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Unformatted text preview: C H A P T E R 21 Externalities in Competitive Markets This chapter moves beyond the consideration of policy-induced distortions of mar- ket prices to externality-induced distortions of such prices. It illustrates that mar- kets will over- or under-produce (relative to the efficient level of production) in the presence of negative or positive externalities on either the consumption or the pro- duction side. Along the way, we illustrate the potential role for Pigouvian taxes or subsidies, for markets in pollution vouchers (or cap-and-trade policies), and for civil society organizations. We furthermore explore how how, at a fundamental level, the market failure" in the presence of externality is a failure of markets to exist and how thinking of externalities through this lens can motivate policies that introduce property rights-based approaches to solving inefficiencies. Finally, the chapter concludes with a discussion of the Coase Theorem in part building on the insight that property rights play an important role in the emergence of ex- ternality problems, and in part adding to that insight by illustrating how small externalities differ from large externalities in the role that transaction costs play in allowing individuals to bargain their way out of inefficiency. Chapter Highlights The main points of the chapter are: 1. Relative to efficient output levels, competitive markets will over-produce when subject to negative exernalities and under-produce when subject to positive externalities . One possible form of non-market intervention to correct these market failures lies in Pigovian taxes and subsidies set at rates that cause markets to produce at the efficient output levels. 2. An alternative policy in the realm of pollution externalities lies in the creation of cap-and-trade or pollution voucher systems. While these do not guaran- tee an efficient level of pollution, they put incentives in place to insure that pollution reductions are undertaken in the least costly (and thus most effi- cient) way. Externalities in Competitive Markets 496 3. Civil society i.e. non-market and non-government organizations often play a role in abating the effect of externalities. The free rider problem faced by such organizations is sometimes partially addressed through government subsidies either directly to particular organizations or in the form of tax deductibility (of, for instance, charitable giving ). 4. At its core, the market failure that arises in the presence of externalities arises because of the failure of some market(s), and property rights, to exist . The non-existence of property rights often gives rise to a Tragedy of the Com- mons ....
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- Fall '08