Announcements•Problem set 2 due *Thursday* so you can have some extra officehours help.•Please hand in a hard copy! Gradescope is difficult for Leila to workwith when answers are detailed.•Lecture notes on public goods and externalities posted•Today’s readings:•Chapter 6 from Boardman et al. (in reader) and•Discount rates: A boring thing you should know about (with otters!)
OutlineExternalities•Why do externalities generate market failure?•Policy responses (in theory)?Intertemporal tradeoffs•Mechanics of discounting•Benchmark model of inter-temporal decision making•Use our experiment to highlight some limitations of standard model.
Externalities?•An “externality” exists when an action or transaction generatesbenefits or costs for individuals outside the action or transaction.•The provision of a public good results in a positive externality (whichis not remunerated)
Are externalities always external to themarket?•Apecuniary externalityoccurs when the actions or transactionsbetween economic actors cause an increase or decrease in marketprices paid by other actors who are external to the transaction.•Anon-pecuniary externalityoccurs when the actions or transactionsbetween actors generate costs or benefits that are external to themarket and not reflected in market prices.
Simple example to elucidate market failure•2 firms located on a lake: Acme Chemical and Beatrix’s Scuba Adventure•Both firms act as price takers in their respective markets.
Profit functions (stylized)
Profit maximizing choice of q?
Cue Pigou!•Pigou (1938) the first to think about negative externalities in terms of adivergence between private and social cost.•Pigou recommended either direct coercion on the part of the government(i.e. a quota or emissions cap) or the judicious use of taxes against theoffending party.•Taxes designed to internalize a negative externality are often referred to as“Pigouvian taxes”•The idea is to eliminate the divergence between marginal private cost andmarginal social cost.
”The Problem of Social Cost”•Coase argues that externality problems are “inherently reciprocal”, arisingfrom incompatible interactions between two parties rather than theharmful actions of one upon the other.•“If we are to discuss the problem in terms of causation, both parties causethe damage” [Coase, 1960, p. 13].•From this perspective, ask which party to a harmful interaction should beinduced to change his behavior (maybe both) to maximize the socialproduct.•Coase widens the range of possible solutions by emphasizing the possibilitythat B may be able to accommodate A more cheaply than A canaccommodate B.
The Problem of Social Cost•Coase examines this problem under the standard assumptions ofperfect competition, including zero transaction costs.