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Lecture Notes - Externalities

Lecture Notes - Externalities - Externalities(chapter 3...

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Externalities (chapter 3) Externalities: Costs or benefits of market transaction that are not reflected in prices. A third part other than buyers or seller is affected by the production or consumption. Negative externalities : Costs to the third party not reflected in the prices. Examples: pollution, smoking. Positive externalities : Benefits to the third party not reflected in prices. Examples: vaccine, fire prevention. 1. Externalities and Efficiency 1.1 Negative externalities MSC = MPC + MEC MEC (marginal external Cost) : The extra cost to the third party resulting from the production or consumption of a good or service. Assume that the paper industry is operating under perfect competition. The marginal private cost is MPC = 200 + 2Q, where Q is the quantity of paper produced per year (in tonnes). The market demand for paper is given by Q = 800 – P. The marginal external cost MEC = 150 is associated with each tonne of paper produced. Now let’s look at the market equilibrium. In the competitive equilibrium, each firm in this industry chooses output such that P = MPC. Equilibrium allocation can be solved from two equations: P = 200 + 2Q Q=800 – P P = 600 Q’ = 200 1
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Next let’s see the Pareto efficient allocation: Efficiency requires MSB = MSC.
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