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course reading---Chapter04

course reading---Chapter04 - Chapter 4 Negative...

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-1- 1 Chapter 4 Negative Externalities and Policy Contents: General Overview Production Externalities Policy 1: Externality Tax Policy 2: Output-reduction Subsidy Policy 3: Standards Elasticity Effects on Magnitude of Externalities Imperfect Competition and Externality Policy Consumption Externalities Externalities from Cigarette Smoking The Economics of Illicit Drugs General Overview An externality can only exist when the welfare of some agent, or group of agents, depends on an activity under the control of another agent. Under these circumstances, an externality arises when the effect of one economic agent on another is not taken into account by normal market behavior. Externalities are a type of market failure. When an externality exists, the prices in a market do not reflect the true marginal costs and/or marginal benefits associated with the goods and services traded in the market. A competitive economy will not achieve a Pareto optimum in the presence of externalities, because individuals acting in their own self-interest will not have the correct incentives to maximize total surplus (i.e., the “invisible hand” of Adam Smith will not be “pushing folks in the right direction”). Because competitive markets are inefficient when externalities are present, governments often take policy action in an attempt to correct, or internalize, externalities. Externalities may be related to production activities, consumption activities, or both. Production externalities occur when the production activities of one individual impose a cost or benefit on other individuals that are not transmitted accurately through a market. Let us first examine production externalities, for example, air pollution from burning coal, ground water pollution from fertilizer use, or food contamination and farm worker exposure to toxic chemicals from pesticide use. We will then analyze the case of consumption externalities, which occur when the consumption of an individual imposes costs or benefits on other individuals that are not accurately transmitted through a market. Production Externalities To motivate the concept of a production externality, consider the following examples: A farmer takes irrigation water out of a river before it reaches a wildlife refuge. The farmer’s actions reduce the flow of water reaching the wetland, which reduces the amount of wetland acreage available to waterfowl. Consequently, fewer birds are attracted to the refuge, which decreases the utility of birdwatchers. If farmers had to account for the value of the lost utility to birdwatchers (i.e., there was a price associated with a reduction in birds), they would probably reduce the amount of irrigation water they pumped from the river. A more common example is the case of a firm polluting an air or water source as a by-product of production. Examples here include, the production of refrigerators using CFC’s, a coal-burning electricity plant (NO x and SO x ), or a paper mill, which
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-2- 2 dumps chlorine bleach into a river as a by-product of producing white office paper.
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course reading---Chapter04 - Chapter 4 Negative...

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