private cost
cost paid by consumer
private benefit
benefit received by producer
external cost
cost paid by people other than consumers or producers
external benefit
benefits received by people other than consumers or producers
in markets of externalities,
consumers and producers focus on the wrong margin when making decisions.
social cost is
price to everyone. private + external cost
social benefit is
benefit to everyone. private + external benefit
when externalities are ignored,
market clearing price is less than optimal
social surplus
everyone's surplus= consumer + producer + everyone's surplus
social surplus and externalities
externalities make social surplus not optimized
without considering externalities
you are underestimating. market quantity is greater than socially efficient level.
At the higher market level of output, costs (all costs) exceed the private benefits to buyers.
A deadweight loss emerges reducing social surplus.
costs: MQ is greater than social efficient
too much output. fix- bring marginal output down. social surplus is reduced if otherwise.
benefits: MQ is less than socially efficient
too little output. fix- bring marginal output up above Marginal quantity. increases social surplus.
if too much externalities,
then market clearing price is not efficient. two solutions: private and government
coase theorem
if transaction costs are low, and property rights are clearly defined, PRIVATE bargains WILL ensure market equilibrium is right and efficient even if there are externalities.
transaction costs
costs necessary to reach agreement.
bargaining in the coase theorem
bargaining ensures the right amount of externality is produced
If there were either too little or too much of the externality, trading would push the quantity to the optimal level.
Thus, the free market equilibrium will maximize social surplus.
The conditions of the Coase Theorem are unlikely to be met.
Transaction costs for many externalities are high, and property rights are often not clearly defined.
When these conditions do not hold, markets alone will not internalize all externalities.
a new market for externalities might develop that maximizes social surplus.
if conditions are met for the coarse theorem.
3 government options
Taxes and Subsidies;
Command and Control;
Tradeable Allowances.
When external costs are significant, governments impose taxes to
reduce the market quantity to the efficient level where social costs equal buyers' benefit.
When external benefits are significant, governments offer subsidies to
increase the market quantity to the efficient level where social benefits equal sellers' costs.
A Pigouvian Tax is a tax on a good with external costs.
A Pigouvian Subsidy is a subsidy on a good with external benefits.
These policies allow markets to send proper signals when externalities are present thus maximizing social surplus.
Governments may not possess enough information to choose the -least costly method- to achieve the necessary reduction in quantity when external costs are present.
Command and control regulations are not flexible for producers and consumers to choose the least costly method (of reducing quantity)
hard to get private information and impose the best policy, but some cases it is good-
under these conditions, command and control is good.
The best approach to the problem is well known;
Success requires very strong compliance.
The government can address external costs by establishing a market for tradeable allowances.
Under this approach, the government sets a maximum quantity and rations a portion of that level to players in the market.
Consumers and producers individually choose the best (least costly) approach to limit their quantity.