Question

An apple grower’s orchard provides nectar to a neighbor’s bees, while the beekeeper’s bees help the apple grower by pollinating his apple blossoms. Use Figure 4.5b to explain why this situation of dual positive externalities might lead to an underallocation of resources to both apple growing and beekeeping. How might this underallocation get resolved via the means suggested by the Coase theorem?

Short answer

The dual externalities are not reflected in the demand curve for each of the two goods (apple and beekeeping); only the people getting private benefits (no external benefits) are demanding the good, which results in the underallocation of resources.

The Coase theorem suggests that the two parties should negotiate and establish a payment system to resolve the underallocation of resources.

Step-by-step solution

Step 1. Dual positive externalities leading to underallocation of resources

The dual positive externality in which the apple-growing helps the beekeeper, and the beekeeping helps the apple grower are the indirect benefits that are not captured while deciding the equilibrium level of output in each good’s market. Hence, the demand for apples and beekeeping is lower compared to their socially desirable levels.

Considering a general case as shown in the diagram below, the demand curve D (apples or beekeeping) is too low compared to the total benefit demand curve, Dt, which includes both private and external benefits.

Given the supply curve, the lower demand curve results in a lower level of equilibrium at point “x,” where the output level is Qe. The difference between optimal level Q0 and Qe is that the market is underproducing the good. Hence, there is an underallocation of resources occurring due to distorted incentives (exclusion of consumers who receive external benefits). The triangle “xyz” gives the efficiency loss.

Step 2. Resolving the problem of underproduction using Coase theorem

The beekeeper and the apple grower know about the external benefits they receive from each other’s economic activities. They can use private bargaining and can collectively decide the payment systems to avoid free riding. In this way, both will produce the optimal output level as the external benefits are now incorporated in the form of a payment mechanism.

Thus, the apple grower should pay the beekeeper for the pollination, and the beekeeper should pay for the nectar produced by the bees using apples. This is called the Coase theorem, where two parties enter into mutually agreeable solutions without government interference to correct the externality.