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Lecture 25

Lecture 25-Externalities

8 Pages
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Department
Economics
Course Code
ECO101H1
Professor
Jack Carr

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Tuesday, January 19, 2010.
Externalities
Externalities
1. Transaction between buyer and seller affects third party
Examples:
Pollution (production externality)
Alcohol (consumption externality)
2. Insights
(1) ,QJHQHUDOPDUNHWRXWFRPHLVQRWHIILFLHQW³PDUNHWIDLOXUDQGJRYHUQPHQW
intervention can improve market outcome
(2) When all parties affected by externality can negotiate, market outcome may be
efficient
Two Anti-Theft Devices
1. Theft Clubs (steering wheel of car)
2. Silent Auto-Tracking Theft Device
Externality?
1. (Possible) Negative externality
2. Positive externality (thefts fall sharply in cities in which many cars have silent theft
device)
Competitive Market
1.
^^ATui
DD
Pc
Qc
www.notesolution.com
2. Allocative Efficiency (No Externalities)
P = MC
Value to buyers cost of production
3. If third pDUWLHVDUHDIIHFWHG³H[WHUQDOLW\´
competitive outcome is not allocatively efficient
Important example: pollution
Market: Aluminum
External Cost: Smoke ($10 per Tonne)
Price Quantity Quantity
(Per Tonne) Demanded Supplied
15 80 40
20 70 50
25 60 60
30 50 70
35 40 80
40 30 90
Market Outcome: P = 25 Q = 60
Market Outcome
P = (private) MC = 25
But:
Social MC = (Private) MC + $10
PC
SS (private cost)
$10
PS
QS
DD (private value
= social value)
QC
Price
(per tone)
Social cost
www.notesolution.com
1. Market outcome is inefficient
At Qc, Pc < social cost Inefficient
At Qs, Ps = social cost Efficient
2. Result
Qc > Qs !SULYDWHPDUNHW³RYHUSURGXFHDOXPLQXP
Pc < Ps !SULYDWHPDUNHW³XQGHUSULFHDOXPLQXP
To right of QS, social cost > value to buyer
Remember
1. Most goods: social cost = private cost
Ö Market outcome is efficient
2. If social cost = (not equal) private cost, social cost must be reflected in market outcome
to achieve efficiency
Example
Government imposes $10 tax (per tone), to be paid by sellers
Market: Aluminum
External Cost: Smoke ($10 per Tonne)
Price Quantity Quantity Quantity
(Per Tonne) Demanded Supplied Supplied
(After $10 tax)
15 80 40 20
20 70 50 30
Social cost
DD
P
QC
Deadweight Loss
QS
Q
www.notesolution.com

