Week 5 term 1 Flashcards
(34 cards)
What is an externality?
An externality occurs when the activities of one economic agent affect others in ways that are not reflected in market transactions.
Provide examples of externalities.
- Chemical makers releasing toxic fumes
- Motorists littering the highway
- Smoke from cigarettes
- A neighbor maintaining a beautiful garden
market prices do not correclty reflect actual social cost because they do not take into account of the damage inflicted on third parties => leads to allocative inefficieny
What is allocative inefficiency in the presence of externalities?
The market will not necessarily result in a Pareto efficient provision of resources.
what is not an externality?
purchasing bread because:
- Affects the prices of products which may have an impact on others’ wellbeing
- Since the effects of the transaction are reflected in market prices, they do not affect the market’s ability to allocate resources efficiently
What is the failure of First Welfare Theorem?
In the presence of externalities, the market fails to allocate resources efficiently => not every equilivrium point is pareto efficient provision of resources. => DWL
That is why governments need to intervene to achieve Pareto efifcieny by either taxation or subsidy => socially efficient outcome
Define private marginal cost (PMC).
The direct cost to producers of producing an additional unit of a good.
Define social marginal cost (SMC).
The private marginal cost to producers plus marginal damage.
Define private marginal benefit (PMB).
The direct benefit to producers (consumers) of consuming an additional unit of a good by the consumer.
Define social marginal benefit (SMB).
The private marginal benefit to producers (consumers) plus any costs associated with the production of the good that are imposed on others.
What is marginal damage?
Any additional costs associated with the production (consumption) of the good that are imposed on others but that producers (consumers) do not pay.
What is a production externality?
The effect of an externality on a profit relationship.
What is a consumption externality?
The effect of an externality on the utility level.
What is the simple generela equilibrium model here?
- one person whose utility depends on quantities of x anf y
- person is endowed with labour => lx + ly = l
- we assume that the production of y depednds on the production of x.
- positive externality when gx > 0, negative externality gx< 0
What does the Lagrangian setup involve in the context of externalities?
the economic problem for society is to maximise utility choosing the correct lx and ly
True or False: A producer of x ignores the effect of its output on the production of y in competitive equilibrium.
True.
What happens if g_x < 0?
The socially efficient level of x is lower than the competitive allocation.
What happens if g_x > 0?
The socially efficient level of x is higher than the competitive allocation.
What happens when there are no property rights assigned?
Leads to inefficient outcomes
What does a Pareto efficient allocation imply?
Both agents gain from the allocation
What is the Coase Theorem?
Initial assignment of property rights does not matter for efficient resource allocation
- assigning property rights results in the social optimum, maximising the joint profit of the agents, regardless of who gets the rights
- however, who gets the rights affects hpe they split the profit
What type of tax is used to correct externalities and why
Pigouvian tax - per unit tax = MD (difference b/n private and social marginal cost)
- one way to correct the fact that the producer of the externality faces the wrong price not accounting the costs its action imposes on others, is to make sure that the producer of the externaility faces correct social cost
What does a Pigouvian tax aim to equalize?
Marginal damage
- reduced output to the socially optimum level.
What is necessary for imposing a Pigouvian tax?
Knowledge of the optimal level of the externality
What is the effect of assigning property rights on social optimum?
Results in the social optimum, maximizing joint profit
