L23 Externalities

Road map 1) Consumers choice 2) Equilibrium, Producers (Pareto efficiency) 3) Market Failures - fixed cost: monopoly and oligopoly - externalities and public goods - asymmetric information

Externalities u So far: utilities on own actions only u Reality: we are not islands u 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 u Air or water pollution. u Loud parties next door. u Traffic congestion. u Second-hand cigarette smoke. u Increased insurance premiums due to alcohol or tobacco consumption. u Bad smell!

Examples of Positive Externalities u A well-maintained property. u High “human” capital u A pleasant cologne or scent worn by the person seated next to you. u A scientific advance.

Today’s questions: u Efficiency of interactions with externalities u Too much or too little activity with externality? u How can we reestablish Pareto efficiency? – taxes – creating markets – social norms

Example: Negative externality u Two producers: steel mill and fishery u A steel mill produces steel u It can also choose the level of pollution u The pollution adversely affects a nearby fishery

Steel mill problem

Fishery problem

Pareto efficient production

u When negative externality – too much activity in decentralized markets u You will show in PS that when externality if positive – too little activity. Conclusion 1

u Problem: information! Implementation: Pigouvian Tax

Creation of missing markets

Property rights (Coase Theorem)

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