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Lecture 13

Economics 2261A/B Lecture Notes - Lecture 13: Marginal Cost, Externality, Overproduction


Department
Economics
Course Code
ECON 2261A/B
Professor
Vandna Bhatia
Lecture
13

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Besanko – Ch17 Externalities and Public Goods
Two cases where a competitive market will not lead to a Pareto Efficient outcome:
1. externality = actions of one consumer or producer affect other producers’ or consumers’
costs in a way not fully reflected by market prices.
Negative externality: SMC >PMC.
Ex: pollution from the production of a good.
Positive externality: SMB> PMB.
Ex: education, vaccination.
2. Public Good = a good that is nonrival and nonexcludable in consumption.
Nonrival: One person’s consumption does not affect the quantity that can be
consumed by another person.
Nonexcludable: No one can be prevented from consuming the good once provided.
Ex: Public TV, Fireworks display, lighthouses, national defense
These sources of market failure occur because either
1. private marginal costs (MPC) social marginal costs (SMC) or
2. private marginal benefits (MPB) social marginal benefits (SMB)

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Externalities
Positive v. negative externalities
1. Positive Externality occurs when the effect on the third party is beneficial.
Ex of positive externalities in consumption: Education, purchase of a fire extinguisher in
an apartment building, vaccination, bandwagon effects, etc.
Ex of positive ext in production: R&D, development of laser, Velcro, etc
2. Negative Externality occurs when the effect on the third party is adverse.
Ex: Pollution, smoking, noise pollution, common resources, congestion, snob effects.
Recall: The supply curve = private marginal costs to producers
The demand curve = marginal benefit (value) to consumers
With a negative production externality: Social Cost > private cost
MSC = MPC + MEC
MEC (marginal external cost) = marginal value of the externality at each unit produced.
Social Optimum: Total surplus is maximized
Optimal quantity occurs where
social marginal benefit = social marginal cost
Figure 17.2
1. Market outcome: Q1, P1 MPC=PMB (demand)
2. Optimal (Pareto Efficient) outcome: Q*,P* SMC=SMB (demand)
3. Overproduction: In a market equilibrium w/ negative externality, suppliers will
overproduce by (Q1 – Q*).

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4. DWL at market outcome: DWL = M (market eqbm not Pareto efficient)
Marginal benefit of last unit produced is lower than MSC or producing it. Lowers TS.
5. Is the optimal amount of pollution = 0? NO.
If we produced no chemical, we would lose A +B+E+F in TS.
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