Transcript Externalities

Externalities
© Allen C. Goodman 2000
Ideal Market Processes are desirable if …
• We accept the value judgment that “personal wants of
individuals should guide the use of society’s resources.”
• Three structural characteristics are necessary:
– All markets are competitive.
– All participants are fully informed.
– All valuable assets can be individually owned and managed
without violating the competition assumption.
• If these hold, government’s best role involves determining
an income distribution, providing rules of property and
exchange and enforcing competition.
Markets
If markets behave properly, COST of item equals the PRICE
that buyers are willing to pay.
Value to consumer = Value to producer
With competition, in the short run, the firm produces to where:
MC = MR = P
Value of resources in production = MR = Value to consumer
We can do a little bit of geometry to show this:
Typical Firm Diagram
Mkt.
Firm
S
AC
P
MR
P*
D
Q
MC
q
Pareto Efficiency
Context of trade.
One can’t make oneself better off,
without making someone else
worse off.
We usually do this with an
exchange Edgeworth Box.
Abner’s Preferences
Belinda’s Preferences
Abner
Belinda
Pareto Efficiency
Start at Point A.
Is this an Equilibrium?
Belinda
No, they can trade
Belinda can be better
off.
B
So can Abner.
A
Abner
Pareto Efficiency
We can plot similar points, which
we recognize as a “contract
curve”
Belinda
And so on.
B
A
Abner
Pareto Efficiency
We must recognize that point X is
Pareto Optimal.
Belinda
Y
So is point Y.
B
A
X
Abner
Utility Possibility Frontier
We can plot Abner’s utility against
Belinda’s Utility.
X
Why do we draw it
this way?
What if we want a perfectly
egalitarian society?
Does equal utility mean
equal allocations?
Y
Abner’s Utility
So, are markets always great?
• Externality – A cost or
benefit in production or
consumption that does
NOT accrue to the producer
or the consumer of the
commodity.
• No single person can own
or manage air or water.
•
Consider a person who
wants to heat a house with a
wood fire.
1. More wood  more heat.
2. W/ more heat, willingness to
pay for additional heat .
3. More wood and more heat
 more smoke
Heat and smoke
Individual sees price of wood as
P1.
Compares price to marginal
benefit (demand curve).
Individual purchases quantity A
of wood.
BUT…
Wood  Smoke.
Assume that more burning 
more smoke.
We get MSC curve
D = WTP
$
MSC
P1
MC
B
Heat, smoke
A
Heat and smoke
•
•
•
•
Wood  Smoke.
Assume that more burning
 more smoke.
We get MSC curve
If we go past B the marginal
benefits are:
D = WTP
$
MSC
P1
Inc.
Costs
Inc.
MC
Ben.
•
If we go past B the marginal
costs are:
B
Heat, smoke
A
Heat and smoke
•
If we go past B we get
societal losses.
D = WTP
$
MSC
•
This is a NEGATIVE
externality.
P0
•
•
How to remedy?
A tax of P0 – P1.
Losses
P1
MC
Inc.
Ben.
B
Heat, smoke
A
Heat and smoke
•
Tax of P0 – P1.
D = WTP
$
MSC
•
•
•
•
Has nothing (necessarily) to
do with cleaning up the air.
We must set up a market for
a resource that no one Tax
specifically owns.
Think of it as taking
revenues and refunding it
back to population.
Who gains? Who loses?
P0
Losses
Tax
P1
MC
Inc.
Ben.
B
Heat, smoke
A
A general problem – the Lake
Externalities Equations
n industrial firms
Yi = output
Pi = price
xi units of labor at wage W
Production Function
+++
Yi = Yi (zi, xi, q),
where:
zi = waste discharges
q = quality of lake
L = assimilative capacity of Lake
- - +
q = Q (z1, z2, ..., zn, L)
Society’s Objective
Societal Objective:
Max U =  Pi Yi (xi, zi, q) -  W xi - C (L) -  (q - Q (z1, z2, ..., zn, L))
Pi is the willingness to pay (related to utility of goods).
PiYi is the amount spent (related to utility of goods).
 is the valuation of the extra unit of environmental quality.
First Order Conditions:
U / xi = Pi Yixi - W = 0.
U / zi = Pi Yizi +  Qzi = 0
U / q =  Pj Yjq -  = 0
U / L =  QL - C' = 0
(a)
(b)
(c)
(d)
Society’s Objective
First Order Conditions:
U / xi = Pi Yixi - W = 0.
U / zi = Pi Yizi +  Qzi = 0
U / q =  Pj Yjq -  = 0
U / L =  QL - C' = 0
For Firm 1:
P1 Y1x1 = W
P1 Y1z1 = -  Qz1
P1 Y1q = 
Eq'm:
P1 Y1z1 = [P1 Y1q] [- Qz1]
(a)
(b)
(c)
(d)
P1 Y1z1
$
[P1 Y1q] [- Qz1]
z1
z*1
Society’s Objective
First Order Conditions:
U / xi = Pi Yixi - W = 0.
U / zi = Pi Yizi +  Qzi = 0
U / q =  Pj Yjq -  = 0
U / L =  QL - C' = 0
For Firm 1:
P1 Y1x1 = W
P1 Y1z1 = -  Qz1
P1 Y1q = 
(a)
(b)
(c)
(d)
[P1 Y1q +  2,n Pj Yjq ] [- Qz1] > [P1 Y1q] [- Qz1]
P1 Y1z1
$
For Society:
P1 Y1x1 = W
P1 Y1z1 = -  Qz1
 Pj Yjq = 
Optimum: P1 Y1z1 =
[P1 Y1q +  2,n Pj Yjq ] [- Qz1] > [P1 Y1q] [- Qz1]
[P1 Y1q] [- Qz1]
TAX
z*1
z1
z*1
So …
• Societal optimum dictates that each firm
produce less than in an autarkical system.
• Remedy, again, would be a tax.
• Once again, a situation where ownership is
not well-defined and one’s actions affect
others.