436 Lecture Note 2 SP16 - 2.1 ECON 436 SP16 Lecture 2...

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2.1 ECON 436 SP16 Lecture 2 Outline Derivation of the standard pollution diagram Coase Theorem Definition Amount of Pollution Equity and fairness Policy relevance Derivation of the standard pollution diagram The producers of pollution will be referred to as polluters and those adversely affected by pollution will be referred to as victims of pollution. While it is common to think of firms as polluters and consumers as victims, pollution may be produced by consumers and governments as well as firms, and victims may include firms and governments as well as consumers. And the polluters and victims may in fact be the same individuals, as when automobile drivers are harmed by the pollution created by themselves and other drivers. We will make the usual assumption that polluters make their decisions solely on the basis of their own benefits and costs. Because negative technological externalities are not reflected in market prices, they will not affect private decisions concerning production or consumption, and this will result in too much pollution. For a simple example, consider an individual consumer who enjoys smoking cigars. The cigar smoker will consume the quantity of cigars that maximizes their utility. As shown in Figure 2.1, this will result in the amount of smoking being equal to Q 0 , the quantity for which the marginal willingness to pay, MWTP, is equal to the price, P. Assuming that the cigar industry is perfectly competitive, the price will be equal to marginal cost, MC. Therefore MWTP = P and P = MC, implying that MWTP = MC. For most goods, this would result in Q 0 being the efficient amount to be produced and consumed.
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2.2 ECON 436 SP16 Figure 2.1 Cigar Demand and Supply $ Cigars smoked P = MC Q 0 MWTP However cigar smoking produces second-hand smoke, which is assumed to affect other individuals’ utility functions negatively and therefore is a form of pollution. Figure 2.2 shows the dollar value of the marginal damage , MD, caused by the second- hand cigar smoke, assuming for the moment that the pollution from second-hand smoke is proportional to the amount of cigars smoked. Figure 2.2 Marginal Damage from Second-Hand Cigar Smoke $ Cigars smoked MD
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2.3 ECON 436 SP16 The marginal damage is a social cost, so the total social marginal cost, SMC, of a cigar is equal to the private marginal cost of producing it, PMC (= MC in Figure 1.1), plus the marginal damage from it being consumed, SMC = PMC + MD. Figure 2.3 combines the information in Figures 2.1 and 2.2. The efficient quantity of cigars for which SMC = MWTP is Q*, which is less than Q 0 . Because the cigar smoker ignores the damage from the pollution, the quantity of cigars smoked is greater than the efficient quantity, and the total net benefits from this activity, which are equal to total benefits minus total damages, are not maximized.
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