Lecture15 - ECON 301 LECTURE #15 EXTERNALITIES As we have...

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1 ECON 301 – LECTURE #15 EXTERNALITIES As we have been discussing, the existence of public goods has a serious impact on both welfare and the resource allocation in the economy. Aside from public goods, other phenomena such as externalities have far-reaching effects, both positive and negative, on the efficiency of the market mechanism. The subject of externalities is, however, quite conceptually difficult and technically demanding. POSITIVE VS NEGATIVE EXTERNALITIES Individuals in a market pricing economy are normally independent and unrelated to each other. The only indirect link among them is the pricing system in the market. Prices (Indirect) [Economic Activities of Individual A] ! [Economic Activities of Individual B] Externalities refer to the situation where the economic activities of one individual (or group of individuals) directly affect those of the other individuals. Common examples of externalities include second-hand smoke, drunk driving and environmental pollution (to name just a few). For instance, the economic activities of a drunk driver have a direct effect on car accident victims. This direct effect is completely outside the normal market pricing system. Externalities (Direct) [Economic Activities of Individual A] ! [Economic Activities of Individual B] The examples of externalities presented so far have all had negative effects on others. Are all externalities negative? No! Externalities are not necessarily always bad. The effect of the economic activities of one individual on another individual can be either positive (in which case we call these positive externalities) or negative (in which case, you guessed it, we call these negative externalities). Examples of positive externalities include the happy event that bees owned by a bee keeper pollinate the apple trees of a neighboring apple orchard. Examples of a negative externality include the unhappy event that the babies of drug addicted mothers become addicted and incur severe health problems (physical and developmental) before they are even born. We can classify externalities in ways other than simply positive or negative. The positive or negative classification refers only to the sign or magnitude of the externality without
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2 revealing the source of the externality or who receives the consequences of the externality. To help clarify, the following table might help… Consumer Producer Consumer (a) (b) Producer (c) (d) The example of the bee keeper and the apple grower falls under category (d) where there are “producer – producer” externalities whereas the unborn drug addict example falls under category (a) where there are “consumer – consumer” externalities. A typical example of a category (c) externality – or “producer – consumer” externalities is the case of chemical dumping (i.e. a factory pouring chemical pollutants into a river basin that turns out to be the source of drinking water for local residents…(see Erin Brocovich for details)). Finally, an example of a category (b) externality – or “consumer – producer” externalities
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This note was uploaded on 03/28/2010 for the course ECON 301 taught by Professor Coreyvandewaal during the Winter '09 term at Waterloo.

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Lecture15 - ECON 301 LECTURE #15 EXTERNALITIES As we have...

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