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ECO100 - JAN 14

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James Pesando

EXTERNALITIES 1. Overview The market for lumber is perfectly competitive ● No barriers of entry, zero profit ● Lumber mills dump toxins into adjourning lakes, thereby reducing the recreational value of the lakes ○ less enjoyment of the lake ● Lumber mills are not required to compensate users of the lakes (or cottage owners) for the decline in recreational quality(value) of the lakes. ● Will the price paid by consumer for lumber be ○ too high? ○ too low? ○ just right? ● Why? - The cost of the pollutants (toxins) is not reflected in the market price of lumber. ● Will the market for lumber produce an allocationally efficient level of output. - No. ○ The point where price (value to the buyer) = marginal cost (cost for the producer to produce the last unit sold). ○ the marginal cost has to reflect both the total cost and the social cost. ● Externality: Transaction between buyer and seller affects third party. ○ Pollution: production externality ○ Alcohol: consumption externality ○ Can be positive or negative ● When the product is made vs. when the product is bought ○ Where does the problem lie? ● In general, market outcome is not efficient (“market failure”) and government intervention can improve market outcome. ○ ● If there is an externality in a perfectly competitive market, the outcome will not be allocatively efficient. ○ Too many firms, cannot negotiate ○ Single firm cannot influence price. ● Allocative efficiency (no externalities) P=MC ● If third parties are affected (“externality”) competitive outcome is not allocatively efficient ○ Important examples: pollution 2. Pollution: Negative Externality of Production ● Market: Aluminum ● External cost: Smoke ($10 per Tonne) Price (Per Tonne) Quantity Demanded Quantity supplied Quantity supplied (After $10 tax) 15 80 40 20 20 70 50 30 25 60 60 40 30 50 70 50 35 40 80 60 40 30 90 70 ● Market
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