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ECO105Y1 Lecture Notes - Externality, Social Cost, Market Price

Course Code
Paul Cohen

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Chapter 10: Acid Rain on Others Parades (Externalities, Carbon Taxes,
Free Riders, and Public Goods)
Negative or positive externalities make smart private choice different from smart
-Smart choices require that all additional benefit and additional opportunity costs
including externalitiesbe counted
Negative externalities (external costs)costs to society from your private choice
that affect others, but that you do not pay
Positive externalities (external benefits)benefits to society from your private
choice that affect others, but that others do not pay for
-Externalities occur when no clear property rights exist
-When externalities exist, prices don’t accurately reflect all social cost and benefits,
preventing markets from coordinating private smart choices with social smart
choices. Market fail:
-Producing too much of things we don’t want (second hand smoke, pollution,
traffic jams)
-Producing to little of things we don’t want (vaccinations, education)
To coordinate smart private choices that generate negative externalities, with smart
social choices, choose the quantity of output where marginal social cost equals
marginal social benefit
As we reduce pollution, “efficient pollution”, balances additional environmental
benefits with additional opportunity costs of reduced living standards
Socially desirable amount of pollution is not zero; at some point additional
opportunity costs of reduction in pollution are greater than additional benefits
For any product/service that generates an externality, rule for a smart choice is:
Choose quantity of output where marginal social costs equal marginal social
Marginal social cost (MSC) marginal private costs plus marginal external cost
Marginal social benefit (MSB) marginal private benefit plus marginal external
Markets overproduce products/services with negative externalities; price is too low
because it does not incorporate external costs.
Government policies can force polluting businesses and individuals to pay the marginal
external cots of their pollution. As a result, polluters internalize their
externalities/costs into their private choices, creating smart social choices
-Without property rights to the environment, businesses have incentives to save
money and improve profits but ignoring external costs like pollution and global
-Governments can remedy market failures from externalities by creating social
property rights to environment, making pollution illegal, penalizing polluters.
Emissions taxtax to pay external costs emissions
Carbon taxemissions tax on carbon-based fossil fuels
Cap-and-trade-systemlimits emissions businesses can release into environment
Internalize the externalitytransform external cots into costs producer must pay
privately to government
-By giving pollution a price reflecting marginal external cost of damage done, smart
individual and business choices become smart social choices.
-Carbon taxes and cap-and-trade systems are smart policies for efficient pollution,
but may also be inequitable in hurting lower-income consumers most.
Positive externalities create a free-rider problem when neither buyers nor sellers are
paid for external benefits their exchange creates. The market-clearing price is too high
for buyers to be willing to buy the socially best quantity of output, and too low for
sellers to be willing to supply
Public goodsprovide external benefits consumed simultaneously by everyone, no
one can be excluded.
-Public goods like lighthouses and national defense are extreme examples of
positive externalities.
-Free-ridersomeone who does not have to pay for external benefits
For any product/service that generates an externality, rule for a smart choice is:
choose quantity of output where marginal social cost equals marginal social
Because of free-rider problem, markets under produce products/services with
positive externalities
-Price charged to buyers is too high
-Price received by sellers is to low
-Market price does not incorporate external benefits
Government policies can reward businesses and individuals creating positive
externalities. As a result, these businesses and individuals internalize the
externalities/rewards, turning smart private choice into smart social choices.
Subsides and public provision are government policy tools to get everyone to
voluntarily choose output where marginal social befit equal marginal social cost.
Subsidypayment to those who create positive externalities
Public provisiongovernment provision products/services with positive
externalities, financed by tax revenue
Subsides and public provision remove the wedge positive externalities drive
between prices for buyers and for sellers, inducing individuals and businesses to
voluntarily chose quantity of output best for society