Topic 4: Externalities Flashcards
Externality
Externalities arise whenever the actions of one economic agent directly affect another economic agent outside the market mechanism
Production externality
effect of externality on a profit relationship (supply side)
Consumption externality
effect of externality is on the utility level (demand side)
Private marginal cost (PMC)
the direct cost to producers of producing an additional unit of a good
Marginal damage (MD)
any additional costs associated with the production of the goods that are imposed on others but that producers do not pay
Social Marginal Cost (SMC)
the private marginal cost to producers plus marginal damage (SMC=PMC+MD)
How to obtain pareto efficient allocations in the presence of externalities?
Maximise the total utility of the society (sum of utilities of all consumers) subject to the production possibilities in the economy
Policy interventions to correct externalities
- Establish property rights (Coasian solution)
- Emission taxes or Pigouvian corrective taxation
- Regulation (Command and Control)
- Permits (cap-and-trade)
Coase theorem
- When there are well-defined property rights and costless bargaining, then negotiations between the party creating the externality and party affected by the externality can bring about the socially optimal market quantity
- The efficient quantity for a good producing an externality does not depend on which party is assigned the property rights, as long as someone is assigned those rights
Assumptions of Coase theorem
- Complete information
- Zero transaction costs
Problems with the Coasian solution
- The assignment problem
- The holdout problem
- Transaction costs and negotiating problems (hard to negotiate when lots of people on both sides of negotiation)
The assignment problem
In cases where externalities affect many agents, assigning property rights is difficult
The holdout problem
Shared ownership of property rights gives each owner power over all the others (because joint owners have to all agree to the Coasian solution)
Pigouvian taxation
Sets tax equal to the wedge between MSC and MPC to restore production efficiency (i.e. set tax equal to the marginal damage)
Advantages of regulation
- Easier to enforce/administer than taxation
- Useful to quickly reduce pollution levels if you want to meet a certain salient target (immediate effect)