Externalities ECON 290 – Canadian Microeconomic Policy Junjie Liu – Econ 290 1
Topics Covered • Externalities • Types of Externalities • Corrective Taxes • Corrective Subsidies • The Coase Theorem Junjie Liu – Econ 290 2
A Scenario… Are you annoyed by second-hand smoke? Cigarette smoke not just harm smokers themselves, but also harm those who happen to be lingering nearby. Smokers also increase our healthcare cost. These are old news. At the same time, smokers do provide benefit to nonsmokers. The average smoker dies seven years earlier than the average nonsmoker, which means that smokers pay into CPP and private pension funds for all of their working lives but they don’t stick around very long to collect the benefits. Junjie Liu – Econ 290 3
Introduction Recall: We made two assumptions to conclude that markets are efficient. 1) Markets are perfectly competitive − a single buyer or seller cannot control market prices. Market power can cause markets to be inefficient. 2) Outcome in a market matters only to the buyers and sellers in that market . Some transactions have side effects, called externalities, that affect people who are not participants in that market at all. Junjie Liu – Econ 290 4
Introduction • In absence of market failures, the competitive market outcome is efficient, maximizes total surplus. • One type of market failure is externality, the effect on third parties from the production or consumption of a good. • Externalities can be negative or positive, depending on whether impact on bystander is adverse or beneficial. • In presence of externalities, public policy can promote efficiency. Junjie Liu – Econ 290 5
Externalities • As producers and consumers make production and consumption decisions, they only have to consider the market prices of goods and services, which is determined by supply and demand. The supply curve represents marginal private costs (MPC). The demand curve represents marginal private benefits (MPB). • In the market equilibrium, P = MPB = MPC. Market prices do not consider the costs or benefits to bystanders. Junjie Liu – Econ 290 6
Externalities • When the production or consumption of goods and services have side effects on other people, we say there are externalities , or external effects. • External effects may be negative or positive: Marginal external cost (MEC) = When third parties experience negative side effects from market transactions. Marginal external benefit (MEB) = When third parties experience positive side effects from market transactions. Junjie Liu – Econ 290 7
Externalities • For these goods the market equilibrium will not be efficient because demand and supply do not include these external costs and benefits. There is market failure. • Evaluating a market outcome requires taking into account the well- being of third parties as well.
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