1. L23
Externalities

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

3. 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.

4. 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!

5. 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.

6. Today’s questions: Interactions with externalities
Too much or too little activity?
How can we reestablish Pareto efficiency?
taxes
creating markets
social norms

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

8. Steel mill problem

9. Steel mill problem

10. Fishery problem

11. Pareto efficient pollution

12. Pareto efficient pollution

13. Pareto efficient pollution

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

15. Implementation: Pigouvian Tax
Problem: information!

16. Missing markets

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