econ unit 11 ppt

Externalities 

1. Fundamental Welfare Theorems — Background for Externalities

__ Welfare Theorem

• In perfectly competitive markets, with ideal conditions, the market outcome is ___.

• “Efficient” = maximizes total surplus.

first, efficient

___ Welfare Theorem

• Any efficient allocation can be achieved by:

  1. ___ wealth first

  2. Then letting markets operate ___

• Meaning: equality concerns ≠ efficiency concerns.

second, redistributing, freely

BUT these theorems depend on unrealistic assumptions:

1. All markets must be perfectly ____
   – No market power, monopolies, or strategic behavior.

2. All agents have ____ information and beliefs
   – No misinformation, uncertainty, or asymmetric information.

3. No externalities
   – People only affect __

When any of these fail → markets can be inefficient.

competitive, perfect, themselves

2. What Are Externalities?

Externalities are the ___ of an economic choice that affect others who did not make the decision.

• Positive externalities → third-party benefits

• Negative externalities → third-party costs

Externalities occur in both production and consumption

• Production: ____, bee pollination, R&D spillovers

• Consumption: ___, congestion, Christmas lights

Externality = external effect.

consequences, pollution, noise

3. Examples from Daily Life (Slides 7–14)

“No man is an island” (John Donne, 1624)

Used to illustrate that: Individuals’ actions ____ affect others.

Negative Externalities

• Congestion

• Conflicting lawn maintenance

• Household ___(Neve’s nasty nicotine addiction)

• CO₂ emissions & climate change

• Noise pollution

inevitably, trash

Positive Externalities

• Christmas lights → neighborhood enjoyment

• Education → societal productivity

• ____ → herd immunity

• Employment → reduced crime

• Flowers & bees → pollination

• Network spillovers → social media value increases with more users

Graph example: CO₂ emissions vs. temperature (Slide 12)

• CO₂ emissions rising from 1900–2025 

Global temperature increases with emissions
→ Clear visual of negative externality: harm falls on everyone

vaccines

4. Externalities and Market Failure

Moral behavior vs. economic incentives

• Ideally: people consider how their actions affect others

• In reality: decisions are made based on ___ costs and benefits
  → Externalities are usually ___.

When externalities are ignored:

Private decision rule (selfish choice):

MC = MB

Social efficiency rule: MSC = MSB

• MSC = MC + __
  (Marginal Social Cost = Private cost + Marginal External Cost)

MSB = MB + MEB
(Marginal Social Benefit = Private benefit + Marginal External Benefit)

private, ignored, MEC

5. Negative Externalities (Slides 18–22)

• Pollution

• ___ emissions

• Traffic congestion

factory

Graph: Negative Externality (Slide 18)

Graph with Q (quantity) on x-axis and P (price) on y-axis. 

Curves:

• ____ (private cost) = ___ curve ignoring external costs

• MSC (social cost) = MC + external cost
  → lies ___*** MC

• Vertical distance between MSC and MC = ____*** (external cost)

Producers do not bear the full cost → they overproduce

MC, supply, above, MEC

Socially Efficient Outcome (Slide 19)

Add the demand curve (D).

• Efficient Q = intersection of ___ and D

• Free-market Q = intersection of ___ ****and D

The efficient quantity is ____.

→ Society prefers ___ production than the market produces.

MSC, MC, lower, less

Competitive Equilibrium (Slide 20)

The market produces where: D intersects ___ (private supply)
→ Overproduction

MC

Negative Externality Summary

Free market results in:

1. ___

2. Too ___ a price

3. ___

overproduction, low, DWL

Graph: Deadweight Loss (Slide 22)

DWL = triangular area between:

• __ 

• __

• __
  between the efficient Q and the market Q.

MSC, MC, Demand

6. Positive Externalities (Slides 23–27)

• Education

• Vaccinations

• R&D

• Public __

• Well-maintained lawns

art

Graph: Positive Externality (Slide 23) 

Curves:

• MB (private benefit) = demand curve

• MSB (social benefit) = MB + external benefit
  → lies above MB

Distance between MSB & ___ = MEB (external benefit)

MB

Efficient Outcome (Slide 24) 

Efficient Q = intersection of: ____and ___

Market Outcome (Slide 25)

Market chooses: ___ intersects ___

→ __

MSB, MC, MB, MC underproduction

Market Outcome (Slide 25)

Market chooses: __ intersects __

→ __

MB, MC, underproduction

Positive __ Summary

Free market results in:

• Underproduction

• Too low a quantity

Deadweight loss
(DWL between MSB & MB between the two quantities)

externality

7. Why Markets Fail with Externalities

Competitive markets are efficient only if:

• Every person is an ___ decisionmaker

• No unintended ___ exist

But: In almost all real-world activities, externalities exist
→ Therefore, policy interventions can improve efficiency.

isolated, spillovers

8. Controlling Pollution (Slides 29–30)

Three major policy approaches:

1. Price Controls (bag fees)

• Toronto considering $2 fee on plastic bags

• Federal ban on single-use plastics (ongoing legal battle)

Effect: Raising price reduces __ = lower pollution.

