191T10 - ECON191 (Spring 2010) 6-7 & 10.5.2010...

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1 ECON191 (Spring 2010) 6-7 & 10.5.2010 (Tutorial 10) Chapter 14 Externalities and Public Goods (Chapter 18 of Textbook) Externalities occur when the welfare of some parties depends on their actions as well as actions under the control of other parties Negative externalities: action of one party imposes a cost on another party Positive externalities: action of one party benefits another party Pigouvian tax Coase theorm In the absence of transaction costs and when property rights are well defined, the Pareto optimal solution can still be attained, irrespective of the specific property rights arrangement that has been chosen. Internalization of costs Case 1 : chemical plant has the property right to produce any level of output To maximum it’s profit, Q 1 will be produced The fishery can pay the chemical plant and ask it t6 reduce its production Possibility of negotiation if decrease in the profit of the chemical plant < increase in profit of the fishery Mutual improvement is obtained and joint profit is maximized. ( Q 2 is produced) Case2 : chemical plant has no right to pollute Production of chemical plant will be 0 The chemical plant can buy a permit from the fishery to produce Q 2 Q P DD PMC SMC Tax Q’ Q* Q* is the socially optimal level of production Firm aims at maximizing its own profit chooses to produce Q ’, and it imposes a social cost on the economy Impose a tax on the producer such that MC of the firm ( PMC ) = SMC Problems: Difficult for the government to know the exact social cost Firms would have incentive to exaggerate the PMC. There is no guarantee that the outcome would be better after the intervention Q 1 Output of chemical plant Fishery + Chemical plant Chemical plant Fishery Q 2 Profits
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2 Possibility of negotiation if decrease in profit of the fishery < increase in the profit of chemical plant Mutually advantageous solution is produced and joint profit is maximized. ( Q 2 is produced) Irrespective of initial property right, socially optimal outcome could be reached Problems:
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191T10 - ECON191 (Spring 2010) 6-7 &amp; 10.5.2010...

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