L23

Externalities

Road map1) Consumers choice

2) Equilibrium, Producers(Pareto efficiency)

3) Market Failures

- fixed cost: monopoly and oligopoly

- externalities and public goods

- asymmetric information

Externalities So far: utilities on own actions only

Reality: we are not islands

An externality is a cost or a benefit imposed upon someone by actions taken by others.

- benefit - positive externality.

- cost - negative externality.

Examples of Negative Externalities Air or water pollution. Loud parties next door. Traffic congestion. Second-hand cigarette smoke. Increased insurance premiums due

to alcohol or tobacco consumption. Bad smell!

Examples of Positive Externalities

A well-maintained property. High “human” capital A pleasant cologne or scent worn by

the person seated next to you. A scientific advance.

Today’s questions:

Efficiency of interactions with externalities Too much or too little activity with

externality? How can we reestablish Pareto efficiency?

– taxes

– creating markets

– social norms

Example: Negative externality

Two producers: steel mill and fishery A steel mill produces steel It can also choose the level of pollution

The pollution adversely affects a nearby fishery

s

2 2( , ) ( 1)sTC s x s x

2( , )fTC f x f xf

x

x

Steel mill problem

( , ) ( , )s s ss x p s TC s x

Steel mill problem 2 2( , ) ( 1)sTC s x s x $2sp

s

s

x

Fishery problem 2( , )TC f x f xf $3fp

f

f

( , ) ( , )f f ff x p f TC f x

f s

Pareto efficient production( , , ) ( , ) ( , )s s f fs f x p s TC s x p f TC f x

Pareto efficient production2 2( , ) ( 1)sTC s x s x $2sp

2( , )fTC f x f xf $3fp

When negative externality – too much activity in decentralized markets

You will show in PS that when externality if positive – too little activity.

Conclusion 1

Problem: information!

Implementation: Pigouvian Tax

( , ) ( , )s s ss x p s TC s x x

Creation of missing markets

( , ) ( , )s s s xs x p s TC s x p x

( , ) ( , )ff f xf x p f TC f x p x

Property rights (Coase Theorem)

( , ) ( , ) ( )s s s xs x p s TC s x p x x

( , ) ( , ) ( )ff f xf x p f TC f x p x x

Social norm: “do not pollute” Moral cost Many norms can be explained using

efficiency argument

Social norms: moral cost

( , ) ( , )s ss x p s TC s x x

( )x