QD

8. Controlling Pollution (Slides 29–30)

Three major policy approaches:

2. Quantity Controls (Quotas / Cap-and-Trade)

• Canada drafting national cap-and-trade

• Systems in: Quebec, California, EU, China

Mechanism:

• Government sets a cap on total emissions

• Firms receive or buy ___

• They can trade permits → ensures ___ reduction.

permits, least-cost

8. Controlling Pollution (Slides 29–30)

Three major policy approaches:

3. Pigouvian Taxes (___ Taxes)

Canada:

• Federal carbon tax + ___ since 2019

• BC + Quebec have provincial systems

• Canada reached peak emissions in 2023

Purpose: Make firms/consumers pay the full ___ cost.

carbon, rebates, social

9. Pigouvian Taxes (Slides 33–35)

A Pigouvian tax is a tax set equal to the marginal external cost (MEC).

T = ____

Effect on price:

Price consumers pay becomes: ___ + ___ = ____ + MEC = MSC

• The tax internalizes the external cost

• Market outcome becomes efficient again.

Assumptions (important for exams):

Government must be able to:

1. Accurately measure __

2. Have correct incentives (not use tax as cash grab)

MEC, P + T, MC, MEC

Graph: Optimal Pigouvian Tax (Slide 34) 

Curves:

• MC = private supply

• MSC = MC + __

• Demand

The tax vertically shifts supply upward until: New supply intersects demand at the efficient quantity

tax

Graph: Efficiency Restored (Slide 35)

• New supply = supply + tax

• Intersection with __ = efficient Q

• No deadweight loss → maximized total surplus

demand

10. Are Carbon Taxes Good? (Slide 36)

Benefits

• Increase ___

• Increase efficiency

• Reduce pollution

Political skepticism

• People perceive it as a “cash grab”

• Public concern: ___

• Despite rebates where 70–90% of households get back more than they pay.

Economist consensus

Large majority support carbon pricing:

• Canadian open letter

• American open letter

• Global expert surveys

revenue, inflation

11. Producing Knowledge (Slides 37–39)

Knowledge production has positive externalities, so markets underproduce it.

Policies to promote knowledge:

1. Public __

• Public universities (including Western University)

Western’s revenue:

• 54% tuition

• 33% government

• 13% other sources

provision

11. Producing Knowledge (Slides 37–39)

Knowledge production has positive externalities, so markets underproduce it.

Policies to promote knowledge:

2. Subsidies / Vouchers

• Work like negative Pigouvian taxes

• Reduce the price to consumers

• Vouchers = more consumer ___

• Provinces offering vouchers: AB, QC, MB, SK (some extent)

choice

11. Producing Knowledge (Slides 37–39)

Knowledge production has positive externalities, so markets underproduce it.

Policies to promote knowledge:

3. Intellectual Property Rights

• Patents

• Copyrights

• ___

These give creators temporary ___ profits → incentive to __.

trademark, monopoly, innovate

12. Coase and Transaction Costs (Slides 40–42)

Coase (1988) Quote - Markets exist to reduce ___ costs.

Coase’s Theory of the Firm

Why do some transactions occur ___ firms instead of in markets?

Because of:

• Search __

• __ frictions

• Incomplete contracts

• Contract enforcement problems

• Misaligned ___

Firms exist to reduce these costs.

transaction, inside, frictions, information, incentives

Property Rights & Externalities

Assigning property rights can ___ externalities.

• Patent owners can license ___

• River owner can sell pollution ___

• Knowledge creators earn ___ profits

Effectiveness depends on:

• __ costs

• ___ costs

Sometimes:

• Private regulators work best

• Sometimes government is needed

internalize, innovations, rights, monopoly, enforcement, transaction

13. Public Goods (Slides 44–46)

1. Rival vs Nonrival

2. Excludable vs Nonexcludable

Rival good - Consumption by one person reduces ___ for others.

• Food

• Fish in a river

• Underground __

Nonrival good - One person’s consumption ___ reduce availability.

• __

• Streaming services

• Pathways

availability, water, doesn’t, knowledge

Excludable good - ___ to prevent someone from using it (through ___ or access).

• ___

• Concert ticket (ERA’s tour)

Nonexcludable good - Cannot prevent ___ from using it.

• Public ___

• Clean air

• __

• Law enforcement

• Carbon capture

possible, price, house, nonpayers, parks, firefighters

Public Goods Grid (Slide 46)

	Rival	Nonrival
Excludable	House, food	ERA’s Tour (___)
Nonexcludable	Fish in rivers, water	Firefighters, law, carbon capture, pathway, social media

Key idea: Public goods → nonrival + nonexcludable → free rider problem → underprovided by market.

concert

Externalities

• MEC, MEB

• MSC = MC + MEC

• MSB = MB + MEB

Negative Externalities

• ___

• price too low

• DWL on __ side

overproduction, right

Positive Externalities

• Underproduction

• Price too low

• DWL on ___ side

Pigouvian Tax

• T = ___

• Makes MC → MSC

• Eliminates __

Cap-and-Trade

• Fixed quantity

• ___ permits

• Achieves efficient allocation

left, MEC, DWL, tradable

Public Goods

• Nonrival + nonexcludable

• Free rider problem

• Underprovided by markets

__ Theory

• Property rights internalize externalities

• Works best when transaction costs low

coase