ECO101H1 Chapter Notes - Chapter 10: Coase Theorem, Externality, Demand Curve

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Published on 14 Mar 2016
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Introduction
An externality arises when a person engages in an activity that influences the well-
being of a bystander and yet neither pays nor receives any compensation for that effect
If the impact on the bystander is adverse, it is called a negative externality; if it is
beneficial, it is called a positive externality
Because buyers and sellers neglect the external effects of their actions when deciding
how much to demand or supply, the market equilibrium is not efficient when there are
externalities
That is, the equilibrium fails to maximize the total benefit to society as a whole
Externalities and Market Inefficiency
Welfare Economics: A Recap
The demand curve reflects the value to consumers, as measured by the prices they are
willing to pay
The supply curve reflects the costs of production
Public Policies Toward Externalities
All of the remedies to fix this inefficiency share the goal of moving the allocation of
resources closer to the social optimum
The government does these in one of two ways:
1. Command-and-control policies which regulate behaviour directly
2. Market-based policies which provide incentives so that private decision makers will
choose to solve the problem on their own
Command-and-Control Policies: Regulation
Market-Based Policy I: Corrective Taxes and Subsidies
Taxes enacted to deal with the effects of negative externalities are called corrective
taxes
Market-Based Policy 2: Tradable Pollution Permits
One advantage of allowing a market for pollution permits is that the initial allocation of
pollution permits among firms does not matter from the standpoint of economic efficiency
The Coase Theorem
The Coase theorem is the proposition that if private parties can bargain without cost
over the allocation of resources, they can solve the problem of externalities on their own
Summary
When a transaction between a buyer and seller directly affects a third party, the
effect is called an externality. Negative externalities, such as pollution, cause the
socially optimal quantity in a market to be less than the equilibrium quantity.
Positive externalities, such as technology spillovers, cause the socially optimal
quantity to be greater than the equilibrium quantity
Governments pursue various policies to remedy the inefficiencies caused by
externalities. Sometimes the government prevents socially inefficient activity by
regulating behaviour. Other times it internalizes an externality using corrective
taxes. Another public policy is to issue permits. For instance, the government
could protect the environment by issuing a limited number of pollution permits.
The end result of this policy is largely the same as imposing corrective taxes on
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Document Summary

An externality arises when a person engages in an activity that influences the well- being of a bystander and yet neither pays nor receives any compensation for that effect. If the impact on the bystander is adverse, it is called a negative externality; if it is beneficial, it is called a positive externality. Because buyers and sellers neglect the external effects of their actions when deciding how much to demand or supply, the market equilibrium is not efficient when there are externalities. That is, the equilibrium fails to maximize the total benefit to society as a whole. The demand curve reflects the value to consumers, as measured by the prices they are willing to pay. The supply curve reflects the costs of production. All of the remedies to fix this inefficiency share the goal of moving the allocation of resources closer to the social optimum.

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