ECO101H1 Study Guide - Final Guide: Allocative Efficiency, Coase Theorem, Cost
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Topic 14 – Externalities
2. Pollution: Negative Production Externality
2.2. Social versus Private cost
2.3 Inefficiency of Market Outcome
2.4 Emissions charge (tax) to achieve efficiency
4. Alcohol: Negative Consumption Externality
5. Other externalities
6. The Coase Theorem
Motivational Example: Lumber Industry Perfect Competition
1. The Lumber Industry is in perfect competition;
2. Lumber mills dump toxic waste into the nearby lake, therefore decreasing the recreational value of the
3. Lumber mills are not required to compensate the users of the lake for the decline of the recreational
quality of the lake.
1. In this industry, will the price paid by consumers: too high; too low?
2. Is the market going to the set the price at the correct level?
3. Will the market for lumber produce an allocatively efficient level of output?
There are third party effects.
Externality: Transaction between buyer and seller affects third party
Production externality: process of producing goods/services affects third party, both for the better/worse)
Consumption externality: consuming of the goods/services affect third party, both for better/worse
Pollution: Negative Production Externality
Market for Aluminum
QAE QC Quantity
(Private Value = Social Value)
SS - Private Cost
SS – Social Cost
1. Pre-externality: Price($25) and Quantity (QC)
result in allocative efficiency because the value to
buyers of the last unit sold equals to the cost to
2. Assume health economics determine that for
each ton of Aluminum produced, the cost to society
(smoke) is $10/ton;
3. With externality: the market outcome is no longer
in allocative efficiency.
2. 4 emissions charge (tax) to achieve efficiency: alcohol: negative consumption externality, other externalities, the coase theorem. Externality: transaction between buyer and seller affects third party. Production externality: process of producing goods/services affects third party, both for the better/worse) e. g. pollution; Consumption externality: consuming of the goods/services affect third party, both for better/worse e. g. alcohol. - note: ss = sum of marginal costs for individual firms = private marginal costs; - social cost = private marginal costs + externality cost (cost to society as a whole) - social cost differs from private costs only when externality is present; Allocatively efficient level of output, with the presence of externality, occurs not at p=mc , but. A perfectly competitive market produces too high a level of output, while consumers confront too low a price; - in the presence of externalities, when private markets get it wrong (i. e. market failure), there exists the. Ss" private cost (= social cost because of the tax)