Question

Assume that meat producers operate in a perfectly competitive industry. Producers include machinery, cattle feed, wages, electricity, etc. in their total cost calculation. However, cows fart....a lot; releasing methane gas in the process. Meat producers do not account for this cost in their day to day operations (Methane is a greenhouse gas that contributes to climate change).

(a) Will the perfectly competitive market equilibrium maximize economic surplus? Why?

(b) What type of government intervention could be used to get a social optimum? Specify what the type and size of the intervention would have to be to generate the socially optimal outcome.

(c) Suppose meat producers convince the government that the real issue stems from the fact that the air space around farms do not have well-defined property rights. If the government assigns property rights for the surrounding air to producers, then leave neighboring citizens and meat producers to negotiate freely, will this process generate a socially optimal outcome? Explain (Hint: think about the assumptions for perfect competition)

Answer 1

A) No, the perfectly competitive market equilibrium will not maximize economic surplus because of the negative external cost emitted by the meat producers (in the form of methane gas) into the environment, which is not taken into account by them while making production decissions.

That is, since marginal private cost is less than marginal social cost (MPC + external cost), it means social optimal output is less than free market output, leading to economic surplus not being maximized.

B) In order to generate social optimal output, the government must impose a per unit tax on producers, equal to the external cost per unit imposed by producers.

C) Yes, through bargaining (application of Coase theorem), farmers and nearby citizens would reach a mutually agreeable output decision, which would maximize economic surplus.