output. • Create a standard and monitor pollution. Control the quantity produced or pollution emiss ion. 3 Property Rights When prope rty rights are well-specified, economic efficiency may be achieved without government intervention. • Factory can install a filter. • Fishermen ca n pay for a treatment plant to intercept and clean up factory waste. Factory Fishermen No Filter No Treatment Filter No Treatment No Filter Tre atment Filter Treatment Factory’s Profit Fishermen’s Profit Total Profit 500 100 600 300 500 800 500 200 700 300 300 600 Table 1: Profits Under Alternative Emissions Choices. In this case (see Table 1), the most efficient result is that factory installs filter and fisher men do not pay for treatment. • If fishermen own the river, they can sue the plant for damages $400. The factory has two options . – The factory do not install the filter and pay damages. Profit 500 − 400 = 100. – The factory install filter. Profit is 300. Thus the factory will install the filter. • If factory owns the river, fishermen have three options. – Fishermen put in treatment plant. Profit is 200. – Fishermen pay the cost of filter installation to the factor y. P rofit 500 − 200 = 300.Cite as: