Externalities

Question 1

Market failure

Answer 1

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

Question 2

Externality

Answer 2

Whenever the actions of one economic agent directly affect another economic agent outside the market mechanism

Question 3

Negative Production Externality

Answer 3

When a firm’s production reduces the wellbeing of others who are not compensated by the firm

Question 4

Private marginal cost

Answer 4

The direct cost to producers of producing an additional unit of a good

Question 5

Marginal damage

Answer 5

Any additional costs associated with the production of the good that are imposed on others but that producers do not pay

Question 6

Social marginal cost

Answer 6

SMC = PMC + MD
The private marginal cost to producers plus marginal damage

Question 7

Negative consumption externality

Answer 7

When an individual’s consumption reduces the wellbeing of others who are not compensated by the individual

Question 8

Private marginal benefit

Answer 8

The direct benefit to consumers of consuming an additional unit of a good by the consumer

Question 9

Social marginal benefit

Answer 9

The private marginal benefit to consumers minus any costs associated with the consumption of the good that are imposed on others

Question 10

Positive production externality

Answer 10

When a firm’s production increases the well-being of others but the firm is not compensated by those others

Question 11

positive consumption externality

Answer 11

When an individual’s consumption increases the wellbeing of others but the individual is not compensated by those others

Question 12

free market outcome

Answer 12

PMB = PMC

Question 13

Social optimum

Answer 13

SMB = SMC

Question 14

Inefficient outcomes of externalities in private market

Answer 14

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

Question 15

Internalising the externality

Answer 15

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

Question 16

Coase Theorem Part 1:

Answer 16

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

Question 17

Coase Theorem Part 2

Answer 17

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

Question 18

Problems with Coasian Solution

Answer 18

1) Assignment problem

2) The holdout problem

3) Free rider problem

4) Transaction Costs and Negotiating Problems

Question 19

Assignment Problem - Coasian

Answer 19

In cases where externalities affect many agents, assigning property rights is difficult

Question 20

Holdout Problem - Coasian

Answer 20

shared ownership of property rights gives each owner power over all the others (because joint owners have to all agree to the Coasian solution)

Question 21

Free Rider Problem - Coasian

Answer 21

When an investment has a personal cost but a common benefit, individuals will underinvest

Question 22

Transaction Costs and Negotiating Problems - Coasian

Answer 22

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)

Question 23

Public Sector Remedies for Externalities

Answer 23

1) Quantity regulation
2) corrective taxation

Question 24

Quantity Regultion

Answer 24

Government limits use of externality producing chemicals. e.g., CFCs

Question 25

Corrective Taxation

Answer 25

corrective tax or subsidy equal to marginal damage per unit

Question 26

Quantity Regulation vs Corrective Tax

Answer 26

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

Question 27

When to choose tax over quantity regulation

Answer 27

tax preferable when MD curve is flat

Question 28

when to choose quantity regulation over tax

Answer 28

Preferable when MD curve is steep