5. Market Failure due to externality

In a free environment, the individual would only take into account his private costs, and ignore (or are unaware of >.>) the wider social costs and benefits. In this case, the common sense mechanism is likely to fail in bringing about an optimal allocation of resources.

[To put it in layman terms:

The majority of students succumb to laziness if left unattended to. They ignore the social implications like their failing of examinations and tests, so as long they can stay in the system. With that said, they usually have little or no common sense.

Why?

That is due to a inverse proportion between distractions and common sense. The higher the amount of distractions in your life, the lesser amount of common sense you have, and vice versa.]

In order to correct such externalities, parents have to intervene.


6. Parental Intervention to Correct Externalities

To correct externalities, parents can use a slew of measures. Which measures they use will depend on the type of externality that occurs.

(i) Limiting

Parents can impose a limit that is equal to the marginal external cost. By doing so, individuals are forced to allocate their time towards knowledge-production, otherwise known as "studying".

Note: In the real world, there would still be some sort of negative externality remaining still. This is due to the obstinate individual insisting of not studying, following a "die-die must play" attitude.

Advantage: Many parents favour this solution because it still allows the individual to operate. By doing this, the individuals may be encouraged to find faster, more efficient ways to study. This limit thus acts as an incentive to reduce inefficiency in the long run: the faster the individual finishes his work, the more time there would be for him to slack.

Disadvantage: However, finding the correct amount of time to limit to eliminate efficiency loss isn't likely to be simple. Some things are very difficult or impossible to express accurately in terms of time. If we over-estimate external costs, we will tend to levy excessively high limites that more than correct for the actual external cost. In other words, the parents will piss the individual off for being "unreasonable".

(ii) Imposition of rules and regulations

Rules can be used to prohibit or regulate behaviour, usually by force, and/or punitive measures. For example, the individual should get good results in order for him to continue staying alive, or risk getting nagged to death by parents.

Advantage: Such measures directly reduce the level of negative externality to the desirable level, and are usually better than limiting. Furthermore, in most circumstances, parents have a better idea of the acceptable level of negative externality such as slacking than the amount of limit that would lead to that result. Rules and regulations are simple and clear to understand and are often easier to administer.

Disadvantage: The main problem of this is that they tend to be a rather blunt weapon. There would not be an incentive for the individual to reduce his slacking below the stated level. No matter how fast the individual finishes his work, he would still have to sit out the entire time allocated for his studying. Pfft. Furthermore, in order for the rule to be effective, the penalties of breaking it must be harsh and inspection or spot-checks must be frequent and rigorous.

(iii) Ban

This only happens in extreme cases, only if either party (the parent or the individual) is insane. You get the drift.

(iv) Parentalization

If the individual has a detrimental effect over his well-being, parents may be forced to take over his role completely, e.g. the sitting of examinations.

However, parents may not have information of the tested topics, and thus do not know how to do the papers.


7. Pseudo-Coase Theorem

Ronald Coase criticized parental intervention such as limiting and rules to correct externalities as he felt this will lead to greater inefficiency due to lack of information. He argued that whenever there are externalities, the parties involved could get together and make some negotiations to ensure efficiency. Thus, parental intervention may not always be necessary. However, there are three necessary conditions before Pseudo-Coase Theorem can be applied:

1. The word of each party should not be broken.
2. There must only be a low cost of negotiations, with little or no strings attached.
3. The source of externality must be well-defined.

As such conditions are often not satisfied in the real world, Pseudo-Coase Theorem is at most a theoretical exercise. However, it is still an important theorem as it forces parents to re-look at the way they tackle externalities.