Intermediate Microeconomics Lecture 10 Notes

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  • EC 202: Intermediate Microeconomics
  • Lecture 10, Autumn 2024
  • Chapters 35 & 37 from Varian

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Recap

  • Competitive markets can achieve efficient outcomes (First Welfare Theorem) for the economy as a whole (General Equilibrium).
  • The difference between efficiency and equity, and the conditions under which any Pareto-efficient allocation can be achieved via competitive markets with transfers (Second Welfare Theorem).
  • Keywords:
    • Pareto Efficiency: A situation where no individual can be made better off without making someone else worse off.
    • Welfare Theorems: Theorems that describe the performance of market economies under certain conditions.
    • Equity: Fairness or justice in the way people are treated.

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Plan for Today

  • Explore situations where welfare theorem conditions fail.
  • Introduce the concept of externalities and their effects on consumption and production decisions.
  • Analyze externalities from the perspective of property rights using the Coase theorem.
  • Discuss problems associated with common property.

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Externalities

  • An externality occurs when someone's consumption or production activities harm or benefit others outside of a market.

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Externalities Explained

  • Example: A manufacturing plant emits noxious fumes, creating a negative externality that harms residents.
  • The firm does not account for this external cost in its output decisions.
  • Positive externalities exist as well; for instance,
    • Planting trees positively impacts the environment.
    • Research (e.g., invention of GPS) benefits society.

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Types of Externalities

Production Externality

  • A production externality arises when a firm’s production capabilities are affected by another firm's or consumer’s actions.
    • Example: A fishery is concerned about pollutants affecting its catch.
    • Example: A firm benefits from a technology developed by another firm.

Consumption Externality

  • Occurs when one consumer’s utility is affected by another’s actions.
    • Example: The loud music from a neighbor affects my pleasure.
    • Example: Enjoying a neighbor's flower garden gives me pleasure.

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Externalities and General Equilibrium

  • Consumers and producers typically aim to maximize utility and profits, respectively.
  • Externalities lead to interdependent preferences in the economy, which can result in Pareto-inefficient allocations.

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Example: Smoking vs. Clean Air

  • Ann (smoker) and Bob (non-smoker) have opposing preferences:
    • Ann's utility function: U_A = 4S + C
    • Bob's utility function: U_B = - rac{1}{2}(S + C)
    • where S is the number of cigarettes and C is the level of clean air.
    • Price of cigarettes is fixed at P = 1.

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Decision Analysis

  • Bob avoids smoking (S = 0) since it reduces his utility (clean air negatively impacts his utility).

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Ann's Optimal Consumption

  • To maximize utility, Ann's consumption point is determined by:
    • ext{max} ext{ } U = 4S + C - ext{cost} (S)
  • Optimal consumption yields: S^* = 2, leading Ann to consume less than before to account for externalities.

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Centralized Allocation

  • If the bar owner intervenes to maximize joint utility (Ann's + Bob's), the outcome reflects externalities imposed by Ann on Bob, leading to a new consumption level for Ann of approximately S = 1.33 instead of 4.

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Example in an Edgeworth Box

  • Consider two agents (Ann and Bob) and two goods (money and smoke).
  • At endowments, Ann prefers smoking while Bob prefers clean air.
    • Initial Endowment
    • Ann has the right to smoke.
    • New Endowment
    • Bob acquires the right to clean air.

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Externalities and Property Rights

  • The equilibrium of an externality scenario depends on who holds property rights.
  • Competitive market transactions can lead to efficient outcomes if property rights are well-defined.
    • Example: If I own the right to clean air, I can sell it to you.

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Coase Theorem

  • Coase Theorem: If property rights are well defined and there are no transaction costs, agents can achieve efficient allocations through trade, resulting in equitable outcomes regardless of initial rights.

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Social Cost

  • The steel firm ignores external costs it imposes on the fishery, leading to overproduction of pollution.
  • Social cost refers to the impact of pollution on the fishery that is not reflected in the firm's costs.

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Merged Firm or Social Planner

  • A merged entity would optimize both production forms by equalizing marginal benefits and marginal social costs associated with pollution.

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Pollution Vouchers

  • The government sets emission limits; firms can sell excess allowances, achieving a more efficient emissions distribution across the industry.

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Coase's Solution

  • The market can resolve externalities by allowing firms to negotiate rights (e.g., polluting firms and affected parties).

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Common Property Problems

Tragedy of the Commons

  • Economic agents often overuse common goods leading to depletion, known as the tragedy of the commons.
    • Example: Overfishing results from individual fishermen failing to consider the total fish stock.

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Elinor Ostrom's Contribution

  • Ostrom's work highlights how communities can effectively manage commons through shared rules, preventing the tragedy of the commons.

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Conclusion

  • The market can achieve Pareto efficiency as per the First Welfare Theorem, but externalities necessitate careful consideration.
  • The Coase theorem elucidates potential resolutions through defined property rights.
  • Yet, problems like the tragedy of the commons often require innovative solutions.