6: Externalities and Public Goods Flashcards
When is the market equilibrium efficient according to the first theorem of welfare economics?
According to the first theorem of welfare economics, the market equilibrium is efficient if we live in a economy with perfect competition.
When is a market a perfect market?
Accordingly, a government can never improve efficiency by intervening in such a perfect market.
What is analyzed in this chapter?
In this chapter we analyze a deviation from the assumption of perfect competition.
==> If externalities are present, the market equilibrium is usually not efficient anymore
How do individuals in a perfect market behave?
How is an efficient market equilibrium possible in this case?
In a perfect market, all individuals are egoistic and maximize only their own well-being.
==> However, the invisible hand of the market (which is actually the signal that the market price sends to all market participants) gives rice to an efficient market equilibrium.
What is an interdependency?
If an economic action has an effect on other individuals, this generates interdependency.
Example:
If a coal-powered power plant pollutes the air, the neighbors might get sick. Without any environmental protection laws or other government intervention, the owner of the power plant likely does not care about the effect of her energy production on these random neighbors. In such a case, the power plant might burn an inefficiently high amount of coal because part of the costs of production is indirectly paid by other individuals (the neighbors).
Another example:
A firm produces chemicals and disposes its waste by dumping it in a nearby river. The pollution of this river reduces the revenue of some people fishing downstream as well as the drinking water of the citizens in a nearby city. This is an interdependency.
What are externalities?
If not all interdependencies are internalized via competitive prices (e.g. via contracts or via taxes), they constitute an externality.
A market equilibrium with an externality is usually not efficient.
What is an example that shows that external effects are not always negative?
If an individual is vaccinating against an infectious disease, also other individuals benefit from this action.
==> Thus, vaccination provides a positive interdependency dor other people.
If this interdependency is not internalized, it becomes a positive externality.
What effects on the economy do non-internalized interdependencies have? Here: Negative externality
The individual that consumes or the firm that produces the good that generated the externality is consuming/producing an inefficiently large quantity of that good because the external costs are not part of the decision of this individual.
What could be a solution for negative externalities?
Introducing a tax on this good such that the external costs are internalized via the additional tax.
What effects on the economy do non-internalized interdependencies have? Here: Positive externality
The individual that consumes or the firm that produces the good that generates the externality is consuming/producing an inefficiently low quantity of that good because the external benefits are not part of the decision of this individual.
What could be a solution for positive externalities?
Subsidize this good to increase the incentive to consume or produce this good.
What is the coase theorem?
So far we have assumed that the government must intervene and internalize the interdependencies with a tax or a subsidy.
==> However, if some requirements are satisfied, the Coase Theorem allows the individuals to solve this problem with individual bargaining and contracts and restore efficiency without intervention by the government.
Which are the requirements so that the coase theorem holds?
- Perfectly defined and enforced property rights.
- Non-existent transaction costs
What are transaction costs?
Transaction costs are additional costs of economic transactions that are caused by the institutional framework.
What are examples for perfectly defined and enforced property rights?
If in our initial example the firm that produces chemicals owns the right to pollute the river or the fishermen own the right to demand that the river stays clea, property rights are sufficiently defined.
==> In this case, the owner of the right to decide what happens with the river can bargain with the other individual.
If the other individual has a higher willingness to pay for the right to pollute (or not pollute) the river, the owner of the property right will be willing to sell his right to the river.
