Externalities

Allocative Efficiency

A deadweight loss exists at the private equilibrium. Moving to the social equilibrium IMPROVES allocative efficiency

Negative Externality of Production

A negative production externality means that the true cost to society is greater than just the private costs. - SMC is above PMC .

Positive Externality of Production

A positive production externality means that there is some offsetting benefit to society that is arising from production that producers do not account for. - SMC below the PMC once the external benefit is accounted for.

Indirect Taxes

Example: - Increased climate change due to pollution from production of a commodity, a negative production externality. This applies equally to negative consumption externalities as well. This was our model from last lecture. In the free market, Qp will be produced but the negative externality of production will mean that we should really only produce Qs.

Subsidies

Example: - Education, a positive consumption externality. Individuals and society both benefit from having an educated population. Where positive externalities are involved, a subsidy lowers the price and therefore raises the quantity traded. e.g. provision of tertiary education (a positive consumption externality).

Indirect Taxes (continued)

Taxes on negative externalities (known as Pigovian taxes after the economist Arthur Pigou) impose the costs on the producers or consumers who enjoy the private benefit, but generate the negative externality. A tax will reduce the amount produced or consumed to the socially optimal level. Transferring the costs back to those who generate the externality is known as internalizing.

Couse Theorem

The Coase theorem states that if property rights are assigned appropriately then markets will take care of externalities. If individuals can negotiate the purchase and sale of the right to perform activities that cause externalities, they can always arrive at efficient solutions to the problems caused by externalities

Externality

The impact of one person's actions on the wellbeing of another 1. Adverse impacts are negative externalities 2. Beneficial impacts are positive externalities Externalities are sometimes called spill over costs and benefits. Externalities can arise from consumption It have to impact on a third party not part of the original transaction SMC (social marginal cost) = PMC (cost of production) + -ue Externality

Socially Optimal Outcome

The socially optimal outcome is the one where the total benefits, after accounting for costs, are maximized. The optimal outcome is economically efficient in that it is the most valued outcome.

Negative Externality of Consumption

The true cost to society is greater than just the private cost - SMC is above PMC

Positive Externality of Consumption

There is some off-setting benefit to society arising from production of the good, which producers do not account for. - SMC is below PMC