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.

Today’s 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 adversely affects a nearby fishery

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

Steel mill problem

Fishery problem

Pareto efficient pollution

Pareto efficient pollution

Pareto efficient pollution

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 Problem: information!

Missing markets (Emission markets)

Social norms: moral cost Social norm: “do not pollute” Moral cost Many norms can be explained using efficiency argument