Externalities

Question 1

Externalities

Answer 1

A situation where a person’s actions have effects on other people that are not accounted for by the market

Question 2

Gruber’s Definition of an Externality

Answer 2

1. When the actions of one party make another party worse or better off . . .
2. but the first party bears neither the benefits nor costs of doing so

Question 3

Market failure

Answer 3

market outcome is inefficient

Question 4

Negative Production Externality

Answer 4

Producing a good has costs for third parties
SMC = PMC + MD
→ SMC curve is above the supply curve

Question 5

Negative Consumption Externality

Answer 5

Consuming a good has costs for third parties
SMB = PMB − MD
→ SMB curve is below the demand curve

Question 6

Positive Production Externality

Answer 6

Producing a good has benefits for third parties
SMC = PMC − MB
→ SMC curve is below the supply curve

Question 7

Positive Consumption Externality

Answer 7

Consuming a good has benefits for third parties
SMB = PMB + MB
→ SMB curve is above the demand curve

Question 8

SMB = SMC

Answer 8

quantity that maximizes social surplus

Question 9

Private Marginal Cost (PMC)

Answer 9

firms’ marginal cost of producing an additional unit

Question 10

Private Marginal Benefit (PMB)

Answer 10

consumers’ willingness to pay for an additional unit

Question 11

If no externalities….

Answer 11

all costs/benefits are borne by market participants and thus, PMB = SMB and PMC = SMC

Question 12

Marginal External Cost

Answer 12

cost on 3rd-parties due to producing/consuming an addit. unit

Question 13

Marginal External Benefit

Answer 13

benefit on 3rd-parties due to producing/consuming an additional unit

Question 14

Coase Therom

Answer 14

Under certain circumstances, the market may be able to deal with externalities on its own
Assume (i) well-defined property rights and (ii) costless bargaining.

Question 15

Coase Therom Eq

Answer 15

1. Parties creating / affected by the externality can negotiate to bring about the socially efficient quantity
   – Negotiation allows the parties to internalize the externality
2. The efficient solution doesn’t depend on which party has the property rights, so long as someone has them

Question 16

Assignment Issue

Answer 16

Hard to decide who to assign property rights too

Question 17

Holdout Problem

Answer 17

A negotiation may break down if just one party doesn’t agree

Question 18

Small Individual Damages Problem

Answer 18

affect a large # of people
→ It may not be worth it for any single impacted person to put in the effort to lead the negotiation
⇒ Coase Thrm doesn’t work for large-scale externalities with many parties but may work for small-scale externalities with just a few parties

Question 19

Corrective Taxation

Answer 19

Place a tax or a subsidy on the externality to equalize the private & social marginal curves aka Pigouvian taxes

Question 20

Quantity Regulation

Answer 20

Mandate that the economy produce/consume a given amount
– Gov. mandates that firms/consumers produce/consume the efficient q.
– requires that the market generate the quantity where SMB = SMC

Question 21

Corrective Taxation Steps

Answer 21

– Set a tax equal to the MD (or a subsidy equal to the MB)
– This shifts the private marginal curves to overlay the social marginal curves
– Generates a new equilibrium, which is efficient (SMB = SMC )

Question 22

With no externalities, social surplus is

Answer 22

SSm = SSe = CSm + PSm
→ The area below the D curve and above the S curve

Question 23

With externalities, social surplus is

Answer 23

1. Market quantity:
   — SSm = CSm + PSm − total external damage(m)
   —- total external damage(m) = MD · Qm
2. Efficient quantity via a corrective tax:
   — SSe = CSe + PSe − total external damage(e) + tax revenue(e)
   — total external damage(e) = MD · Qe = tax revenue(e)
   SSe = CSe + PSe

thus, SSe = SSm + DWL