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A Deﬁnition A direct and unintended effect the activity of one economic agent has on another that is not
taken into account by the price system (no price is charged to reward/ compensate for the beneﬁt [ harm . Formally: Suppose Jerry’s ﬁrm generates Z units of pollution. His aim is to maximize his
proﬁt as a producer so he doesn’t take into account the effect his pollution generating activity
has on others, such as Tom and Pat. Tom’s utility function is given by 6U
UT 2 UT(X,Y, Z) where 8—; < 0 Then we say Jerry imposes a negative CONSUMPTION externality on Tom. Pat is a producer with production function 8F
=FKLZ h — 0
q (7,)W6reaz< Then we say Jerry imposes a negative PRODUCTION externality on Pat. Examples 0 Pollution —> Acid Rain :> Damages soil :> reduction of farm output or more expensive
to produce the same amount as before o Pollution —> Acid Rain :> Damages Sea/ Lake ecosystem :> Less ﬁsh /threatens ex—
tinction of some species 0 Pollution —> Reduced air quality :> More difﬁcult for people to breath/ increased like—
lihood of death for some 0 Pollution —> Smog :> Reduced visibility :> More difﬁcult to ﬂy airplanes/ drive cars o Pollution —> Global Warming :> Northern Ice Melts :> Houses in Florida get flooded. 0 Jerry plays his music loud (noise pollution) :> disturbs his neighbours; they can’t enjoy
their coffee on their patio. 0 Education of a person —> More polite person (?), more pleasant to interact with; more
courteous as an employee / employer / customer / supplier; better able to read instructions
and road signs :> fewer accidents. What do these examples have in common? 0 The person who causes the externality does not intend to harm or beneﬁt those affected.
However, he is assumed to be motivated only by her private beneﬁt /cost from the
activity. 0 Property rights (the right to carry out the activity in question) are not well deﬁned.
So there is no market where we can pay or charge people to complain when harmed
to reduce pollution, to turn down their volume, to educate their children, etc. How we analyze market performance in the presence of externalities?
The Case of a Negative Externality An activity associated with a negative externality results to damages to society. To keep
things simple suppose the damages are incurred by people other than the market participants
(the buyers and sellers). Let D(Q) represent the damage done if Q units are produced. The
total social cost (TSC) includes the private (production) cost plus the damage: T50(6)) = 0(6)) +D(Q) so the marginal social cost is MSO(Q) = MO(Q) + MD<Q> Proﬁt maximizing ﬁrms sell the good to utilty maximizing consumers who receive total utility
U and marginal utility JWU (same as lWWT Therefore, the efﬁcient amount is such that [WU(Q*) = MSC(Q*)
But the free market yields an allocation (15, such that A A A A A p = MU(Q) = MC(Q) <MC(Q) + MD(Q) = Mso(o) that is the damages to third parties are not taken into account by self—interested buyers and
sellers and so: o JWU < lWSC which means the allocation is ineﬁicient: too much of the good is produced
in the case of a negative externalitg. In principle a tax can be used to generate the efﬁcient amount of trade namely, 15* = MWTP(Q*) — MC(Q*) = M D(Q*) MSC The Case of a Positive Externality Now suppose there is no negative externality. Instead7 the good has a positive external effect.
There is a total beneﬁt to third parties equal to B (Q) and thus marginal beneﬁt of M B (Q)
such that MB is decreasing in Q. Then marginal social beneﬁt is then given by MSB(Q) = MU(Q) + MB(Q) and so the efﬁcient output amount is Q* such that MSB(Q*) = MC(Q*) but the free market yields (15, such that p = MC(Q) = MU(Q) < MU(Q) + MB(Q) = MSB(Q) o lilSU > JWC which means the allocation is ineﬁicient: too little of the good is produced
in the case of positive externality. In principle, this can be corrected by subsidizing the production of Q by a per—unit subsidy equal to 8* = JWBlQU. ...
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This note was uploaded on 02/29/2012 for the course ECON 2350 taught by Professor Bardis during the Fall '12 term at York University.
- Fall '12