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UNC-Chapel Hill ECON 410 - Market Efficiency & Externalities

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Slide 1Econ 410: Micro TheoryMarket Efficiency & ExternalitiesMonday, October 15th, 2007Slide 2Market Efficiency Introduction to Welfare Economics Pareto Efficiency An allocation of goods and services is Pareto efficientif there is no way to make someone better off without making someone else worse off. Pareto efficiency is not the same thing as “fairness”, and does not involve making interpersonal comparisons Example – Allocating $1.00Slide 3Market Efficiency If it is true that: All producers and consumers act as perfect competitors (without any market power) A market exists for all commodities Then the First Fundamental Theorem of Welfare Economics states that: The market allocation of goods & services is Pareto-efficient. When do these conditions fail to hold? Asymmetric Information ExternalitiesSlide 4Market Efficiency Market Failures Last week, we discussed how information problems affect market efficiency. This week, we’ll discuss how externalities and public goods can affect the market’s ability to increase welfare. Externalities An externality occurs when the activity of a person or firm directly affects the welfare of another in a way that is outside th market mechanism.Slide 5Externalities Externalities can be positive or negative Positive Externality Example Getting a flu shot protects you from the flu and protects others from catching it from you. Your flu shot imposes a benefit on others for which you are not compensated. Negative Externality Example Answering your cell phone in class may distract others.  Your cell phone use imposes a cost on the rest of the class that for which you do not compensate them.Slide 6Negative Externalities Example – Cell phone use Marginal Cost of cell phone use (MC) Per-minute charge Marginal external cost of cell phone use (MEC) - The “cost” to each of your classmates for their annoyance at listening to your call. As the call gets longer, the annoyance increases Marginal social cost of cell phone use (MSC) MSC = MC + MEC Marginal benefit (MB) – The (private) benefit you receive from talking on your cell phone.Slide 7Negative ExternalitiesMCMB1q1MSCCell Phone CallsMBMECq*The optimizing caller will receive q1calls in classThere is a MEC of “annoyance” from cell phone calls. The MSC reflects the true cost of the call. The optimizing caller will receive q1calls in class while the efficient number of cell phone calls is q*. Slide 8Negative Externalities What happens if the whole class takes cell phone calls?By not producing at the efficient level, there is a social cost to the class. Aggregate social cost ofnegativeexternalityMCS = MCCDMB1P1q1Q1MSCMSCCCell Phone CallsMBClass calls“Price”MECMECCq*P*Q*Slide 9Negative Externalities Negative externalities encourage inefficient individuals or firms to remain in the market This creates excessive production of a good in the long runSlide 10Positive Externalities When positive externalities are present, the market outcome can result in too little of a good being produced. Book Example – Home Repair Marginal external benefit (MEB) - Mowing your lawn or repairing your home adds value to your neighbor’s property The marginal social benefit (MSB) of fixing your house includes the MEB and your own private benefit. MSB = MEB + DSlide 11MSBPositive ExternalitiesMCP1DRepair LevelValueq1When there are positive externalities (the benefits of repairs to neighbors), marginal social benefits (MSB) are higher than marginal benefits (D).q*P*A self-interested home owner invests q1in repairs. The efficient level of repairs q* is higher. The higher price P1discourages repair.MEBSlide 12Correcting Market Failures What can we do to correct the potential market failures that could arise from externalities? Policies that equate the private costs/benefits of production to the social costs/benefits Example – Pollution The social harms (MSC) from pollution increase as emissions levels increase. Why? But, eliminating externalities is costly The marginal cost of abatement (MCA), or reducing emissions, increases with the amount reduced. Why?Slide 13Correcting Market Failures246Dollars/ Unitof EmissionsLevel of Emissions0 2 4 6 8 10 12 14 16 18 20 22 24 26MSCMCAE*The efficient level ofemissions is where MCA = MSC.At Eo the marginal cost of abating emissions is greater than the marginal social cost.E0At E1the marginal social cost is greater than the marginal benefit.E1Slide 14Correcting Market Failures Several methods for encouraging firms to reduce emissions have been attempted, including: Emissions standards Emissions fees Tradable emissions permits Suppose the government is considering 2 options to reduce emissions:  Setting an emissions standard Charging a “fee” (tax) on emissionsSlide 15Correcting Market Failures Emissions Standard Set a legal limit on emissions at E* (12) Enforced by monetary and criminal penalties Increases the cost of production and the threshold price to enter the industry Emissions Fee Charge levied on each unit of emission Both policies are considered to be market distortions, where the 1stfundamental welfare theorem does not hold.Slide 16Correcting Market FailuresLevel of EmissionsDollars/ Unitof EmissionsMSCMCA312E*StandardFeeWhat are the hidden costs to society associated with an emissions standard?312E*StandardFeeSlide 17Correcting Market FailuresTotalAbatement CostThe firm will reduce emissions until the marginal cost of abatement is equal to the fee for not reducing.Level of EmissionsDollars/ Unitof Emissions3Total Feeof Abatement12MSCMCAE*If a tax of $3 per unit of emissions is imposed…Slide 18Correcting Market Failures In this case, a government could use fees or regulations to obtain the same emissions goal. But, there may be unintended consequences of these policies that increase social costs Examining a proposed policy in detail is critical to understand the long-run implications for society.Slide 19For next time… We’ll look at the benefits and drawbacks of using a variety of government policies to correct externalities Please read: Sections 18.2 and 18.3 of your text Assignment: Due Wednesday at the beginning of


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UNC-Chapel Hill ECON 410 - Market Efficiency & Externalities

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