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Flashcards in Week 9 - Externalities Deck (38)
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what is a market?

An institution that involves the exchange of goods and
services AND the rights (property rights) to use them.
 Individuals with purely selfish motives mutually benefit from exchange.


Define market failure

Situations where the market fails to achieve an efficient outcome, or where efficient, the outcome is deemed to be socially undesirable


Define government failure

Situations where the government fails to achieve an efficient outcome or redress a market failure, or where efficient, the outcome is deemed to be socially undesirable.


define public goods

Goods that are neither excludable nor rival in consumption


define private goods

Goods that are both excludable and rival in consumption


define rival in competition

The property of a good whereby one person’s use diminishes other people’s use


define excludable

The property of a good whereby a person can be prevented from using it


define 'free rider problem'

A person who obtains the benefit of a good but does not pay for it
(typically public goods)


explain the market failure of asymmetric infomation

Markets use prices to convey information, but some information is not provided in sufficient quantities or somebody in the market knows more than somebody else
Certain foods, entertainment activities and products
o Hence the need for health warnings, building codes, prevention of deceptive advertising etc
o Landlords know more about their properties than tenants such a students
o Mortgages: borrower knows more about their ability to repay a loan than the lender
o Used car dealer knows more about a vehicle quality than a buyer
o Inside information of traders in financial markets


Define externality

The uncompensated impact of one person’s actions on the wellbeing of a third party not involved in the transaction

o Economic transactions generate costs and benefits
o Often, these costs and benefits fall on third parties.
o Those undertaking the transaction do not consider these costs and benefits.
o Third parties are not compensated for the cost or benefit falling upon them.
o Also know as spillovers


Define negative externality

uncompensated cost born on a third party


Define positive externality

Uncompensated benefit born on a third party


result of negative and positive externality

Negative externalities – lead to oversupply of a good/service

Positive externalities – lead to undersupply of a good/service

Market outcomes are inefficient in the presence of externalities because the individual consumer or producer chooses a quantity that equates his marginal benefit with his marginal cost, but the marginal social cost is larger (negative externality) or the marginal social benefit is larger (positive externality). Thus, markets produce a larger quantity than is socially desirable when there is a negative externality, and a smaller quantity than is socially desirable when there is a positive externality. Economists often refer to externalities as having a missing market, the demand for or supply of the “good” (or “bad”) that affects others.


types of externalities

Producer on producer:
Chemical plant polluting a lake used for fishing
Bee-keeper located next to apple grower
Producer on consumer:
Impact of noise from factory on residential areas
Factory builds a sealed road
Contamination of ground water from fertilizers

Consumer on consumer
o Congestion of roads, automobile emissions
o Neighbor renovates their house
o Knowledge passed on to others
o Smoking in restaurant
o Anti-social behaviour
o Sand dune destruction from 4WDs.
Consumer on producer
o Campers burn tree plantation

Government on producer
Knowledge from government research centers
spilling over to industry
US government stabilisation policies on Australian producers
Government on consumer
Government owned coal-fired electric utility plant causing air pollution

Producer on government
Consumer on government


define internalising an externality

Altering incentives so that people take into account the external effects of their actions
• E.g. Imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity


explain positive externalities

The intersection of the supply curve and the social-value curve determines the optimal output level.
The optimal output level is more than the equilibrium quantity.
The market produces a smaller quantity than is socially desirable.
The social value of the good exceeds the private value of the good.

Internalising externalities: Subsidies Used as the primary method for attempting to internalise positive externalities. Also patent laws – allowing firms to sell off their innovation


explain coast theorem

The Coase Theorem = the proposition that if private parties can bargain without cost over allocation of resources, they can solve the problem of externalities on their own
*read page 229*

Coase (1960) argued that externalities could be resolved as long as property rights exist over a resource and transaction costs are low. Private transactions will be Allocative efficient. Importantly, it does not matter who has the property rights – the polluter or the sufferer
According to Coase’s Theorem, people will never pass up an opportunity to cooperate by means of mutually advantageous exchange


Why private solutions do not always work? (coase theorem)

Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible.
Transaction costs = are the costs that parties incur in the process of agreeing to and following through on a bargain.


When externalities are significant and private solutions are not found, government may attempt to solve the problem through:

1. Command-and-control policies:
form of regulations:
forbid certain activities and require certain activities
• Requirements that all students be immunized.
• Stipulations on pollution emission levels set by state/territory environmental protection agencies (EPAs).

2. Market-based policies:
Government uses taxes and subsidies to align private
• incentives with social efficiency.
• Pigovian taxes are taxes enacted to correct the effects of a negative externality. (e.g. carbon tax)


what are Pigovian taxes

taxes are taxes enacted to correct the effects of a negative externality. (e.g. carbon tax)


define corrective tax

A tax enacted to correct the effects of a negative externality


draw supply and demand graphs of positive and negative externliaites in consumption and production



What command-and-control policy might the landlord impose? Could such a policy lead to an inefficient outcome?

The landlord could impose a rule that music couldn’t be played above a certain decibel level. This could be inefficient because there would be no harm done by Kylie playing her music loud if Nigel isn’t home. Further, if Kylie benefits more from loud music than Nigel suffers, it is actually efficient to play loud music.


Suppose the landlord lets the tenants do whatever they want. According to the Coase theorem, how might Kylie and Paul reach an efficient outcome on their own? What might prevent them from reaching an efficient outcome?

Kylie and Paul could negotiate an agreement that might, for example, allow Kylie to play her music loud at certain times of the day. Or, Kylie could compensate Nigel for playing loud music.

They might not be able to reach an agreement if the transactions costs are high or if
bargaining fails because each holds out for a better deal.
Note that Kylie, in compensating Paul if she plays music presumes that, (as is usual), that Paul owns the right to quietude. As such Kylie “purchases” the right to violate it (purchases the noise)


Greater consumption for alcohol leads to more vehicle accidents and thus, imposes costs on people who do not drink and drive.
a) Illustrate the market for alcohol, labeling the demand curve, the social-value curve, the supply curve, the social-cost curve, the market equilibrium level of output and the efficient level of output.

week 10 tute
The market for alcohol is shown in the figures below. We can think of the externality as either reducing the social value (marginal social benefit is less than marginal private benefit) or as increasing the social cost (marginal social cost is greater than marginal private cost). Notice that both result in the same optimal output, optimal price, and deadweight loss. Without intervention, the equilibrium is denoted by QLF and PLF. The socially optimal quantity and price are given by P* and Q*. The deadweight loss is given by the shaded area.

learn how to these :)


types of goods

Private goods
 are both excludable and rival

 Public goods
 are neither excludable nor rival

 Common resources
 are rival but not excludable

 Natural monopolies
 are excludable but not rival


explain  Quasi-Public Goods (also called Near Public Goods)

• Non-rival up to a point, until congestion occurs (e.g. roads, ambulance, police)
• Can exclude others


Pure public good:

 National defense, lighthouses, police
• Cannot supply a good or service without providing it to others
• Consumption by person A does not deplete consumption by person B


Quasi Public good:

 Museums, roads, bridges, parks, cable-tv, internet access
• Can be non-rival up to a point
• Can exclude others


define common resources

Goods that are rival in consumption but not excludable