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 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.

4. 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!

5. 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.

6. 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

7. 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

8. Steel mill problem

10. Fishery problem

11. Pareto efficient production

13. 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

14. u Problem: information! Implementation: Pigouvian Tax

15. Creation of missing markets

16. Property rights (Coase Theorem)

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