‘Suggested Answers : S6 Econ Rev. Test: The Problem of Social Cost (36 marks) 1. The Coase Theorem states that if property rights are well defined and transaction costs are zero, then: (1) the allocation of resources will be identical regardless of the initial assignment of property rights, and (2) the allocation of resources will be efficient so there will be no problem of externality. The theorem of exchange is that trade occurs because participants find it mutually beneficial since people place different use values on scarce goods. It can be seen, therefore, that since the Coase Theorem suggests that external effects are potential gains from trade, which may be captured through contracts between those responsible for effects and those affected by them, it is just the theorem of exchange. The theorem of exchange is based on well defined property rights and transaction costs which are not prohibitively high, so that exchange will be mutually beneficial and the gains from exchange are fully utilized. Thus, externalities can be transacted, provided that the conditions of exchange are satisfied. 2. If transaction costs are zero, by the Coase Theorem, private contracting will internalize the external cost. The social optimum will be achieved and so as the allocative efficiency. There is no need for the government to intervene. If transaction costs are prohibitively high, although there exists a divergence between private and social costs and deadweight loss appears, the situation Is still efficient because no reallocation of resources is worth enforcing. Yet, as different assignment of property rights will affect the resources allocation and the resulting deadweight losses, the government should assign the rights to the one who can minimize the deadweight loss. However, the question does not supply enough information to determine the appropriate assignment of property rights. Besides the assignment of property rights, other forms of intervention are unnecessary and inappropriate. 3. A market demand curve describes the relation between the market quantity demanded and the price. “ Adding horizontally’ means that at each price level, quantity demanded of each individual is added together to get the market quantity demanded. As each consumer has to buy its own share of the good for consumption, the good must be exclusive in consumption. The good is a private good. On the other hand, ‘ adding vertically’ means that for each unit, MUV of each individual is added together to get the market price. As every consumer is paying for the same u of good, the good must be non-exclusive in consumption. It is a public good.4. If the cost of serving an additional customer is equal to zero, to maximize TUV (to achieve consumption efficiency), all individuals with a positive MUV should be allowed to consume the public good. To welcome all users, the producer may practice either perfect price discrimination or zero pricing. However, production of public good is costly. Under zero pricing, the production cost cannot be covered. No public good can be produced unless it is financed by the government. Allocative efficiency cannot be achieved under zero pricing. So perfect price discrimination is the only pricing method that can achieve both consumption efficiency and allocative efficiency. Notes on ‘efficiency’ 1, Production efficiency is attained when firms adopt the cost ~minimizing production methods and MCs of firms producing the same good are equal. Then, the good will be produced at the minimum cost. 2. Consumption efficiency is attained when MUVs of individuals consuming the same good are equal. Then , the good will be consumed by individuals with the highest MUV. 3. Allocative efficiency is attained when MUV of each good is equal to its MC. Then, all resources will be allocated to their highest-valued uses.