Microeconomics Assignment 5

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Welcome, Nicole Jarvey.
Monday, December 25, 2017 8:42 PM
Assignments & Exams
Course: Microeconomics: ECO-1011709
Assignment: Assignment 5
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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