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.
FOC for individual optimisation with consumption externality. What does this mean?
U’(yi) = 1
PMB = PMC of additional unit of good y.
Each consumer doesn’t account for other’s consumption of good y despite the externality.
How do we find PE allocation for consumption externality
Maximise total utility of society s.t. aggregate resource constraint.
FOCs for PE allocation for consumption externality
u’1(y1) + v’2(y1)=1
u’2(y2) + v’1(y2)=1
Account for other’s consumption of the good st the externality.
If the consumption externality is positive, what does this mean for v’1 and v’2 and how do free market and PE allocation compare?
v’1(y2) > 0, v’2(y1)>0
This means u’1(y1) and u’2(y2) LOWER for PE
Lower MU = higher Y1 and Y2 by diminishing MU.
SO: free market = underconsumption.
If the consumption externality is negative, what does this mean for v’1 and v’2 and how do free market and PE allocation compare?
v’1(y2) < 0, v’2(y1)<0
This means u’1(y1) and u’2(y2) HIGHER for PE
Higher MU = lower Y1 and Y2 by diminishing MU.
SO: free market = overconsumption.
What’s the rat race problem? What’s the NE and PE outcomes?
A competition for relative position.
Gain advantage over rivals by competing harder than they do.
But if everyone competes hard the extra effort cancels out.
NE = both high effort
PE = low effort - account for -VE externality on others