MicroEcon 10


the uncompensated impact of one's actions on the well-being of a bystander. can be negative or positive. It is an example of market failures.

Relationship of market failure, externalities, and efficiency

without market failure (which can include externalities), competitive market outcome is efficient and maximises total surplus. In the presence of externalities, the public policy of governments can improve efficiency.

examples of negative externalities:

air pollution, dog barking, second hand smoke. If there is negative externality, market quantity is larger than social desirable.

welfare economics graph:

the supply curve shows the private cost (cost directly incurred by sellers), demand is private value (value to buyers) and there's a social value curve (takes into account external costs imposed on society)

social cost:

the private + external cost. the social-value curve is below or above the normal supply curve depending on whether it's negative or positive.

external cost:

value of negative impact on bystanders.

social optimum and how to reach it.

social optimum is intersection of social-value curve and demand curve. Reducing the production/consumption below market equilibrium of a negative good raises total economic well-being as it reaches social optimum.

internalising the externality:

altering incentives so that people take into account of the external effects of their actions. It would make the sellers' cost equal the social cost. when they pay the social cost, then market equilibrium is equal to the social optimum. government can tax

positive externalities: (social value of a good, etc.)

vaccinations, research and development, education. in the presence of positive externality, the social value of a good includes the private value and external benefit (value of the positive impact on bystanders). government provides the incentive to inter

if there is a positive externality, the market quantity is

smaller then socially desirable. remedy: subsidy.

if there is a negative externality, the market quantity is:

larger than desirable. remedy: tax

2 approaches to externalities:

1) command-and-control to regulate behaviour directly. Ex: limit on quantity of pollution emitted.
2) market-based policies to provide incentives to that private decision-makers will choose to solve problem on their own. Ex: tradable pollution permits or

corrective taxes

a tax designed to induce private decision-makers to take account of the social costs that arise from a negative externality. The idea corrective tax = external cost. the ideal corrective subsidy = external benefit. economists like using corrective taxes m

3 things that corrective taxes/susidies do for us

align private incentives with society's interests. make private decision-makers take into account the external costs and benefit of their actions. move economy toward more efficient allocation of resources.

corrective taxes vs regulations:

different firms have different costs to achieve lower levels of pollution. regulation requires all firms to equally reduce pollution. taxes are better as it gives the incentive to reduce pollution or get better technology. (however, firms have no incentiv

gas tax can target 3 negative externalities:

congestion, accidents, pollution.

tradable pollution permits:

permit systems reduces pollution at lower cost than regulation. firms with low cost of reducing pollution sell unused permits. firms with high cost buy permits. goal is achieved because the total level of pollution is still lowered but at a lower cost. It

objections to pollution permits:

people argue no one should be able to buy the right to pollute as you cannot put a price on the environment. economists would compare the value of clean air and water to the cost as the environment can be viewed as another good.

types of private solutions to externalities:

moral codes and social sanctions (ex; "golden rule" of treat others), charities, contracts between market participants and affected bystanders.

coase theorem:

if private parties can costlessly bargain over the allocation of resources, they can solve the externalities problem on their own. the base principle is that the private market achieves the efficient outcome of economic well-being regardless of initial di

why private solutions do not always work:

transaction costs: cost parties incur in the process of agreeing to and following through on a bargain. may make it impossible to reach mutually beneficial agreement. There are other problems like stubbornness, parties holding out for a better deal, coord