Externalities Flashcards
What is a consumption externality?
This is when other people will care about another person’s consumption preferences.
What is a production externality?
This is when the production decisions of one firm will affect the production possibilities of another firm.
What is one thing that we need to consider with regards to initial endowments where there are externalities involved?
Which consumer holds the property rights (this will affect initial endowment). The amount of externality inflicted will be dependent on who holds property rights.
However, property rights need to be well defined and understood by all relevant parties in order for trade to occur efficiently. (e.g. I might think it is okay to play the guitar at 3am whereas Aman might not think the same).
What does the Coase Theorem state?
The Coase Theorem states that if transaction costs are low and if property rights are well defined, then private markets can be created in which the problem of externalities creating inefficient solutions is solved.
If both parties know what they are getting out of the deal and what they are entitled to/have to pay AND the cost to them in engaging in the trade is low, then an efficient solution can be created privately.
Trade by itself cannot be used to internalise external benefits and costs - this will only lead to inefficiency.
When can we define the amount of externality generated as independent of the assignment of property rights?
This is when both consumers have quasi-linear preferences and therefore, there will always be a set externality imposed, regardless of how much of the other good each agent has.
for example, if agents display quasi-linear preferences in money, then they are indifferent to trading money for property rights.
When property rights have been reassigned to ensure that both firms incur the cost of production, what is it called?
This process is called internalisation.
What does a Pigouvian tax do?
It imposes a tax on producers such that their output will be reduced to the socially optimal amount, rather than the privately optimal amount.
Why are externalities deemed to be pareto -inefficient?
Agents will always consume up to the point where their PRIVATE marginal benefit = private marginal cost, maximising utility/ profits etc. However, this does not take into account the social benefits or costs.
