Handout 12: Externalities and Public Goods Flashcards
Externality
An action by either a producer or a consumer which affects other producers or consumers, but that is not accounted for in the market price.
- Are created when the actions of an agent in the economy (firm/consumer) affect the well-being of other agents through non-market means.
- Results in efficiency losses because externality producing agents do not take into account the costs/benefits they impose on others.
Private Costs and Benefits
-Costs and benefits that accrue to individual firms and consumers as a result of their own decisions.
External Costs and Benefits
-Those that accrue to other firms/consumers because of externalities
Social Costs and Benefits
-The sum of private costs/benefits and external costs/benefits
Private Net Benefit
Private benefit minus private cost
Social Net Benefit
Social benefit minus social cost
Social Marginal Costs/Benefits
Benefits/Costs that accrue to everyone in society as a result of an extra unit of hte good being produced. Sum of private + external costs/benefits.
Why do externalities result in efficiency losses?
Because efficiency requires that goods get produced until social marginal costs equal social marginal benefits (SMC=SMB), but private individuals/firms will produce until private marginal costs equal private marginal benefits (MC = MB).
Marginal external benefit
The dollar value of the increase in firm 2’s output that is due to a one-unit increase in firm 1’s output (when dealing with producer-producer externalities).
What is the efficient level of K for firm 1 to hire given that the use of an input by firm 1 affects the output of firm 2?
-marginal benefit = marginal value product of labor = P1 (change in Q1/change in K1)
-marginal cost = if Firm 1 is a price-taker in input market, marginal cost of hiring K is rental rate (r)
-marginal external benefit = P2(change in Q2/change in K1)
SO, efficient level is MB + MEB = MC –>
P1(change in Q1/change in K1) + P2(change in Q2/change in K1) = r
Total external cost of extra unit of pollution (externality)
- Total amount people would be willing to pay to avoid the externality
- External marginal cost = MD = Sum of MD
What are efficient taxes?
1) Should be directed at the source of the problem i.e. tax on fertilizers instead of all farm products
2) When externalities are not directly related to a single input in the production process, optimal tax is on the pollution itself, where the tax equals the external damage caused by an extra unit of pollution
Public goods
1) nonexclusive: no one can be excluded from consuming it
2) nonrival: one person’s consumption of the good does not come at the expense of anyone else’s consumption.
What is the efficient quantity for a public good?
- The marginal cost of producing an extra unit = social benefit of having an extra unit of the good
- The social marginal benefit of an extra unit equals the sum (over all consumers) of the private marginal benefit associated with consuming the good.
- Public goods should be produced until the cost of producing an extra unit equals the total amount people would be willing to pay for an extra unit of the good.
What is the fundamental problem with public goods?
Individuals have incentives to be free-riders: each person would rather that other people volunteer to pay for the good.