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Description
Tuesday, January 19, 2010. Externalities Externalities 1. Transaction between buyer and seller affects third party Examples: Pollution (production externality) Alcohol (consumption externality) 2. Insights (1) ,QJHQHUDOPDUNHWRXWFRPHLVQRWHIILFLHQW³PDUNHWIDLOXUH´DQGJRYHUQPHQWintervention can improve market outcome (2) When all parties affected by externality can negotiate, market outcome may be efficient Two Anti-Theft Devices 1. Theft Clubs (steering wheel of car) 2. Silent Auto-Tracking Theft Device Externality? 1. (Possible) Negative externality 2. Positive externality (thefts fall sharply in cities in which many cars have silent theft device) Competitive Market 1. ^^ATui DD Pc Qc www.notesolution.com 2. Allocative Efficiency (No Externalities) P = MC Value to buyers cost of production 3. If third pDUWLHVDUHDIIHFWHG³H[WHUQDOLW\´ competitive outcome is not allocatively efficient Important example: pollution Market: Aluminum External Cost: Smoke ($10 per Tonne) Price Quantity Quantity (Per Tonne) Demanded Supplied 15 80 40 20 70 50 25 60 60 30 50 70 35 40 80 40 30 90 Market Outcome: P = 25 Q = 60 Market Outcome P = (private) MC = 25 But: Social MC = (Private) MC + $10 PC SS (private cost) $10 PS QS DD (private value = social value) QC Price (per tone) Social cost www.notesolution.com 1. Market outcome is inefficient At Qc, Pc < social cost Inefficient At Qs, Ps = social cost Efficient 2. Result Qc > Qs !SULYDWHPDUNHW³RYHUSURGXFHV´DOXPLQXP Pc < Ps !SULYDWHPDUNHW³XQGHUSULFHV´DOXPLQXP To right of QS, social cost > value to buyer Remember 1. Most goods: social cost = private cost Ö Market outcome is efficient 2. If social cost = (not equal) private cost, social cost must be reflected in market outcome to achieve efficiency Example Government imposes $10 tax (per tone), to be paid by sellers Market: Aluminum External Cost: Smoke ($10 per Tonne) Price Quantity Quantity Quantity (Per Tonne) Demanded Supplied Supplied (After $10 tax) 15 80 40 20 20 70 50 30 Social cost DD P QC Deadweight Loss QS Q www.notesolution.com 25 60 60 40 30 50 70 50 35 40 80 60 40 30 90 70 Charge (Tax) Imposed on Suppliers 1. 66VKLIWVXSZDUGWR66¶ 2. Achieve allocative efficiency ( At q = 50, price = social cost = 30) 3. Incidence of Tax Price received by seller: market price ± 10 = 20 (versus 25) Price paid by buyers: market price = 30 (versus 25) Output (and employment) in aluminum industry declines Consumers of aluminum pay a higher price Market: Alcohol Negative Consumption Externality: $5 per bottle (impaired driving or similar costs) 1. 0DUNHW³RYHUSURGXFHV´DOFRKRO 25 SS (private cost) $10 30 50 DD 60 Price (per tone) ^^[~A}]o} www.notesolution.com At QC, social value < private cost (allocative inefficiency) At QS, social value = private cost (allocative efficiency) Welfare Analysis: Negative Consumption Externality To right of Qs, social value < private cost 2. Government Intervention 2.1 Impose tax of $5 per bottle, to be paid by buyer **Remember: incidence of tax does not depend upon whether it is imposed on buyer or seller 2.2 Student Exercise (1) ''VKLIWVWR''¶DQGHTXDOVVRFLDOYDOXH (2) Q = QS (3) P (paid by buyers): rises P (received by sellers): falls SS (private cost = social cost) Social value QS DD (private value) QC Price (per bottle) $5 SS Social Value P QC Deadweight Loss QS Q www.notesolution.com Observations: 1. Q = Qs (allocatively efficient) 2. P (paid by buyer) = p + $5 increases (exceeds Pc) P (received by seller) = p decreases (less than Pc) Externalities ,QJHQHUDOPDUNHWRXWFRPHLVQRWHIILFLHQW³PDUNHWIDLOXUH´DQGJRYHUQPHQWintervention can improve market outcome Coase Theorem If: (1) property rights exist (exclusive right to deal with property or assets), and (2) transactions cost are low Then: Private markets, in the presence of externalities, can arrive at allocatively efficient outcomes Further: Result does not depend on who owns the property rights Example #1 Farm A: cattle Farm B: crops (Negative) Externality: cattle stray and damage crops Cost of Fence: $2000 Damage to Crops: $3000 P SS $5 PC Q = QS [~]ÀÀoµA}]oÀoµ DD P + 5 www.notesolution.com Coase Theorem (Property rights: exclusive right to use resource) Example #2 Cost of Fence is $5000 Property Right Result Why Farm A Farm B does not build fence Cost of fence exceeds crop damage Farm B Farm A does not build fence (pay $3000 for crop damage) Cost of fence exceeds crop damage Key Result Fence is built if it is efficient to do so, regardless of who has property right. (Economic well being is affected by who has property right) Limitations of Coase Theorem 1. Transaction costs may be high (and bargaining may not take place) 2. Property rights may not be well defined Example: one firm emits pollution into lake many cottages are negatively affected (high transactions costs) :QRWFOHDUZKHWKHUILUPKDVULJKWWRSROOXWHRULIFRWWDJHVKDYHULJKWWRclean lake Property Right Result Why Farm A (cattle can stray, with no damages payable) Farm B builds fence Cost of fence is less than crop damage Farm B (owner of Farm B must be compensated for crop damage) Farm A builds fance Cost of fence is less than crop damage www.notesolution.com MB $ MC qE qF Pollution Abatement: Economic Perspective Question: ,V³3ROOXWLRQ)UHH´HQYLURQPHQWWKHDSSURSULDWHJRDORISROLF\" 1. Marginal Benefit, Marginal Cost of Pollution Abatement 2. ³3ROOXWLRQ)UHH´Ù Invest in Pollution Abatement until MB = 0 (at qF) 3. Economically efficient investment in Pollution Abatement (1) At qF, MC > MB => inefficient (2) At qE, MC = MB => efficient www.notesolution.comTuesday, January 19, 2010. Externalities Externalities 1. Transaction between buyer and seller affects third party Examples: Pollution (production externality) Alcohol (consumption externality) 2. Insights (1) ,3J0307,O2,7N094:9.420L8349011L.L039 2,7N091,LO:70 ,3J4;0732039 intervention can improve market outcome (2) When all parties affected by externality can negotiate, market outcome may be efficient Two Anti-Theft Devices 1. Theft Clubs (steering wheel of car) 2. Silent Auto-Tracking Theft Device Externality? 1. (Possible) Negative externality 2. Positive externality (thefts fall sharply in cities in which many cars have silent theft device) Competitive Market 1. ^^)6K i Pc DD Qc www.notesolution.com
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