Externality An unintended cost or benefit created for a third party as a result of a transaction This cost or benefit is unintended and uncompensated Positive Externality Benefit or positive externality Examples honey production vaccinations ID: 1027434
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1. Externality and Coase Theorem
2. ExternalityAn unintended cost or benefit created for a third party as a result of a transaction. This cost or benefit is unintended and uncompensated.
3. Positive ExternalityBenefit or positive externality Examples: honey production, vaccinations Economics: traders don't receive the full benefits of their actions Consequence: If a positive externality is present the market, Q will be inefficient and under producedNot pareto optimal MichaelShanel
4. Negative ExternalityCost or negative externality Examples: pollution, noiseEconomics: traders don't pay the full cost of their actions Consequence: If a negative externality is present in the market, Q will be inefficient and over producedNot pareto optimal
5. Production and Consumption ExternalityA consumption externality is an externality generated by the consumption behavior of an economic actor. Vehicle exhaustLoud music A production externality is an externality generated by the production activity of a firm. Acid rainPollution
6. Correcting for Negative ExternalitiesMPC (Marginal private cost)MSC (Marginal Social Cost)MSB (Marginal Social Benefit)MPCMSCMSBQuotaPigouvian Taxtq1Free marketq2DWLDWLPareto optimalPareto optimalInefficientInefficientq1Free marketq2Quota
7. Correcting for Negative ExternalitiesMPCMSCMSBMPCMSCMSBQuota = Command and Control StrategyPigouvian Tax = Regulatory Strategy t (tax = negative externality)q1Free marketq2DWLDWLPareto optimalPareto optimalInefficientq1Free marketq2QuotaThe optimal amount of pollution is greater than zeroInefficient
8. Acid Rain Program (1995)A hybrid solution: A solution to inefficiencies in the allocation of quota rights is to permit trading them. Tradable permits are quotas for pollution that can be exchanged to create a market in the right to pollute, and thereby create a tax on polluting. Some level of pollution makes the economy more efficient. At least for now … Is it equitable though??? … Not reallyPermit Price for SO2
9. Summary: Positive and Negative Externality (Producer)CharacteristicPositive ExternalityNegative ExternalityImpact on third partiesBenefitCostAlgebraic form:MBeMCeMarket Q:Too smallToo largeMarginal social B or C:MSB = MPB + MBeMSC = MPC + MCeCorrective policySubsidy Quota or Pigouvian tax
10. Coase TheoremIn the absence of transaction costs, and with symmetric information, the initial assignment of property rights does not matter in determining the efficient allocation of resources. AS LONG AS SOMEONE IS ASSIGNED PROPERTY RIGHT, you will reach efficient outcomeEquity and distribution is another story
11. Coase Theorem
12. Coase TheoremNote: Transfers are occurringIn case 1: From Chem to Boat Pareto ImprovingIn case 2: From Boat to Chem Pareto Optimal
13. Coase TheoremWhy might such compensation schemes not occur/ break down in reality? (Lets think about global warming)Transactions costs may be high if too many parties are involved. Lack of information. What are the costs? Do both sides know and agree on the MC of the externality? Is the profit matrix agreed upon?The Free Rider Problem: When an investment has a personal cost but a common benefit, individuals will underinvest
14. Practice QuestionSuppose a good creates a negative externality (Producer) and has the demand, supply and externality marginal cost curves given below:P =1000−2Q (D)P =100+Q (S)MCe=300Please determine the following:The market P and Q before any policy is adopted to deal with the externality.The efficient Q and the values of Pd and Ps that would be needed to achieve it.The optimal tax rate “t” that will reach pareto optimal Q. The optimal quota “q” that will reach pareto optimal Q.
15. Solution1. p = 400 and q = 3002. pd =600, ps = 300 and q = 2003. t = 3004. q = 200