SUBMISSION QUESTION 7
EXTERNALITIES AND COASE THEOREM

(a) Explain what is meant by “externalities”? (b) Consider an industry whose production process emit a gaseous pollutant into the atmosphere. Use the simple supply and demand model to demonstrate that, in the absence of any regulation, this industry’s production will result in allocative inefficiency in the use of society’s resources. Externalities is cost or benefit from production or consumption of commodity that flow to external parties but not taken into account by market (Bajada, 2012). The impact of externalities is the distortion in allocation of resources. Externalities will cause individual to pursuit based on their self-interest. Hence, it will cause …show more content…

This will reflect by the shift of the demand curve to the right. (3) Government supply

The correction will cause the shift both in the demand and supply curve to the right. The market will meet new equilibrium that reflect the social benefit at price Ps that higher than Pp and Quantity at Qs that higher than previous equilibrium Qp.

(c) Explain the Coase Theorem. What are the limitations of Coase theorem which might make its approach to resolving the externality problem inapplicable for this industry? (d) Discuss alternative forms of intervention by government aimed at correcting the externality problem in this case?

Coase theorem states that if property rights are well defined and parties can negotiate in negligible costs, then the outcome will be efficient solution to the externalities regardless of to whom the property rights are assigned (Haworth, 2010).
Consider the following example:
A firm locates near to the lake, dumps its waste to the lake rather than pays for the waste removal. Fishermen, who earn their livelihood in the lake, are affected – it will lower their profits by $2000 per year – because the waste kills many of the lake’s fish. The cheapest way to eliminate the pollution problem is to buy pollution control equipment which cost $1000 per year to operate and maintain. (i) The firm has the property rights to the lake.
The fishermen must