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Chapter 21 - Chapter 21 Externalities in Competitive...

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Chapter 21 Externalities in Competitive Markets At this point you may have gotten the impression that economists believe markets always and unambiguously result in efficient outcomes — with total surplus maximized when markets operate without interference from other institutions. 1 If this were the case, there would be no efficiency role for non-market institutions in society, and their only justification would lie in concerns about the distribution of surplus — concerns about equity and fairness as these relate to the market allocation of scarce resources. But, while such issues do play an important role in justifying non- market institutions (including government), we will in this and the coming chapters investigate conditions under which non-market institutions are motivated by efficiency rather than equity concerns. These conditions include all the possible violations of the assumptions underlying the first welfare theorem (Chapter 15) – including the presence of market power and of asymmetric information. Before we get to asymmetric information and market power, however, we will first take a look at yet a third set of conditions that lead to dead weight losses in the absence of other institutions – even when markets are perfectly competitive. These conditions are called externalities , and they arise whenever decisions of some parties in the market have a direct impact on others in ways that are not captured by market prices. When a firm’s production process emits pollution into the air, for instance, this pollution potentially has a direct impact on many. Put differently, the emission of pollution imposes on society costs that are typically not priced by the market and thus are not costs taken into account by producers unless some other institution imposes those costs on them. When I decide to get in the car and enter a congested road, I am similarly contributing to the overall congestion and thus am delaying others from getting to where they want to go, but I don’t think about others when I make the decision of whether to get in the car. When I play loud music on my patio at home, my neighbors get to “enjoy” the music as well. These are all examples of externalities — of “external costs or benefits” that markets do not internalize because the market participants do not have to pay for them. 1 This chapter builds once again on a basic understanding of the partial equilibrium model from Chapters 14 and 15. Section 21B.3 also builds on the discussion of exchange economies in Chapter 16 but can be skipped if you have not yet read Chapter 16.
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760 Chapter 21. Externalities in Competitive Markets 21A The Problem of Externalities The essential feature of an externality is then that either costs or benefits of production or consump- tion are directly imposed on non-market participants. Since non-market participants are neither demanders nor suppliers of goods, neither market demand nor market supply curves are affected by such externality costs or benefits. Thus, a competitive market composed of price-taking consumers
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