ECE1010-12 - UNIT IV: INFORMATION & WELFARE 1/7...

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• Decision under Uncertainty • Bargaining Games • Externalities & Public Goods • Review 1/7
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• Externalities • Coase Theorem • Tragedy of the Commons • Remedies • Public Goods • We Play a Game
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Externalities Externalities are the effects of consumption and production that are not accounted for in the market (e.g., steel industry creating air pollution). When externalities are present, the price of a good may not reflect its true social cost. As a result, firms may produce too much (or too little) and the market outcome may be inefficient. The practical problem with externalities generally arise when property rights are poorly defined. Remedies include government regulations, taxes, legal recourse, and bargaining among those affected.
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Externalities Consider a farmer and a rancher that produce on neighboring land. The rancher’s cattle stray onto the farmer’s land, causing damage to his crops. Number in Herd Annual Crop Loss Crop Loss per Add/l (Steer) (Tons) Steer (Tons) 1 1 1 2 3 2 3 6 3 4 10 4
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Externalities Consider a farmer and a rancher that produce on neighboring land. The rancher’s cattle stray onto the farmer’s land, causing damage to his crops. Should the rancher be prohibited from grazing his cows to prevent damage to the farmer’s crops? Coase noted that while this prohibition would remove the cost to the farmer, it would also impose a cost on the rancher (and on society). He called this the reciprocal nature of the externality.
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Externalities We know that in a market equilibrium, both consumers (MRS = Px/Py) and firms (MR = MC) are optimizing, and we used these conditions to derive demand and supply curves. that burning gasoline causes pollution which is harmful to peoples health, and that this harm is measured to be $1 for each gallon gasoline burned. What is the optimal level of gasoline consumption, taking this externality into account? P P* Q* Q Q D : MRS = Px/Py Q S : MR = MC
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Externalities We know that in a market equilibrium, both consumers (MRS = Px/Py) and firms (MR = MC) are optimizing, and we used these conditions to derive demand and supply curves. that burning gasoline causes pollution which is harmful to peoples health, and that this harm is measured to be $1 for each gallon gasoline burned. What is the optimal level of gasoline consumption, taking this externality into account? P P* Q* Q Q D = MSB Q S = MSC If there are no externalities, the supply curve depicts the marginal social cost of production; the demand curve depicts the marginal social benefit of production.
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Externalities In the presence of a negative production externality (e.g. pollution), the marginal social cost (MSC) is higher than the firms’ marginal cost of production (MC). MSC
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ECE1010-12 - UNIT IV: INFORMATION & WELFARE 1/7...

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