Notes06 - Notes 06 Introductory Microeconomics ECON 1110...

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Notes 06– Introductory Microeconomics ECON 1110 Externalities An externality occurs when the consumption or production activities of an economic agent directly affect the well being of another. (By directly we mean that the effect is not one that occurs through market prices). When you smoke a cigarette in a classroom, you attack the lungs of other students, causing a negative externality (i.e., a harmful externality). When you drive your car during rush hour you increase the level of traffic and decrease the quality of the air, two negative externalities. Externalities can also be beneficial. When you clean your living room you cause a positive externality over your flat-mate. When you paint the outside of your house you create a positive externality for your neighbors. The chocolate smell that floods Chicago can be considered a positive or negative externality caused by chocolate producers, depending on your taste for that smell. An important consequence of externalities is that, when left unattended, they lead to inefficient resource allocations. In particular, competitive market allocations can involve either an under- or an over-production of goods, depending on the type of externality. When measuring social surplus, we must now take into account all of the effects a society experiences from production and consumption of a good, and not only the effects experienced by the producers and consumers themselves. We refer to the latter effects as the private effects, as opposed the social effects, which will encompass all parties involved. When no externalities are present in a given market, the suppliers and consumers involved in a transaction experience all the effects of their actions. In other words, all production costs are those experienced by producers and all consumption effects are those that accrue to the consumers in that market. The private costs and benefits will equal the social costs and benefits, and therefore the competitive equilibrium will be efficient in the sense of maximizing social (and private) surplus. Things change when an externality is present. Every additional unit of gasoline consumed imposes a pollution cost over the rest of society. As a consequence, the social marginal valuation (or benefit) of gasoline consumption is the private marginal valuation experienced by consumers minus the externality. A General Approach to Optimal Taxes and Subsidies Consider the general case where we can potentially encounter positive and negative externalities caused by both production and consumption. In order to determine the market outcomes, socially optimal quantities, and optimal government intervention, we use two different sets of curves: Private and Social. 1
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The first set is the private supply and demand curves. These curves correspond to the private marginal cost of production and the private marginal valuation of consumption.
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Notes06 - Notes 06 Introductory Microeconomics ECON 1110...

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