Lesson8_Externalities_PublicGoods.pdf - Externalities and Public Goods Mankiw Chapter 10 and Chapter 11 Externalities • Concept the uncompensated

Lesson8_Externalities_PublicGoods.pdf - Externalities and...

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Externalities and Public Goods Mankiw, Chapter 10 and Chapter 11
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Externalities Concept : the uncompensated impact of one person’s actions on the well-being of a bystander. The impact on bystanders may be positive or negative. In other words, the equilibrium market outcome affects the well-being of a third party not involved in the market. Externalities are market failures : self-interested buyers and sellers ignore the collateral effect of their actions and the market equilibrium is not efficient. We will study public and private solutions to externalities. 2
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Negative Externalities 3
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Negative Externalities Suppose that steel factories emit pollution. In that case, the private cost (supply) does not reflect the external cost: air of lower quality for others to breathe. Social cost = private cost + external cost . In the socially optimal equilibrium, the traded quantity is lower than in the market equilibrium. P Q Social cost Private cost (supply) q* q mkt D External cost 4
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Positive Externalities 5
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Positive Externalities Suppose that educated individuals are more productive and pay higher taxes. In that case, the private value (demand) does not reflect the external benefit: more collected money to sustain the welfare system. Social value = private value + external benefit . In the socially optimal equilibrium, the traded quantity is larger than in the market equilibrium. P Q Private value (demand) Social value S q mkt q* External benefit 6
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Solutions to Externalities Some solutions are oriented to internalize the externality , that is, to alter incentives so that people take account of the external effects of their actions. However, not all solutions are equally efficient . Public Solutions : Command-and-control policies: regulate behavior directly. Market-based policies Corrective taxes ( Pigovian taxes ) and subsidies Tradable pollution permits Private Solutions : the Coase Theorem. Arthur Pigou (1877 1959) Ronald Coase (1910 2013) 7
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Corrective Taxes and Subsides Corrective tax (subsidy) : a tax (subsidy) designed to induce private decision makers to take account of the external cost (benefits) that arise from a negative (positive) externality. Ideally, it will equal the external cost (benefit). Other taxes (subsidies) create distortions, but corrective taxes (subsidies) move the economy toward a more efficient allocation of resources because they align private incentives with society’s interest.
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