Term 1 week 5

Question 1

What is an externality?

Answer 1

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.

Question 2

How does externalities link with the first welfare theorem?

Answer 2

Externalities can cause the first welfare theorem to fail.

Question 3

What are the types of costs?

Answer 3

-PMC Private marginal costs -direct costs to producers of producing an additional unit.

-SMC Social marginal costs - private marginal costs + marginal damage.

Question 4

What are the types of benefit?

Answer 4

-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

Question 5

What is marginal damage?

What is the opposite to this?

Answer 5

Any additional costs associated with consuming (producing) that consumers (producers) do not pay

Marginal benefit - positive outcome on third party.

Question 6

Graphically what are marginal costs and marginal benefits?

Answer 6

Marginal costs. = supply curve

Marginal benefits = demand curve

Question 7

Draw positive extern in production

Question 8

Draw negative extern in production

Question 9

Draw positive extern in consumption

Question 10

Draw negative extern in consumption

Question 11

What is the MRT under externalities?

Answer 11

MRT is now no longer just the ratio of marginal products it is also - the externality.

Question 12

What is the set up of the simple externalities model?

Answer 12

-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.

Question 13

In the simple externalities model how is the utility maximised?

Answer 13

• Utility (x, y) which is the production functions are maximised subject to l = lx =ly

Question 14

1.aside from property rights how else can externalities be rectified?

Why does it work?

What is it?

What is the outcome?

Answer 14

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.

2. Piguovian tax is a per unit tax which is = to the marginal damage of that unit.
3. It reduces output to socially optimum level.

Question 15

How can underproduction and underconsumption be solved?

Answer 15

With a pigouvian subsidy. Per unit subsidy where unit subsidy = marginal benefit.

Increases output to socially optimal level.,

Question 16

How do you solve the externalties model?

Answer 16

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.

Question 17

What does solving the externality economy model imply?

Answer 17

you get that
MRS = MRT - externality

but usually you just get MRS = MRT

Question 18

What does MRS = MRT mean in terms of production?

Answer 18

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.

Question 19

What is pertinent about externalities model when looking at the whole economy and just one consumer.

Answer 19

When looking at an individual conusmer they do not take into account externality whilst production does.

Question 20

Why is perfect competition relevant when finishing up the individual maximisation in externality model?

Answer 20

as the wages are equal to the price of marginal product x marginal product.

Question 21

What is the set up of an open edgeworth box to model property rights?

Answer 21

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.

Question 22

How do the preferences work in an open edgeworth box?

Answer 22

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.

Question 23

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?

Answer 23

It would be an equal amount of money and a certain amount of smoke
Would be along the dashed line in the very centre.

3. Exact point is decided by who has property rights.

Question 24

1. What is Coase Theorem
2. What is the implication of this?

Answer 24

1. 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.
2. Assigning property rights leads to the highest social optimum, maximising join profits, regardless of who gets it.

Question 25

How does open edgeworth box show that no pollution is not good?
With property rights.

Answer 25

Even if endomwent is at extreme for person a they will have a higher utility if they trade some of the thing they dont like for money

Question 26

What is the issue with Coase theorem?

Answer 26

It stipulates the person creating externality must be known, but in climate change that is not possible.

Question 27

Draw pigouvian taxation graphically