Lecture 3: Externalities Flashcards
Externalities
“When actions of agents affect the welfare of other agents outside
the market mechanism.”
external cost
uncompensated cost that an individual or firm
imposes on others.
e.g. polluting firms/cars creating costs for future generations
external benefit
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
negative externalities
external costs
positive externalities.
external benefits
Marginal social cost of pollution
the additional cost imposed on society as a whole by an additional unit of pollution
Marginal social benefit of pollution =
he additional gain to society as a
whole from an additional unit of pollution.
Socially optimal quantity of pollution
the quantity of pollution that
society would choose if all the costs and benefits of pollution were fully
accounted for.
Coase theorem:
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.
transaction costs
The costs of making a deal
Society needs a public solution:
- Environmental Standards
- Pigouvian Taxes
- Tradable pollution permits
Environmental standards:
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”)
Tradable emissions permits
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
Marginal social cost
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)
Optimal Pigouvian tax
tax equal to the marginal external costs at the socially
optimal quantity.
Positive Externalities
Marginal social benefit
Pigovian subsidy
Optimal Pigouvian subsidy
Pigouvian subsidy
payment designed to encourage
activities that yield external benefits.
Optimal Pigouvian subsidy
subsidy equal to marginal external
benefit at the socially optimal quantity.
marginal social benefit of a good activity
qual to the
marginal benefit that accrues to consumers plus its marginal
external benefit.
Characteristics of Goods
• 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)
public good
A public good is a good that is both non-excludable and non-rival in
consumption, e.g., public sanitation and national defense
Game theory
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.
Nash equilibrium
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)
Prisoner’s dilemma
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.
