LECTURE 4 Flashcards
MARKET FAILURE VIOLATES WHICH THEOREM?
1ST WELFARE THEOREM - any market equilibrium should be PE.
Externalities arise when…
One agent’s actions directly affect another agent outside the market mechanism.
What kind of benefits/costs do agents account for?
Private costs and benefits only - not social.
3 main causes of externality market failure
Lack of property rights
Jointness in production and consumption
Information failure
Production externality =
effect of externality on profit relationship
Consumption externality =
effect of externality on utility level.
-VE production externalities =
when a firm’s production reduces well being of others not compensated by the firm.
PMC=
direct cost to the firm of producing an additional unit.
Marginal damage =
any additional costs associated with the production of an additional unit that are imposed on others but the producer does NOT pay.
-VE production externality SMC and PMC relationship
SMC = PMC + MD
SMC > PMC
The DWL triangle always…
Points to the SOCIAL optimum
How does -ve production externality affect market outcome?
Free markets overproduces compared to social optimum.
-VE consumption externalities =
when an individual’s consumption reduces well being of others not compensated by the individual.
PMB =
direct benefit to the consumer of consuming an additional unit.
Marginal damage for consumption =
any additional costs associated with the consumption of an additional unit that are imposed on others but the consumer does NOT pay.
-VE consumption externality PMB and SMB relationship
SMB = PMB - MD
SMB < PMB
How does -ve consumption externality affect market outcome?
Overconsumption
+VE production externalities =
when a firm’s production increases well being of others, but the firm is not compensated by those others.
+VE production externality SMC and PMC relationship
SMC = PMC - MB
SMC < PMC
Effect of +ve production externality on outcome
Underproduction
+VE consumption externalities =
when an individual’s consumption increases well being of others, but the individual is not compensated by those others.
+VE consumption externality SMC and PMC relationship
SMB = PMB + MB
SMB > PMB
Effect of +ve consumption externality on outcome
underconsumption
Individual optimisation to show consumption externality –> suboptimal outcome.
Max individual utility (which depends on others consumption) s.t. individual resource constraint s.t. aggregate resource constraint too.