Week 8 - Externalities, Public Goods and Common Resources Flashcards
What is an externality?
The uncompensated impact of one person’s actions on the well-being of others.
What are the consequences of externalities?
If there are externalities the market equilibrium will no longer be efficient.
Externalities are a form of market failure.
What does pollution mean in terms of externalities?
Its social cost is above the private cost.
What is the socially optimal point? What does this imply?
Where MSC = MSB. This implies that a competitive market will produce too much of a good with a negative externality.
Why do firms produce too much of a good?
Since they are profit maximising they do not take into account the social cost but only the private costs involved.
What is a positive externality?
When marginal social cost is below marginal private cost.
What are some solutions to get rid of market failure?
- Establish a market or clear property rights
- Taxes and subsidies
- Regulation
How can markets be a solution to an externality?
-Externalities can be thought of as a situation where a market is missing
- One example is the market for clean-air factories
- But for market to work well they need
–Clear property rights- who owns the air
–Cheap enforcement- if someone takes away my clean air, it is easy to see who has to pay.
This is difficult in practice.
What is the coarse theorem?
If private companies can negotiate without a cost then an efficient outcome will be reached.
The Coase Theorem states that if property rights are well-defined and transaction costs are negligible, then private bargaining will lead to an efficient allocation of resources, regardless of who initially owns the property rights.
How can you use taxes to correct a negative externality?
If a polluter has to pay a tax for each unit of the good produced it will raise their private costs and alter the market equilibrium.
Draw a diagram for the effect on a negative externality a tax can have.
MPC shifts up
What is the optimal tax?
Makes private cost = social cost.
How could you use regulation to negate a negative externality?
Limit the amount of the good produced.
Efficient to set a quota at the efficient level of output, Q*.
What are the reasons to prefer taxes or regulation?
Regulation: must set quota for each firm
Might not be efficient
Tax: set single tax for whole industry
But regulation makes sure you get the quantity you want
Less clear with taxes
What is the EU Carbon Trading Scheme?
This is a hybrid system, known as ‘cap and trade’
Factories in certain industries are given a CO2 allowance
If they pollute more than their allowance they have to buy permits to pollute from those who produce less than their allowance
Price is market-determined
Intended to limit amount of CO2 emissions while ensuring efficient distribution of emissions across firms
