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Chapter 10 - Externalities

Chapter 10 - Externalities - Chapter 10 Externalities...

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Chapter Externalities 10
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Externalities Externality The uncompensated impact of one  person’s actions on the well-being of a  bystander Market failure  Negative externality Impact on the bystander is adverse Positive externality Impact on the bystander is beneficial 2
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Externalities Examples of negative externalities: Exhaust from automobiles Barking dogs Examples of positive externalities: Restored historic buildings Research into new technologies Decision maker - fails to account for  externalities Government: protect the interests of  bystanders 3
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Externalities and Market Inefficiency Externalities  Cause markets to allocate resources  inefficiently Welfare economics: a recap Demand curve – value to consumers Prices they are willing to pay Supply curve – cost to suppliers Equilibrium quantity and price Efficient Maximizes sum of producer & consumer surplus 4
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Figure The market for aluminum 1 5 Price of Aluminum Quantity of Aluminum 0 Demand (private value) Supply (private cost) The demand curve reflects the value to buyers, and the supply curve reflects the costs of sellers. The equilibrium quantity, Q MARKET , maximizes the total value to buyers minus the total costs of sellers. In the absence of externalities, therefore, the market equilibrium is efficient. Q MARKET Equilibrium
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Externalities and Market Inefficiency Negative externalities Pollution Cost to society (of producing aluminum) Larger than the cost to the aluminum  producers Social cost - supply Private costs of the producers Plus the costs to those bystanders affected  adversely by the negative externality Social cost curve – above the supply  curve 6
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Figure Pollution and the social optimum 2 7 Price of Aluminum Quantity of Aluminum 0 Demand (private value) Supply (private cost) In the presence of a negative externality, such as pollution, the social cost of the good exceeds the private cost. The optimal quantity, Q OPTIMUM , is therefore smaller than the equilibrium quantity, Q MARKET . Q MARKET Optimum Social cost (private cost and external cost) External Cost Q OPTIMUM Equilibrium
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Externalities and Market Inefficiency Negative externalities Optimum quantity produced Maximize total welfare Smaller than market equilibrium quantity Government – correct market failure Internalizing the externality Altering incentives so that people take 
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