lecture9_10 - Lecture Note 9 and 10 Externalities Part 2B...

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Lecture Note 9 and 10: Externalities Part 2B: Paper 1. ° Dr. T.S. Aidt University of Cambridge Michaelmas 2010 1 Introduction An externality is present when some agent°s (a consumer°s or a producer°s) welfare (utility or pro±t/cost) is directly a/ected by a choice made by another agent (consumer or producer). The word directly is important in this de±nition: the choice made by another agent must have a direct e/ect on the welfare on another; it is not enough that it a/ects the welfare indirectly, say, by changing a price that others face in a market. The later is called a pecuniary externality and the market system is perfectly able to deal with them. The problem is if the choice of some agent a/ect someone else°s welfare directly, whether that someone else want it or not. Externalities are everywhere. Here are some examples: 1. Environmental pollution: Waste dumping, emission of waste water to rivers and lakes, acid rain, greenhouse gas emission, noise from tra¢ c and aircraft, etc. 2. Over-exploitation of open access resources: putting cows on a common, ±sheries, using the atmosphere to deposit CO 2 ; management of water resources; deforestation, etc. 3. Congestion and tra¢ c jams. 4. The rat-race e/ect: your welfare is a/ected by your consumption relative to the consumption of others in your reference group. 5. Envy. 6. Bandwagon e/ect: adopting common standards for technologies, the key- board choice (QWERTY or Dvorak). ° Disclaimer: This note may contain mistakes. If you spot any, please bring them to my attention. Thanks to Gaurav Vohra (Caius) for doing so. 1
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This lecture note provides a framework for thinking about externalities ² including a useful classi±cation ²and a brisk overview of what can and should be done about externalities in terms of public policy. This includes a discussion of the ±rst best where a so-called Coasian or Pigouvian solution might help and a discussion of the second best. In particular, we shall focus of two im- portant considerations in a second best world: 1) what happens if information imperfections are such that the externality cannot be observed and quanti±ed? and 2) what happens to the Ramsey rule and the Diamond-Mirrlees production e¢ ciency result in the presence of externalities? 2 Externalities and the Pareto Conditions Governments should care about externalities because their presence causes one or more of the Pareto conditions to fail, and so resources are allocated inef- ±ciently. Recall that the First Welfare Theorem requires a complete set of markets to work. Kenneth Arrow and James Meade have long ago pointed out that there is a close connection between externalities and the notion of missing or incomplete markets. 1 In fact, if we de±ne externalities as additional (private) commodities and let these commodities be traded at competitive markets, then the external costs associated with the externality would be internalized by the ³invisible hand´. To see why, recall the de±nition of an externality: the ³re-
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