Term 1 week 5 Flashcards
What is an externality?
When the actions of an economic agent impacts someone who is not directly involved / that are not reflected in market transactions.
Impacts people directly and not through the prices.
How does externalities link with the first welfare theorem?
Externalities can cause the first welfare theorem to fail.
What are the types of costs?
-PMC Private marginal costs -direct costs to producers of producing an additional unit.
-SMC Social marginal costs - private marginal costs + marginal damage.
What are the types of benefit?
-PMB - Private marginal benefit, the direct benefit to consumers / producers of consuming an additional unit.
-SMB - Social Marginal Benefit = PMB + the costs associated with anyone else
What is marginal damage?
What is the opposite to this?
Any additional costs associated with consuming (producing) that consumers (producers) do not pay
Marginal benefit - positive outcome on third party.
Graphically what are marginal costs and marginal benefits?
Marginal costs. = supply curve
Marginal benefits = demand curve
Draw positive extern in production
Draw negative extern in production
Draw positive extern in consumption
Draw negative extern in consumption
What is the MRT under externalities?
MRT is now no longer just the ratio of marginal products it is also - the externality.
What is the set up of the simple externalities model?
-A person gets utility from two goods x and y.
-Endowed with l’ = lx + ly
-Production of x = f(lx) MPL = fl
-Production of y depends on the production of x. y = g(ly, x)
gx> 0 positive externality gx< 0 negative externality.
In the simple externalities model how is the utility maximised?
- Utility (x, y) which is the production functions are maximised subject to l = lx =ly
1.aside from property rights how else can externalities be rectified?
Why does it work?
What is it?
What is the outcome?
1.Pigouvian taxation:
Producer of the externality faces the wrong price for the externality it generates. (It neglects the cost it has on others).
Producer must be faced with the correct social cost.
- Piguovian tax is a per unit tax which is = to the marginal damage of that unit.
- It reduces output to socially optimum level.
How can underproduction and underconsumption be solved?
With a pigouvian subsidy. Per unit subsidy where unit subsidy = marginal benefit.
Increases output to socially optimal level.,
How do you solve the externalties model?
Set up Lagrange with maximise utility S.T labour constraint.
U(f(lx), g(ly,x)) + lamda [ l’ - lx - ly]
FOC
Ux . fl + uy . gx . gl - lamda = 0
Uy . gl - lamda = 0
l’ - lx - ly
Then combine these two equations
ux . fl + uy . gx . gl = uy . gl
divide both sides by UyFl
gives
Ux/Uy = fl /gl - gx where gx is externality
Then solve on an individual level.
Then move onto when individual is only caring about how much x and y to consume.
So they maximise where MRS = price ratio
As markets are competitive they would get wage = marginal product x value of that MP
This means w= gl py
w = fl px
Then rearrange this so then
ux/uy = px/py = fl/gl
ux/uy = fl/gl then compare this to externality
Ux/Uy = fl /gl - gx where gx is externality
if it is negative externality gx<0
which means MRS with externality is greater than MRS in individual market.
As MRS is diminishing the more x you have lower MRS.
so as with externality has lower MRS is means x is higher in non-externality.
This means what the individual chooses to produce will be more than what society wants because he is not taking into the externality.
What does solving the externality economy model imply?
you get that
MRS = MRT - externality
but usually you just get MRS = MRT
What does MRS = MRT mean in terms of production?
How many units of one good production do you have to give up to release enough resources to increase the production of the other good.
What is pertinent about externalities model when looking at the whole economy and just one consumer.
When looking at an individual conusmer they do not take into account externality whilst production does.
Why is perfect competition relevant when finishing up the individual maximisation in externality model?
as the wages are equal to the price of marginal product x marginal product.
What is the set up of an open edgeworth box to model property rights?
Two agents A, B
Two commodities smoke and money
Person A like money and smoke
Person B likes money but dislikes smoke
Edgeworth box draw with origin A bottom left origin b bottom right.
How do the preferences work in an open edgeworth box?
As person A likes both goods ICs are convex as higher utility in. both goods.
However, person B has concave as they do not like smoke and enjoyment for smoke goes in opposite direction.
1.What would the endowment be in an open edgeworth box
2.So what would it be graphically?
3.What decides where it would be?
It would be an equal amount of money and a certain amount of smoke
Would be along the dashed line in the very centre.
- Exact point is decided by who has property rights.
- What is Coase Theorem
- What is the implication of this?
- If there is costless bargaining between two individuals and you know who is creating the externality. It is possible to remove the externality from the system if the price those individuals pay reflect the externality.
- Assigning property rights leads to the highest social optimum, maximising join profits, regardless of who gets it.
