EEP101_04 - General Overview Production Externalities...

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Chapter 4: Negative Externalities 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
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General Overview Externalities are a type of market failure -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. Externalities may be related to production activities, consumption activities, or both. - Production externalities : production activities of one individual imposes costs/benefits on other individuals that are not transmitted accurately through a market. - Consumption externalities : consumption of an individual imposes costs or benefits on other individuals that are not accurately transmitted through a market.
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Examples of production externalities Air pollution from burning coal Ground water pollution from fertilizer use Food contamination and farm worker exposure to toxic chemicals from pesticide use Irrigation water and consequential decline of waterfowl population in nearby wildlife refuge Production of refrigerators using CFC’s Health issues resulting from gold mining
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Production Externalities $ A MSC MPC MEC D B P* Q* C C E G C H F P Social optimum at B (where MSB=MSC) Social Benefits = ABQ * O. Social Costs = OBQ * . Social Welfare = ABO. Free market outcome at C Social Benefits = ACQ c O. Social Costs = OCQ c + OEC = OEQ c . Social Welfare = ABO - BEC. Deadweight Loss = BEC.
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Mathematical Representation of production externalities The Social Welfare Maximization Problem is: Max{W(Q)=B(Q)-C(Q)-E(Q)} Q where: Q = Output B(Q) = Total Social Benefit of Producing Q. C(Q) = Total Private Cost of Producing Q. E(Q) = Total External Cost of Producing Q. W(Q) =Social Welfare Function (Total Surplus From producing Q) Social Welfare is maximized where Q satisfies the First-Order Condition (FOC) : Q Q Q Q
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Unregulated competition with externalities Under unregulated competition, firms maximize profits, resulting in the FOC:B (Q) = C (Q), or MB = MPC.
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Policies to achieve social optimum Q* Three possible policies: -Tax -Subsidy -Restriction, Standard, or Quota Choice of policy affects the distribution of economic benefits among producers, consumers and government.
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EEP101_04 - General Overview Production Externalities...

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