handout7externalities - E l A Definition A direct and...

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Unformatted text preview: E l. . 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.

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handout7externalities - E l A Definition A direct and...

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