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Unformatted text preview: luded in their optimal decisions. At the same time, the victims keep getting hurt by the pollution in the environment because compensation remedies are not included in their optimal decisions as well. In other words, the economic inefficiency of externalities comes from the fact that the effects of externalities are not incorporated into the optimal economic decisions of individuals in the economy. So, how can we correct this situation? Since the main problem of externalities is that externalities are not incorporated into the optimal decisions of individuals, the solution concept is, in principle, quite simple: 262 If individuals do not incorporate externalities into their optimal decisions then we will have to make them accountable for the externalities caused by their actions. If the problem was caused by the fact that externalities have remained to be "outside" the optimal decisions of individuals, then a solution to the problem requires us to move them "inside" the individual decision. In other words, the solution concept boils down to ... Internalizing Externalities EXAMPLE Consider a simple example economy with unit aggregate endowments of both goods X and Y. X=Y=1 unit initial endowment incomes M A = MB = 1 and the following utility functions for person A and person B: UA = XAYA XB UB = XBYB The interesting thing about this example is that the quantity (XB) of good X consumed by B now enters the utility function of A. Everything else will be the same, the more good X that B consumes, the less utility that A will get. This is a simple example of a negative externality of the "consumerconsumer" type. Let's use the contract curve to illustrate...first, we need to solve for the contract curve! To derive the contract curve for this externality economy, we need to solve the Pareto problem. A unit of aggregate endowment for both goods means that inside the Edgeworth Box, we have the following equations: XA + XB = 1 YA +YB = 1 First, we need to use the fact that XB = 1 XA to eliminate the XB term from the utility function of A. 263 UA = XAYA XB UA = XAYA (1 XA) UA = (YA + ) XA And then calculating the marginal rate of substitution for person A...
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This note was uploaded on 05/25/2010 for the course ECON 301 taught by Professor Sning during the Spring '10 term at University of Warsaw.
 Spring '10
 sning
 Economics

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