Externalities Flashcards
Externalities
A situation where a person’s actions have effects on other people that are not accounted for by the market
Gruber’s Definition of an Externality
- When the actions of one party make another party worse or better off . . .
- but the first party bears neither the benefits nor costs of doing so
Market failure
market outcome is inefficient
Negative Production Externality
Producing a good has costs for third parties
SMC = PMC + MD
→ SMC curve is above the supply curve
Negative Consumption Externality
Consuming a good has costs for third parties
SMB = PMB − MD
→ SMB curve is below the demand curve
Positive Production Externality
Producing a good has benefits for third parties
SMC = PMC − MB
→ SMC curve is below the supply curve
Positive Consumption Externality
Consuming a good has benefits for third parties
SMB = PMB + MB
→ SMB curve is above the demand curve
SMB = SMC
quantity that maximizes social surplus
Private Marginal Cost (PMC)
firms’ marginal cost of producing an additional unit
Private Marginal Benefit (PMB)
consumers’ willingness to pay for an additional unit
If no externalities….
all costs/benefits are borne by market participants and thus, PMB = SMB and PMC = SMC
Marginal External Cost
cost on 3rd-parties due to producing/consuming an addit. unit
Marginal External Benefit
benefit on 3rd-parties due to producing/consuming an additional unit
Coase Therom
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.
Coase Therom Eq
- Parties creating / affected by the externality can negotiate to bring about the socially efficient quantity
– Negotiation allows the parties to internalize the externality - The efficient solution doesn’t depend on which party has the property rights, so long as someone has them
Assignment Issue
Hard to decide who to assign property rights too
Holdout Problem
A negotiation may break down if just one party doesn’t agree
Small Individual Damages Problem
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
Corrective Taxation
Place a tax or a subsidy on the externality to equalize the private & social marginal curves aka Pigouvian taxes
Quantity Regulation
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
Corrective Taxation Steps
– 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 )
With no externalities, social surplus is
SSm = SSe = CSm + PSm
→ The area below the D curve and above the S curve
With externalities, social surplus is
- Market quantity:
— SSm = CSm + PSm − total external damage(m)
—- total external damage(m) = MD · Qm - 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
