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externalities2-ho - Externalities Chapter 34 Approximate...

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Externalities Chapter 34
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Approximate Grade Cutoffs Combined (MT1+2) score A range: 76 (top 15%) B range: 62 (50%) C range: 46 (85%)
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Big Picture Externalities cause market failure They affect people who are not buyers or sellers of the good That is, they occur outside markets The market for the external effect is missing Private cost 6 = social cost; private benefit 6 = social benefit Goods w/ negative externalities are overproduced Goods w/ positive externalities are underproduced
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Big Picture How can we correct this market failure? Regulate market activity Corrective (Pigouvian) tax/subsidy Quotas Create the missing market Assign property rights (Coase Thm.) Tradeable permits (Cap n’ trade)
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Two Firm Example Firm 1: Joe’s coal-burning power plant Costs: C e ( e , a ) = e 2 + (4 - a ) 2 Produces electricity ( e ) CO 2 ( a for polluted air ) emissions as a byproduct C e e = 2 e > 0: more costly to produce more power C e a = - 2(4 - a ) < 0 (assuming 0 a 4): it’s cheaper to make electricity while polluting
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Two Firm Example Firm 2: Sarah’s polar bear farm Costs: C l ( l , a ) = l 2 + la + a 2 Produces polar-bear pelts ( l ) C 0 2 emissions cause global warming, making it more difficult to raise polar bears C l l = 2 l + a > 0: it costs more to produce more polar bear pelts C l a = l + 2 a > 0: raising bears is more costly with lost of CO 2 in the air (global warming)
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What We Saw There are three goods: electricity, bears, and polluted air However, there are only two markets: electricity and bears—the polluted air market is missing! Without this market, the power plant does not take into account—does not internalize —the effect of its pollution on the polar bears Sarah loves clean air, so there is a cost of pollution from a social point of view Joe will release “too much” polluted air: a will be “too high”
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Competitive Outcome vs. Social Optimum
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