21 - Externalities I The Problem Contrast Market Success...

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Externalities I – The Problem Contrast Market Success with Market Failure Associated with Externalities. Recall that perfectly competitive markets are characterized by: 1. complete property rights (i.e., no public goods), 2. atomistic participants (i.e., no monopolies), 3. complete information (i.e., rules out inefficiencies from inadequate information), 4. no transactions costs (i.e., rules out externalities). Three Points: 1. The private market level of output (market equilibrium) with an externality will be the same as the private market output without an externality. 2. The socially desirable level of output (the social equilibrium) will differ from the private market (or simply market) output when there is an externality. 3. When an externality exists, the net economic surplus (welfare) of society can be improved by moving from the market equilibrium to the social equilibrium.
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Externalities, Market Failure, and Inefficiency •E x t e r n a l i t y : definition in two parts: 1. Occurs when the production or consumption decisions of one agent affect real (i.e., non-monetary) variables in the production or well-being (utility) of another in an unintended way. 2. When no compensation is made by the producer of the external effect to the affected party.
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Specifics of Externality Definition • “Real” variables, not prices: Price effects are not regarded as an externality. A shift in demand for blue jeans, that raises prices of blue jeans, hurts people who like to buy blue jeans. Note, however, that nothing has been done to interfere with the ability to produce or consume blue jeans. They are simply more expensive. Price effects called pecuniary externalities. • “Unintended” effects: If you intentionally blow cigar smoke in my face, this is not an externality. You are intending to lower my well-being. If your cigar smoke drifts from one restaurant table to another, and you disregard these effects on others, then this would be an externality. You are making decisions without concern for their well-being. • Internalized : If appropriate compensation is made to the affected party, then the externality is said to be internalized.
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Positive and Negative Externalities and Efficiency • Negative externality : imposes unwanted costs on others. – examples: • Positive externality : provides benefits to others. – examples: • We shall see that a market economy will (relative to efficient levels): – produce too large a quantity of goods with negative external effects.
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21 - Externalities I The Problem Contrast Market Success...

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