Lecture 25-Externalities

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1 Aug 2010
School
Department
Course
Professor
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
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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
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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
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