ECON 2 Class 11 Study Notes: Externalities, Property Rights, and Climate Policy

Course Logistics and Midterm Regulations

• Problem Set and Schedule Details

  • Problem Set 2 (PS 2) is due on Sunday, 10/4 at 11:59pm via Gradescope.

  • Monopoly content was presented asynchronously on Tuesday, 9/29 (including lecture slides and Jupyter notebook material).

  • Externalities and climate change are covered on Thursday, 10/1.

  • Review for the midterm occurs in class on Tuesday, 10/6.

  • The in-class 60-minute midterm exam takes place on Thursday, 10/8.

• Midterm Exam Scope and Coverage Guidelines

  • Monopoly is an essential topic and is included on PS 2 and the midterm exam.

  • The monopoly question on the midterm will be shorter than Fall 2025 Question 3 regarding monopolist Taylor Swift.

  • Topics given full in-class coverage will receive greater prominence on the exam.

  • Material excluded from lecture—such as the exact shape of firms' average cost curves and the evolution of profits from Class 09—does not need to be studied for the exam.

• Exam Administration and Rules

  • Standard Exam Location: Dwinelle 155, starting promptly at 9:40am and running for 60 minutes.

  • Seating and Verification: A seating chart will be implemented; students must sit in their assigned seats. Upon completion, exams must be handed to a proctor along with student ID verification. Students who forget their ID must visit office hours and produce a writing sample on the spot.

  • DSP and Accommodations:

  • Students approved for $150\%$ time, as well as left-handed students, report to Evans 648 (6th floor, middle of the building). Testing runs strictly from 9:30am to 11:00am. Left-handed non-DSP students sit for 60 minutes.

  • All students requiring testing in Evans 648 or left-handed seating must RSVP using the online form (https://forms.gle/oDX4o3oArzzqBV6T8).

  • Students requiring accommodations beyond $150\%$ time must schedule proctoring through the DSP online portal at dsp.berkeley.edu.

  • Grading Policy: There is no clobber policy for Fall 2026. Total scores directly reflect overall student performance. Grades will never be curved downward (in contrast to policies at Berkeley Law).

Building Safety Rules and Scooter Externalities

• Prohibition Policy

  • Scooters, bicycles, and skateboards are strictly prohibited inside all university buildings and classrooms. Owners must lock them outside.

  • Unattended or indoor personal vehicles pose severe trip hazards during emergency evacuations and will be removed.

• Microeconomic Explanation of Indoor Scooters

  • Scooter owners pay market price, implying their private marginal benefit is at least equal to that price ($PMB \ge P$).

  • Market prices contain no implicit insurance or compensation against the risk of tripping over parked vehicles during a emergency building evacuation.

  • When brought inside, personal transportation devices convert into negative externalities by imposing uncompensated risk onto third parties.

Fundamentals of Externalities

• Definition and Core Principles

  • An externality occurs when the actions of an economic agent directly affect another economic agent outside the market mechanism without monetary compensation or agreement.

  • Market transactions transfer goods and services between buyers and sellers; spillovers represent side effects experienced by non-participating third parties.

  • Market mechanisms fail to price these spillovers, leading to sub-optimal resource allocation.

• Terminology

  • Private: Refers directly to agents participating in market transactions (buyers, sellers, and government bodies issuing taxes or subsidies).

  • Social: Encompasses all economic impacts, including those felt by market participants and external third parties.

  • External Marginal Cost ($EMC$): The incremental cost imposed on external non-participants per additional unit produced or consumed.

  • Social Marginal Cost ($SMC$): The total marginal cost to society, defined as:

$\text{Social Marginal Cost} = \text{Private Marginal Cost} + \text{External Marginal Cost}$

$SMC = PMC + EMC$

• External Marginal Benefit ($EMB$): The incremental benefit conferred on external non-participants per additional unit produced or consumed.

• Social Marginal Benefit ($SMB$): The total marginal benefit to society, defined as:

$\text{Social Marginal Benefit} = \text{Private Marginal Benefit} + \text{External Marginal Benefit}$

$SMB = PMB + EMB$

• Systemic Market Distortions

  • Markets oversupply goods that generate negative externalities.

