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chap20x - Externalities Externalities are an example of...

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1 Page 1 1 Externalities Externalities are an example of market failure effects of consumption or production are not fully reflected in the market prices do not fully reflect the costs or benefits from a good when externalities are present market price provides the “wrong” signal to decisionmakers and market inefficiencies occur Two topics: describe externalities and implications of externalities for efficiency remedies - firm merges to internalize the externality - government regulation or taxation to control output - bargaining among individuals and property rights 2 Examples of External Benefits Examples of External Benefits Immunization helps reduce the chances that third parties catches a disease–this is the rationale for public health funding cleaning the yard may help the neighbors one store’s advertising may bring customers into the mall, but purchases may increase at other firms as well as at the firm that advertises apple orchard located near a beekeeper
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2 Page 2 3 Examples of External Costs Examples of External Costs Steel factory dumps pollution in river and hurts downstream fishing industry Smokers in a restaurant do not bear the full cost of smoking Drivers do not bear the full cost of pollution 4 External Costs: steel plant on a river steel plant on a river MC does not capture all social cost of production the company purchases labor and capital through the market firm does not bear the economic cost of the pollution it generates Marginal external cost (MEC) captures the external cost to downstream fisherman curve is upward sloping because small levels of pollution have little effect on fishing, but to fishing increases incrementally with output Marginal social cost (MSC) = MC + MEC MEC MC MSC=MC+MEC Price q P q 1 q 0
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3 Page 3 5 Steel plant continued Steel plant continued If only one firm has the pollution problem, then the market price is unaffected by the externality The individual firm produces at q 1 where it equates private MC with P From a social viewpoint, the firm should take account of all costs and produce q 0 , where it equates MSC with P MEC MC MSC=MC+MEC Price q P q 1 q 0 Steel Firm 6 Steel plant continued Steel plant continued Now look at steel industry If all steel plants create externalities, then the market price of steel is artificially low MSC I =MC I +MEC I Efficient level of output is Q 0 and equilibrium price is P* Competitive output is too high and price is too low from a social point of view MEC MC MSC=MC+MEC Price q P q 1 q 0 MEC I S= MC=MC I MSC I Price Q Q 1 Q 0 Steel Firm Steel Industry D P*
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4 Page 4 7 Positive Externality: Home Repair Positive Externality: Home Repair The “extra” benefit of home repairs is that the neighbors benefit as well as the individual homeowner The home repair industry is competitive, so cost is unaffected by the amount of individual repairs The individual chooses q 1 , but q* is the efficient level of repairs, where
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