nlecture15 - externalities - slides

nlecture15 - externalities - slides - 2/25/2009 Topic 6:...

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2/25/2009 1 Topic 6: Competitive Markets (4) USC Marshal Externalities and public goods Externalities and public goods • When do competitive markets fail to maximize aggregate surplus? Externalities • When the consumption or production of a good impacts other people (third parties) USC Marshal –Pollution, traffic congestion, noise,… Public goods • When everybody benefits from the availability of a good. National security,… Common property resources • When a resource is available to all for free. Lakes, rivers, beaches, highways,… Externalities • Efficiency of competitive markets: – Prices established in competitive markets reflect the private costs and benefits of consumption – But prices can fail to reflect the impact that the production or the consumption of a good have on thi d ti USC Marshal third parties • i.e. involves an externality – In the presence of externalities, the prices established in competitive markets fail to reflect the social costs and benefits of production and consumption
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2/25/2009 2 Externalities • Competitive markets equate private marginal benefit with private marginal cost – But ignores external marginal benefits and costs • The output level that maximizes aggregate surplus is given by social marginal benefit equals USC Marshal social marginal cost – Social = private + external Externalities Some examples: – Loud music can impose a negative externality on your neighbors – Driving increases congestion and imposes a negative externality on other drivers USC Marshal – A beautiful garden improves the outlook of a neighborhood and thus generates a positive externality – Education, by making people more knowledgeable, is generally thought of as generating positive externalities Externalities • How can we restore efficiency? Private remedies • When the parties involved can be easily identified, then private negotiations under well- defined property rights will lead to the efficient t USC Marshal outcome –Establishing markets for pricing the externalities
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2/25/2009 3 Externalities • How can we restore efficiency? Public remedies • Support private remedies –Establish clearly defined property rights –Rule of law USC Marshal • Quantity controls • Taxes and subsidies • Hybrid solutions Externalities An example: – A paper mill operating next to a river pollutes the river. A farmer downstream uses that water for irrigation and the pollution reduces the quality of his crops. Then, the paper mill is imposing a negative externality on the farmer USC Marshal negative externality on the farmer. • The price of paper is P=30 • The (private) total cost of production for the paper mill is • The reduction in the crop yield due to a pollution resulting from output level Q is given by TC Q 10 Q Q 2 EC Q 2 Q 1 2 Q 2 Externalities • The profit-maximizing output level: P = MC • This output level imposes an externality of
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nlecture15 - externalities - slides - 2/25/2009 Topic 6:...

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