Lecture 3: Externalities

Question 1

Externalities

Answer 1

“When actions of agents affect the welfare of other agents outside
the market mechanism.”

Question 2

external cost

Answer 2

uncompensated cost that an individual or firm
imposes on others.
e.g. polluting firms/cars creating costs for future generations

Question 3

external benefit

Answer 3

a benefit that an individual or firm confers on
others without receiving compensation for it.
e.g. bee keepers (bees) creating benefits for nearby orchards

Question 4

negative externalities

Answer 4

external costs

Question 5

positive externalities.

Answer 5

external benefits

Question 6

Marginal social cost of pollution

Answer 6

the additional cost imposed on society as a whole by an additional unit of pollution

Question 7

Marginal social benefit of pollution =

Answer 7

he additional gain to society as a

whole from an additional unit of pollution.

Question 8

Socially optimal quantity of pollution

Answer 8

the quantity of pollution that
society would choose if all the costs and benefits of pollution were fully
accounted for.

Question 9

Coase theorem:

Answer 9

even in the presence of externalities an economy
can always reach an efficient solution provided that the costs of
making a deal are sufficiently low and regardless of who is
assigned the property rights.

Question 10

transaction costs

Answer 10

The costs of making a deal

Question 11

Society needs a public solution:

Answer 11

• Environmental Standards
• Pigouvian Taxes
• Tradable pollution permits

Question 12

Environmental standards:

Answer 12

ules that protect the environment by specifying actions of producers and consumers (e.g.: “all plants should cut emissions by half”; “all cars should have catalytic converters”; “only electric cars are allowed in our city”)

Question 13

Tradable emissions permits

Answer 13

licenses to emit limited quantities of
pollutants that can be bought and sold by polluters

Given these permits are tradable:

• firms with differing costs of reducing pollution can engage in
  mutually beneficial transactions
• those that find it easier to reduce pollution will sell some of their
  permits to those that find it more difficult.
• result: market outcome is socially efficient

Question 14

Marginal social cost

Answer 14

The marginal social cost of a good or activity is equal to the marginal private costs
plus its marginal external cost (costs that the good imposes on others outside MM)

Question 15

Optimal Pigouvian tax

Answer 15

tax equal to the marginal external costs at the socially

optimal quantity.

Question 16

Positive Externalities

Answer 16

Marginal social benefit
Pigovian subsidy
Optimal Pigouvian subsidy

Question 17

Pigouvian subsidy

Answer 17

payment designed to encourage

activities that yield external benefits.

Question 18

Optimal Pigouvian subsidy

Answer 18

subsidy equal to marginal external

benefit at the socially optimal quantity.

Question 19

marginal social benefit of a good activity

Answer 19

qual to the
marginal benefit that accrues to consumers plus its marginal
external benefit.

Question 20

Characteristics of Goods

Answer 20

• More general framework to predict whether market is efficient or not;
look at characteristics of good.
• A good is excludable in consumption if the supplier of that good can
prevent people who do not pay for it from consuming it.
• A good is rival in consumption if the same unit of the good cannot be
consumed by more than one person at the same time.
• A good that is both excludable and rival in consumption is a private good
(e.g. ice cream)

Question 21

public good

Answer 21

A public good is a good that is both non-excludable and non-rival in
consumption, e.g., public sanitation and national defense

Question 22

Game theory

Answer 22

a framework for modelling and predicting behavior in situations
in which the outcomes of decisions are not only depending on own decisions,
but also on decisions made by others.

Question 23

Nash equilibrium

Answer 23

the equilibrium that results when all players choose
the action that maximizes their payoffs given the actions of other
players, named after John Nash (1944-2015)

Question 24

Prisoner’s dilemma

Answer 24

a game based on two premises: (1) each player has an incentive to choose an action that benefits itself at the others player’sexpense;
and (2) both players are worse off than if they had acted cooperatively.

Question 25

Free rider problem

Answer 25

problem that results when individual who have no incentive to pay for their own consumption of a good “free ride” on anyone who does pay

Question 26

Common Resources

Answer 26

• A common resource is non-excludable and rival in consumption: you can’t stop me from
consuming the good and more consumption by me means less of the good available for
you. e.g.: fish in the sea
• Common resources left to the market suffer from overuse: individuals ignore the fact
that their use depletes the amount of the resource remaining for others.

Question 27

Artificially Scarce Goods

Answer 27

• An artificially scarce good is excludable but non-rival in consumption.
E.g.: Netflix, pay per view film
• An artificially scarce good is made artificially scarce because producers
charge a positive price but the marginal cost of allowing one more
person to consume the good is zero.