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Chapter 16

Economics 1021 Chapter 16 Notes

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Western University
Economics 1021A/B
Jeannie Gillmore

Chapter 16: Externalities Externalities in our Lives  Externality: A cost or a benefit that arises from: o Production and falls on someone other than the producer o Consumption and falls on someone other than the consumer  Negative externality: An externality that imposes a cost o Of production:  Traffic congestion during rush hours  Pollution of air, water, and land o Of consumption:  Smoking  Noisy parties and concerts  Positive externality: An externality that imposes a benefit o Of production:  Honey farming  Education o Of consumption:  Vaccinations  Restoration of historical artefacts and buildings Negative Externality: Pollution  Private cost (of production) : A cost that is borne by the producer of a good or service  Marginal private cost (MC): The cost of producing an additional unit of a good or service that is borne by the producer of the good or service.  External cost: The cost producing a good or service that falls on the people other than the producer  Marginal external cost: The cost of producing an additional unit of a good or service that falls on the people other than the producer.  Marginal social cost (MSC): The marginal cost incurred by the producer and everybody else whom the cost falls o MSC = Marginal private cost + Marginal external cost  When an industry is unregulated, the amount of created pollution depends on the market equilibrium price and the quantity of the good produced. o Since firms are only concerned about the costs they will bear, the MC curve and the MSC curve are different. o Equilibrium is inefficient, since MSC does not equal MSB. o Grey triangle shows the deadweight loss Efficient equilibrium x (MSC – MC) x ½  Property rights: Legally established titles to the ownership, use, and disposal of factors of production and goods and services that are enforceable in court o If a firm polluting a river happened to own it and the homes by the river, the firm now faces the cost of their pollution (forgone rent from the people who live by the river). o Since the cost of pollution is taken by the firm, MC = MSC and the equilibrium is efficient.  Coase theorem: Proposition that if property rights exist, if only a small number of parties are involved, and if transaction costs are low, then private transactions are efficient. o Transaction costs: Opportunity cost of conducting a transaction. o There are no externalities because the parties take all the costs and benefit into account. o It does not matter who has the property right. o If the residents own their homes and the river, the firm must pay a fee to the homeowners, and so the firm faces an opportunity cost of the pollution just the same. o However, in most situations, transaction costs are too high to apply the coase theorem.  Possible government actions in a market with external costs: o Pigovian taxes: Taxes
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