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Unformatted text preview: Lecture Note #16: Externalities, the Coase Theorem and Market Remedies David Autor 14.03, Microeconomic Theory and Public Policy, Fall 2005 1 Introduction & You encountered the topic of externalities in 14.01. An externality arises when an eco- nomic actor does not face the &correct pricefor taking a specic action. The &correct priceof an action is the marginal social cost of that action. As we discussed during the section on General Equilibrium, when markets work properly, they align private costs and benets with social costs and benets. When private benets di/er from social benets (either higher or lower), externalities result. & Some classic externalities include: & Tra c: When I take the highway, I increase congestion for other drivers, a negative externality. Since the toll on the Mass Turnpike does not vary with tra c conditions, I probably face the wrong price of driving on the highway (too high at non-peak hours, too low at peak hours). As a result, I use the Pike &too muchduring peak hours and not enough during non-peak hours. & Disease transmission: When I decide whether to have my children receive u shots, I consider whether the cost of the inoculation in time, money, discomfort is worth the reduced risk. I probably do not consider that by protecting my children from the u, I also protect the children at their school. Because my private benet of the shot does not incorporate the external social benet of the shot, I am less motivated than I should beto get my children inoculated. It is therefore likely that too few children receive small pox vaccines. 1 Similarly, there are other parents who recognize that, because most parents do get their children inoculated, other kids may be reasonably protected even without re- ceiving an inoculation. Hence, these parents free-ride on the positive externality, and are even less motivated to get a shot than the parents who do not consider the positive externality they are generating. & Pollution: Because clean air is not priced, I pay essentially no cost to pollute the air. When I decide whether to drive to work or take the train, my marginal cost of driving (fuel plus wear and tear on my car) probably does not incorporate the social cost of additional pollution. Because my private cost is lower than the social cost, I will likely drive &too muchrelative to a case where I faced the full marginal social cost. Are these externalities never & internalizedby the market? 2 The Coase Theorem & Until the publication of Ronald Coase1960 paper, The Problem of Social Cost,most economists would have answered yes. Coase made them reconsider that view. & Coase gave the example of a doctor and a baker who share an o ce building. The problem: the bakers loud machinery disturbed the doctors medical practice. The doctor could not treat patients while the bakers machinery was running....
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