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Lecture

Chapter 10 Externalities

2 Pages
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Department
Economics
Course Code
EC120
Professor
petersinclair

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KEITHD IAZ Chapter 10 – Externalities  Externality: the uncompensated impact of one’s actions on the well-being of a bystander.  Internalizing externality: altering incentives so people take account of external effects of actions  It is difficult to be efficient if there are a lot of interested parties  transaction costs = difficult  Optimal value = social value  not always equilibrium Community Surplus  When a market is in equilibrium, with no external influences/effects, it’s in a state of Pareto optimality: it’s impossible to make someone better off without making someone worse off. This does not mean everyone is equal. The market is socially efficient: community surplus is maximised.  At any lower Q, social value > costs, and any higher Q, the cost of the last unit > social value.  S is private cost, and D is private value  Supply = marginal social cost (MSC)  marginal cost to whole community (including externalities)  Demand = marginal social benefit (MSB) marginal benefit to whole community (including externalities) Existence of externalities  Externality occurs when the production/consumption of a good/service affects a third party  MPC (marginal private cost): private supply curve that is based on the firm’s costs of production. MSC = MPC +/- any external cost/benefit of production.  MPB (marginal private benefit): private demand curve that is based on the utility/benefits to consumers. MSB = MPB +/- any external cost/benefit of consumption.  Thus, if no externalities exist in a market, MSC = MSB and there’s social efficiency and maximum community surplus. If externalities exist, MSC does not equal MSB, so there is market failure. 1) Negative externalities of production: when the production of a good/service creates external costs. MSC > MPC. The firm is only concerned with its private costs, and will produce at market equilibrium, not optimal (where MSC = MSB), so there is market failure. Too much is produced for too low a price. There is a welfare loss = yellow triangle. Total cost to society is between MSC and Qmkt, so F + G + B + C + H. Q mkt Qopt Change Consumer surplus F + G + B + C + H D - (A + B + C) Producer surplus E – (B + C + H) A + E A + B + C + H = (E + F + G) – TC Total surplus D + A + E – H D + A + E H 2) Positive externalities of production: production creates external benefits. The firm produces below socially efficient level. There is a potential welfare gain shown by the triangle, where MSB > MSC. A. Subsidize the cost. MPC shifts right by subsidy, to MSC 3) Negative externalities of consumption: when products are consumed, they negatively affect third parties. Hence, MSB < MPB. But consumers consume at Q1 (MSC = MPB), ignoring negative externality (triangle). Hence, they over-con
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