  • Markets undersupply goods that generate positive externalities.

  • If external costs or benefits can be quantified, an optimal production level exists where social marginal cost equals social marginal benefit ($SMC = SMB$).

Negative Externalities and Social Marginal Cost

• Market Dynamics in the Gasoline Sector

  • In a standard market without accounting for externalities, market equilibrium occurs where Private Marginal Cost equals Private Marginal Benefit ($PMC_1 = PMB_1$) at quantity $Q_1$ and price $P_1$.

  • Total economic welfare under competitive conditions is represented by the sum of Consumer Surplus and Producer Surplus.

• U.S. Carbon Dioxide Emission Sources

  • According to Environmental Protection Agency (EPA) data, emissions originating from U.S. sources are broken down as follows:

  • Electricity: $37\%$

  • Transportation: $31\%$

  • Industry: $15\%$

  • Residential & Commercial: $10\%$

  • Other (Non-Fossil Fuel Combustion): $6\%$

• Impact of Pollution Externalities on Welfare

  • Pollution raises the social cost of gasoline production above its private cost, creating a higher curve $SMC_1 = PMC_1 + \text{External } MC$

• The market equilibrium quantity $Q_1$ exceeds the socially optimal quantity $Q^*$ where $SMC_1 = SMB_1$

• At market quantity $Q_1$, Social Marginal Cost exceeds Social Marginal Benefit ($SMC > SMB$).

• This overproduction generates a deadweight loss (DWL) triangle pointing leftward directly toward the social optimum $Q^*$.

• Examples of Negative Externalities

  • Second-hand cigarette smoke inhalation.

  • Texting or drinking while driving.

  • Agricultural pesticide runoff polluting water systems.

  • Excessive noise pollution generated by construction projects.

• General Rule for Negative Externalities

  • The $SMC$ curve lies above the $PMC$ curve.

  • Private markets produce where $PMC = PMB$.

  • Social efficiency requires producing less output where $SMC = SMB$

Positive Externalities and Social Marginal Benefit

• Demand-Side External Benefits

  • Positive externalities generate uncompensated third-party benefits from production or consumption.

  • The $SMB$ curve lies above the $PMB$ curve by the magnitude of the External Marginal Benefit ($EMB$).

• Market Dynamics in Vaccines

  • In a private market, individuals demand vaccines where private marginal benefit equals private marginal cost ($PMB_1 = PMC_1$), establishing equilibrium quantity $Q_1$

• Because vaccinated individuals reduce disease transmission for others, the social benefit curve $SMB_1$ lies above $PMB_1$

• The socially optimal quantity $Q^*$ exceeds private market quantity $Q_1$ ($Q^* > Q_1$).

• Underproduction generates a deadweight loss triangle because at $Q_1$, Social Marginal Benefit exceeds Social Marginal Cost ($SMB > SMC$).

• Examples of Positive Externalities

  • Industrial technology spillovers and open innovation.

  • Primary, secondary, and higher education.

  • Landscaping and planting flowers on private residential properties.

  • Beekeeping (apiaries) providing free pollination to nearby agricultural crops and garden vegetation.

• General Rule for Positive Externalities

  • The $SMB$ curve lies strictly above the $PMB$ curve.

  • Private markets settle where $PMC = PMB$.

  • Social efficiency requires producing higher output where $SMC = SMB$

Private and Institutional Solutions to Externalities

• Overview of Solutions

  • Private Approaches: Direct negotiation, financial compensation, social sanctions, public education.

  • Government Approaches: Command-and-control regulation, Pigouvian corrective taxes, and subsidies.

• Ronald Coase and Property Rights (1991 Nobel Laureate)

  • Coase Theorem: If property rights are well-defined and transaction/bargaining costs are negligible, private parties can negotiate to eliminate externalities efficiently regardless of initial property right allocations.

  • High transaction costs impede bargaining; thus, policymakers must assign initial property rights strategically to minimize friction.

• Elinor Ostrom and Common Pool Resources (2009 Nobel Laureate)

• **Refuting the