Externalities Flashcards
Market failure
A problem that violates one of the assumptions of the first welfare theorem and causes the market economy to deliver an outcome that does not maximise efficiency
Externality
Whenever the actions of one economic agent directly affect another economic agent outside the market mechanism
Negative Production Externality
When a firm’s production reduces the wellbeing of others who are not compensated by the firm
Private marginal cost
The direct cost to producers of producing an additional unit of a good
Marginal damage
Any additional costs associated with the production of the good that are imposed on others but that producers do not pay
Social marginal cost
SMC = PMC + MD
The private marginal cost to producers plus marginal damage
Negative consumption externality
When an individual’s consumption reduces the wellbeing of others who are not compensated by the individual
Private marginal benefit
The direct benefit to consumers of consuming an additional unit of a good by the consumer
Social marginal benefit
The private marginal benefit to consumers minus any costs associated with the consumption of the good that are imposed on others
Positive production externality
When a firm’s production increases the well-being of others but the firm is not compensated by those others
positive consumption externality
When an individual’s consumption increases the wellbeing of others but the individual is not compensated by those others
free market outcome
PMB = PMC
Social optimum
SMB = SMC
Inefficient outcomes of externalities in private market
Negative production externalities lead to over production
positive production externalities lead to under production
Negative consumption externalities lead to over consumption
Positive consumption externalities lead to under consumption
Internalising the externality
when either private negotiations or government action lead the price to the party to fully reflect the external costs or benefits of that party’s actions
Coase Theorem Part 1:
When there are well-defined property rights and costless bargaining, then negotiations between the party creating the externality, and the party affected by the externality can bring about the socially optimum market quantity
Coase Theorem Part 2
The efficient quantity for a good producing an externality does not depend on which party is assigned the property rights, so long as someone is assigned those rights
Problems with Coasian Solution
1) Assignment problem
2) The holdout problem
3) Free rider problem
4) Transaction Costs and Negotiating Problems
Assignment Problem - Coasian
In cases where externalities affect many agents, assigning property rights is difficult
Holdout Problem - Coasian
shared ownership of property rights gives each owner power over all the others (because joint owners have to all agree to the Coasian solution)
Free Rider Problem - Coasian
When an investment has a personal cost but a common benefit, individuals will underinvest
Transaction Costs and Negotiating Problems - Coasian
The Coasian approach ignores the fundamental problem that it is hard to negotiate (especially when there are large numbers of individuals on one or both sides of the negotiation)
Public Sector Remedies for Externalities
1) Quantity regulation
2) corrective taxation
Quantity Regultion
Government limits use of externality producing chemicals. e.g., CFCs
Corrective Taxation
corrective tax or subsidy equal to marginal damage per unit
Quantity Regulation vs Corrective Tax
When there is no uncertainty over the cost of pollution reduction, a corrective tax and quantity regulation are identical
tax cannot target a specific quantity while quantity regulation can
Choice depends on whether the government wants to get the amount of pollution reduction right or whether it wants to minimise costs
When to choose tax over quantity regulation
tax preferable when MD curve is flat
when to choose quantity regulation over tax
Preferable when MD curve is steep
