Chapter 5 summary: Externalities occurs when the activity of one person or firm positively or negatively affects another person/group/firm outside the market mechanism; an inefficient allocation of resources results because the market price does not reflect the external costs or benefits; the coase theorem indicates that private solutions through bargaining can achieve the efficient outcome under certain circumstances. | EXTERNALITIES Chapter 5 ©2014 by McGraw-Hill Education. All Rights Reserved. Externalities Externality – An activity of one entity that affects the welfare of another entity in a way that is outside the market mechanism A paper mill’s production of the carcinogen dioxin increases society’s health care costs; these costs to society are not included in the paper mill’s paper price However, when large numbers of suburbanites relocate to a city, society is affected, although the effect is captured through higher prices of city housing ©2014 by McGraw-Hill Education. All Rights Reserved. 5- The Nature of Externalities Privately-owned vs. commonly-owned resources A privately owned resource: its price reflects its value so used efficiently (MSC=MSB) A commonly-owned resource (air, oceans): price ($0) does not reflect its value so used inefficiently (MSC>MSB) Externalities can be produced by consumers & firms Externalities are reciprocal in nature Externalities can be positive or | EXTERNALITIES Chapter 5 ©2014 by McGraw-Hill Education. All Rights Reserved. Externalities Externality – An activity of one entity that affects the welfare of another entity in a way that is outside the market mechanism A paper mill’s production of the carcinogen dioxin increases society’s health care costs; these costs to society are not included in the paper mill’s paper price However, when large numbers of suburbanites relocate to a city, society is affected, although the effect is captured through higher prices of city housing ©2014 by McGraw-Hill Education. All Rights Reserved. 5- The Nature of Externalities Privately-owned vs. commonly-owned resources A privately owned resource: its price reflects its value so used efficiently (MSC=MSB) A commonly-owned resource (air, oceans): price ($0) does not reflect its value so used inefficiently (MSC>MSB) Externalities can be produced by consumers & firms Externalities are reciprocal in nature Externalities can be positive or negative Public goods can be viewed as a special kind of externality ©2014 by McGraw-Hill Education. All Rights Reserved. 5- The Nature of Externalities-Graphical Analysis Q per year $ MB 0 MD MPC MSC = MPC + MD Q1 Q* Actual output Socially efficient output a b c d f e g h Reduction from Q1 to Q* means dcg profit loss for Supplier and dchg welfare gain for Demander. ©2014 by McGraw-Hill Education. All Rights Reserved. 5- Axes and labels 1st click – MB 2nd click – MPC, Q1 3rd click – MD 4t click – MSC, Q* What Pollutants Do Harm? Empirical Research on Pollution Effects on Health Difficult to measure because of inability to perform randomized studies on pollution effects Must rely on cross-sectional or time-series analysis Studies unable to measure lifetime exposure to air pollution Once pollutant identified: Must identify the activities that produce the pollutant Must identify the value of the damage done Must identify the costs of remedying the damage Empirical .
