Micro Chapter 18 - Externalities

Environmental externalities

an action that affect the well-being of those outside of a market transaction

Positive Externality

if an activity creates benefits for others that are not captured in private benefits

positive externalities example

vaccinations

Negative Externalities

if an activity imposes costs on others that are not captured in private costs

negative externalities example

pollution

economic efficiency

maximises the total benefits of the market without externalities

How to include externalities?

The Social Marginal Cost Curve

the social marginal cost curve consists of what and why?

It is the supply curve + externalities which have been given monetary values

Assumption based on cars example

external cost of cars is constant so a parallel line above supply curve. External costs should increase as more cars are bought. More congestion -> more pollution

Private benefit and Cost of activity X

the maximum monetary amount a person would be willing to pay to do an activity X and the cost to that person of doing activity X

Private benefit and cost relationship

If PB > cost, do the activity and if not, don't

Social Benefit and Cost of activity X

combined monetary amount people would be willing to pay for activity X and the combined cost of activity X

Social benefit and cost relationship

If SB > SC then do the activity and if not, don't

Marginal social benefit and marginal social cost

it is efficient to increase the level of activity as long as MSB > MSC

Supply Curve (aggregate over firms)

tells us marginal private costs

Demand Curve (aggregate over firms)

tells us marginal private benefit

Demand = Supply at market equilibrium, relationship between MPC and MPB

Marginal private cost = marginal private benefit

Pigovian Tax

people responsible for externality should pay the external cost (tax). The tax per unit of good = external damage per unit. Increases MC so shifts supply upwards by the amount of the externality

Who has the tax burden

More inelastic - the higher the burden and the more elastic, the lower the burden

Equity Concerns

the lower the household income is, the more they tend to spend as a share of their income on electricity and gasoline

Coase Theorem - Free Market Solution

when the parties affected by the externalities can negotiate costlessly with each other, an efficient outcome results no matter how the laws assign responsibility for damages. Also applies for positive externalities.

"free market solution"

if property rights are well defined and there are no transaction costs, an efficient allocation of resources will result, even if externalities exist, independently of who has the property rights

Rule of Coase's Theorem

efficient laws and social institutions are the ones that place the burden of adjustment to externalities on those who can accomplish it at the least cost

Implications of Coase's Theorem

the best laws regarding harmful effects cannot be identified unless we know something about how much it costs different parties to avoid harmful effects

Property Rights

no free market economy can function successfully without laws that govern the use of private property.

if negotiation is costless,

people will forge agreements that result in efficient outcomes. Institutions often tend to evolve that encourage activities with positive external effects

Tragedy of Commons

reason for failure to produce the best result by the invisible hand theory is by ignoring externalities. Can only function properly when all resources sell for prices that reflect their true economic value

Transaction costs

everything that will be associated with market transaction or negotiation

Why don't we always get an arrangement

1. It is hard to define who has the property rights eg. to pollute and to be free from pollution, 2.Non-existent transaction costs for large numbers of parties eg. Free rider effect or Holdout effect, 3. Equity Problem, 4. Effect on non-human and 5. Intergenerational problem

Free Rider effect

50 firms and the farmer has the right, one firm can choose not to pay

Holdout effect

1 firm and many small communities, if one community disagrees then no arrangement

Positive Externalities

unregulated markets will fail to maximise social welfare so quantity will be below social optimal. Imposing subsidies to maximise benefit

Positional Externalities

contests - situations in which rewards are determined by relative performance. When stakes are high, unregulated contests often lead to costly positional arms races

Positional externality when one person is striving to improve…

relative performance necessarily harms another

Positional Arms Race

a situation where rivals make competing investments that ultimately cancel each other out, leading to no overall improvement in performance but a wasteful increase in costs

a rarely effective solution to a positional arms race

voluntary restraint due to the urge of human nature to be victorious

Taxing Externalities

tax the negative and subsidise the positive externalities

If negotiation is costless (taxing)

taxing will always lead to an efficient outcome but so will not taxing, just producing a different outcome

If negotiation is impractical (taxing)

taxing will still be efficient if the 'polluter' has the least costly way of reducing the damage or inefficient if the victim has the least costly means of avoiding damage

Taxation vs regulation

direct regulatory approach (telling each firm how much to reduce externality by) could achieve any given reduction if regulators knew MC of reduction of each firm. This is difficult as regulators generally have no idea

Advantage of taxing

it achieves efficiency without requiring any such knowledge on the part of regulators

If tax on product that doesn't generate externalities

product will sell for a price that exceeds its MC

When P > MC

output falls short of the level that would maximise economic surplus

No tax on product that producers negative externalities

output of product exceeds the level that would maximise economic surplus

Comparative Advantage Theory

2 trading countries will gain by specialising in producing these goods and services that they can producer more efficiently and then trade with each other so will both end up better off

Production externalities

externalities associated with producing a good eg. producing a car

consumption externalities

externalities associated with consuming a good eg. driving a car

Environmental benefits from trade

spread environmentally friendly technology, more efficient reduction, reducing materials and energy use and exporting countries may increase the quality of their products to enter high-standards markets

Markets will operate with inefficiency if

marginal social cost > marginal private cost

In a perfectly competitive market, if the market is at equilibrium then

marginal private cost = marginal private benefit

Who won the Nobel Prize with paper 'The Problem of Social Cost'

Ronald H. Coase

How to solve NIMBYism

relocation and compensation

For common resources, privately owned inputs is used until…

their average product equals their opportunity cost resulting in zero economic surplus