Chapter Thirty-One

Chapter Thirty-One

L22 Externalities Externalities So far: utilities on own actions only Reality: we are not islands

An externality is a cost or a benefit imposed upon someone by actions taken by others. - benefit - positive externality. - cost - negative externality. Examples of Negative Externalities

Air or water pollution. Loud parties next door. Traffic congestion. Second-hand cigarette smoke. Increased insurance premiums due

to alcohol or tobacco consumption. Bad smell! Examples of Positive Externalities A well-maintained property.

High human capital A pleasant cologne or scent worn by the person seated next to you. A scientific advance. Todays questions:

Interactions with externalities Too much or too little activity? How can we reestablish Pareto efficiency? taxes creating markets social norms Example: Negative externality

Two producers: steel mill and fishery Steel mill: Production of steel level of pollution The pollution fishery adversely affects a nearby

Marginal benefit from pollution 2 Scenarios: In both scenarios - producers are small - They maximize profit

Scenario 1: Decentralized free markets Scenario 2: Social planner Steel mill problem s (s, x) pss TC s (s, x) Steel mill problem

2 T C s ( s , x ) s ( x 1) 2 ps $2 s x

s Fishery problem TC ( f , x) f f f f

2 ( f , x) p xf f p f $3 f TC f ( f , x)

f s Pareto efficient pollution (s, f , x) pss TC s (s, x) p f f TC f ( f , x) Pareto efficient pollution Pareto efficient pollution 2

T C s ( s , x ) s ( x 1) 2 T C f ( f , x ) f xf 2 ps $2 p f $3 Comparizon

When negative externality too much activity in decentralized markets You will show in PS that when externality if positive too little activity. Implementation: Pigouvian Tax s (s, x) pss TC s (s, x) x

Problem: information! Missing markets (Emission markets) s (s, x) pss T C s (s, x) p x x f

( f , x) p f f TC f ( f , x) px x Social norms: moral cost (s, x) pss T C s (s, x) x Social norm: do not pollute Moral cost ( x )

Many norms can be explained using efficiency argument

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