CHAPTER 17 (final exam) Flashcards
What is the most common world example of an externality and what are other more personal examples?
Pollution
- the noise of your neighbour’s party
- the person smoking next to you
- the mess in someone’s lawn
Explain what an efficient market is/does
Markets are efficient when all transactions that positively benefit society takes place
- it takes ALL costs and benefits (both private and external) into account
- extra costs or benefits that are not taken into account are evidences of a market failure
Define externalities
Negative externalities?
Positive externalitites?
Externalities are a cost or benefit that affects a party not directly involved in a transaction - not included in the price paid or received for the good
negative: cost imposed on a party not directly involved in a transaction (ex. air pollution > health effects are external costs paid by society)
positive: benefit conferred on a party not directly involved in a transaction (ex. beekeeper’s bees producing honey AND helping neighbouring farmers by pollinating crops)
Define social cost and social benefit
Explain these relationships
What’s the ideal world scenario?
social cost = the cost of a transaction to society, equal to the private cost + external cost
social benefit = the benefit of a transaction to society, equal to the private benefit + the external benefit
When there are externalities, the social costs and social benefits will differ from the private costs and private benefits (because the social cost/benefit accounts for externalities but the private cost/benefit doesn’t)
In an ideal world, the market accounts for ALL costs and benefits > social cost = private cost
(no external costs/benefits to society unaccounted for)
Define external marginal cost and external marginal benefit
External marginal cost: the cost imposed on a third party when an additional unit of a good is produced/consumed
External marginal benefit: the benefit conferred on a third party when an additional unit of a good is produced or consumed
Explain the electricity power plant pollution example in terms of the market quantity and socially optimal quantity aspects
In a competitive electricity market:
- pollutants are a negative externality of production
- this external cost is a cost to society that is not included in the price of electricity because the suppliers aren’t paying for it
- society is technically paying for the price of electricity (private cost) plus the health costs (external cost) = social cost
- the price of electricity doesn’t reflect its full costs
- this means that consumers end up buying too much because it’s relatively cheaper than it would be if the price reflected the health costs (if the suppliers had to pay more for production costs then they would have to charge more)
- the market quantity sold is higher than the socially optimal quantity (quantity sold if the external costs were included in the market price)
- with the market quantity sold > the socially optimal quantity, there is DWL in the market
Deadweight loss in a competitive negative externality market is dependent on what two factors?
- the size of the externality (how big is the external marginal cost?)
difference between the original Supply curve (MC) and the Socially optimal supply curve (SMC = MC+EMC) - the quantity that wouldn’t be bought if the price reflected the true social cost
aka how much more quantity are people buying based on the price not being high enough
Negative externalities create too ____ of a ___ thing and positive externalities create too ____ of a _____ thing
much
bad
little
good
Explain what results from positive externalities and use the education example
Positive externalities exist when an economic activity has a spillover benefit enjoyed by third parties > the social demand/benefit of an economic activity (SD = D+external marginal benefit) is higher than the private marginal benefit (demand curve on graph)
Ex. Education
private benefits = higher lifetime earnings
social benefits = increase in overall entrepreneurial activity, higher incomes, and a faster pace of technology growth
problem?
- ppl might under invest in education because the full benefit/value is not rewarded
- the good is relatively too expensive to the rewards and happens too little > DWL from the externality
What are the 2 kinds of market interventions to help correct externalities?
- target prices (ex. taxes)
- target the quantity produced and consumed
With market interventions to help correct externalities, what do we need to determine and what is this (pollution example)
We need to determine the Efficient Level of Pollution > the level of emissions necessary to produce the efficient quantity of the good tied to the externality
- results from the quantity where demand equals the marginal SOCIAL cost
- the efficient amount of pollution balances its costs and benefits (Marginal Cost Pollution = Marginal Benefit Pollution)
- will create a hypothetical market for pollution, where MBP/MAC is the demand for pollution, and MCP is the marginal societal cost, or the supply of pollution > where they intersect is the optimal price and quantity of pollution (the question is how we get private parties to produce and consume at this level)
Explain what the benefit of pollution means
It’s referring to the fact that pollution is an automatic by-product of producing some crucial goods - to completely ban pollution would prevent the production of a lot of necessary goods and would crease a huge loss for society
- so the benefit is just the benefit of the goods that require pollution to supply
Why does the marginal cost of pollution (MCP) curve slope upward and why does the marginal benefit of pollution (MBP) curve slope downward
MCP:
- at low levels of pollution, the damage associated with an additional unit of pollution is relatively low
- at higher levels of pollution, health effects become more severe, and additional units of pollution are more costly to society
MBP:
- high levels of pollution are associated with high levels of production, hence lower market prices. As pollution falls, so does production, and the forgone consumer and producer surplus is an opportunity cost
- as pollution falls, the cost of further reducing pollution increases because easy methods are exhausted
^that was the MAC way of looking at it
or just think, as pollution increases, the benefit of the good we get bc of the pollution decreases because the pollution is taking over
Describe the other way to look at the marginal benefit of pollution
it is the same as the Marginal Abatement Cost
- the cost of reducing emissions by one unit (includes technological costs AND forgone production)
How can price be used to correct externalities?
Changing the price of goods produced in the presence of externalities so that the social and private benefits and costs align
- negative externality > levy a tax on production or consumption
- positive externality > subsidize production or consumption
What is Pigouvian tax?
It is a tax on an activity that raises a good’s price to take into account the external marginal costs imposed by a negative externality
- makes producers internalize the external cost
- the externality (EMC) becomes the tax > suppliers marginal cost/supply shifts left > reduces quantity and raises the price
- designed to correct market failures and therefore improve societal welfare
What is a Pigouvian subsidy?
