Externalities_SS-Public

Externalities_SS-Public - EXTERNALITIES EEP101/ECON125...

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EXTERNALITIES EEP101/ECON125 Steven Sexton | January 29, 2008
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What is an externality? A direct effect of the actions of one economic agent (a person, firm, etc.) on the welfare of one or more other agents that is not transmitted by market prices. e.g. air pollution by factories; air pollution by motorists; damage to roadways by heavy trucks; noise pollution by garage band; alien species invasions by importers; Not loss in welfare to consumers of corn products due to biofuels. Production vs. consumption externalities
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Why do externalities arise? Missing markets: If the market for a commodity is missing, market forces will not lead to efficient provision. e.g. the missing market for air. Defining property rights for non-marketed goods.
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Defining terms Marginal Benefit (MB): Benefit to society of production of one additional unit of a commodity (demand curve). Marginal Private Cost (MPC): Cost of production of one unit of a commodity that is borne by producer, incl. costs of inputs (supply curve). Marginal Externality Cost (MEC): Economic harm (benefit) from production of one unit of a good that a negative (positive) externality imposes on others; i.e. damage from pollution resulting from production of one unit of a good. Marginal Social Cost (MSC): MPC + MEC
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Graphical Analysis MSC S = MPC MEC D = MB Q $ Q C P C Q * P * DWL
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Mathematical Analysis Social Welfare Maximization: FOC: ( ) ( ) ( ) ( ) Q Max W Q B Q C Q E Q = - - '( ) '( ) '( ) '( ) 0 '( ) '( ) '( ) W Q B Q C Q E Q B Q C Q E Q = - - = = +
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Mathematical Analysis Competitive Firms maximize profits: FOC: Given downward sloping demand, this implies Q* < Q C for MEC > 0. ( ) Q Max PQ C Q π= - '( ) '( ) '( ) P C Q B Q C Q = =
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Assignment of property rights and bargaining Mergers Taxes and Subsidies Quotas Process Standards Market formation: Cap and Trade Voluntary agreements Education (changing preferences) Though any of these policies can achieve socially optimal provision, they have significant consequences for distribution of economic benefits. Principle of Targeting: policy should target the externality-
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Externalities_SS-Public - EXTERNALITIES EEP101/ECON125...

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