lecture13 - Microeconomics I - Lecture #13, May 12, 2009 13...

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Microeconomics I - Lecture #13, May 12, 2009 13 Externalities Up until now we have implicitly assumed that each agent could make consumption or production decisions without worrying about what other agents were doing. All interactions between con- sumers and producers took place via the market, so that all the economic agents needed to know were the market prices and their own consumption or production possibilities. Now we relax this assumption and examine the economic consequences of externalities . We say that an economic situation involves a consumption externality if one consumer cares directly about another agent’s production of consumption. For example we can have definite pref- erences about neighbors being too loud in the middle of the night, people smoking in restaurants, pollution caused by cars etc. These are examples of negative consumption externalities. On the other hand we can get pleasure from observing neighbor’s nice garden. This is an example of a positive consumption externality. Other examples of externalities include exhaust from cars, restoring buildings, barking dogs, research into technologies, etc. Similarly, production externality describes a situation in which production possibilities of one firm are influenced by choices of the other firm. A classic example is a bee farm and an apple farm located next to each other. Each firm’s production positively affects the production possibilities of the other firm. So we have a case of mutual positive production externalities. Similarly, a fishermen care about pollution in the lake because that will negatively affect their catch. Market inefficiency caused by externality: As we discussed during previous lectures the supply and demand curves contain important infor- mation about costs and benefits. The demand curve for aluminum reflects the value of aluminum to consumers, as measured by the prices they are willing to pay. At any given quantity, the height of the demand curve shows the willingness to pay of the marginal buyer. In other words, it shows the value to the consumer of the last unit of aluminum bought. Similarly, the supply curve reflects the costs of producing aluminum. At any given quantity, the height of the supply curve shows the cost of the marginal seller. In other words, it shows the cost to the producer of the last unit of aluminum sold. The price adjusts to balance the supply and demand for aluminum. 65
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Now lets suppose that aluminum factories emit pollution: For each unit of aluminum produced, a certain amount of smoke enters the atmosphere. Because this smoke creates a health risk for those who breathe the air, it is a negative externality. How does this externality affect the efficiency of the market outcome? Because of the externality, the cost to society of producing aluminum is larger than the cost to
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This note was uploaded on 09/21/2011 for the course ECON 1023 taught by Professor Mark during the Spring '11 term at UC Irvine.

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lecture13 - Microeconomics I - Lecture #13, May 12, 2009 13...

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