It is a subsidy for an activity that produces a positive externality
- serves to equate the external marginal benefit imposed by an externality
- raises a good/service’s benefits to take into account the external marginal benefits imposed by a positive externality
- increases quantity to socially optimal levels
- EMB becomes the subsidy amount
What is a Quota in response to externalities?
Quota = a regulation mandating that the production or consumption of a certain quantity of a good or externality be limited (cap) or required (floor)
- goal to move a market with externalities toward the efficient outcome
- the MC/supply curve becomes vertical at the quota quantity level
Compare Price-Based vs. Quantity-Based interventions with and without uncertainty
With perfect information/no uncertainty, price and quantity instruments are equally effective in controlling externalities
Without perfect information/with uncertainty, price and quantity mechanisms are NOT equivalent
- the costs of controlling externalities (MAC) are often difficult to figure out
- the benefits of controlling externalities (MCP) are also difficult to estimate
Explain some of the issues with price and quantity interventions to externalities and what is often used in response to these challenges
Price/quantity interventions take a lot of effort:
- firms may differ dramatically in their abatement costs (costs of reducing pollution) > and some firms don’t even perfectly understand their own costs
- problem of moral hazard > firms have an incentive to overstate their costs to regulators, hoping to reduce their financial liability
- often, pollution control regulations require a fixed aggregate emissions reduction which is hard to enforce with taxes
* a one size fits all approach doesn’t always work because firms are diverse > can lead to costly errors if they mis-estimate
Solution = Tradable Permits
- many regulatory agencies issue tradable permits to control pollution
What are Tradable permits? how do they work?
- a government-issued permit that allows a firm to emit a certain amount of pollution and that can be traded to other firms
- in theory, these are effective in achieving allocative efficiency - (when marginal abatement costs equalize across firms) which results in a more efficient reduction of pollution (firms with lowest costs are incentivized to reduce emissions the most and other firms have to be willing to pay to pollute)
- high-cost firms purchase permits from low-cost firms until no mutually beneficial trades remain
ex. if a permit price was below its MAC, the firm could raise its profits by buying a permit and polluting the extra unit - therefore, the market-clearing price of permits will be equal to MAC for each firm (or their marginal benefit of polluting)
- this is similar logic to a PC market where all firms produce a quantity that equates their MC to the output price)
What are public goods? What are they similar to?
- they are accessible to anyone who want to consume them
- they benefit the individual consumer, even as others consume it (can all enjoy together)
- they remain valuable to the consumer even as other people consume them
- they are similar to positive externalities as they can provide external benefits to individuals other than those who purchase them (also similar because markets can fail to deliver the socially optimal level of output)
ex. national defence, fireworks display, clean air
What are the two important properties of public goods?
- Nonexcludable > consumers cannot be prevented from consuming the good
- Nonrival > one person’s consumption of the good doesn’t diminish another consumers enjoyment of the same good
What are the 4 categories of goods?
- Private goods > goods that are rival and excludable
- Common resource goods > goods that are rival, but nonexcludable
- Club goods > goods that are nonrival and excludable
- Pure public goods > goods that are nonrival and nonexcludable
What is the marginal benefit of a public good?
Since public goods are nonrival, the marginal benefit of a given level of provision is the vertical sum of all individuals’ marginal benefit curves
MBt = sum of MBi
total marginal benefit = sum of individual marginal benefits
Explain how the total marginal benefit in a market for public goods is split between consumers and what this leads to in terms of efficiency
Qpub = Q1+Q2
MBt = MB1+MB2
BUT, the marginal benefit at Qpub is not split equally between consumers > each person enjoys the FULL benefit of the good
Person1 only wants/purchases Q1, but they still get the total public benefit because of Person2’s purchase - same goes vice versa
Because each of their consumption levels are less than Qpub, underprovision occurs > each individual only purchases goods until their private marginal benefit equal marginal cost (but market efficiency requires that a good be produced until the marginal benefits of production are equal to the marginal costs = Qpub)
What are the 2 reasons that markets will underprovide public goods?
- The graph example > since individuals purchase goods themselves, they will only do so until their private marginal benefit equals marginal cost, but the efficient level occurs when the total marginal benefits equal marginal cost (misalignment of private and total marginal benefits)
- Free-rider problem > results from the nonexcludability of public goods
- individuals can consume a public good or service without paying for it > why take one private costs when you can benefit without paying?
What are some ways to solve the free-rider problem?
Most common:
government funding + taxation: taxing used to provide public goods such as national defence, air traffic control, and weather forecasting
Others:
- groups of private citizens can form to provide public goods (ex. homeowner associations) > problem: it’s hard to make ppl pay for something they’ve been using for free or something they don’t value
- lobbying
- ppl don’t always succumb to the free-rider problem - often, private motivations are more complicated than assumed by the theory of rational agents
Explain the Tragedy of the Commons
(common resources are nonexcludable and rival - not public good but presents a similar kind of inefficiency)
The tragedy of the commons is the dilemma that common resources create when everyone has free access (nonexcludable) and the resource is used more intensively than it would be if privately owned, leading to a decline in its value for everyone
- key element is nonexcludability > consumers can’t be prevented from consuming the good once it’s available = overuse
- results in a special form of a negative externality
ex. public forests, public restrooms
What are the solutions for tragedy of the commons?
Many same as the solutions for negative externalities
- Pigouvian taxes : charge individuals for the external damage they do to the common resource
- Quotas : quantity restrictions on the rate at which common resources can be extracted (limits on fishing or hunting)
- Defining property rights and facilitating negotiation among those who share the common resource
