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ISU ECON 201 - Externalities
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Econ 201 1st Edition Lecture 27Outline of Last Lecture 1.ExternalitiesOutline of Current Lecture 1. ExternalitiesCurrent LectureExternalities and the Logic of Market Failure• An economic activity, Q, (production ~ consumption) should be increased if MSB >MSCor decreased if MSB <MSC .– MSB = marginal social benefit MSC = marginal social cost– Efficient level of activity occurs where MSB = MSC. • Free market outcomes are guided by price signals: P*.– At free market equilibrium ~ Q*: MPB* = P* = MPC*– MPB = marginal private benefit MPC = marginal private cost• No externalities: Free market equilibrium implies social efficiency.– MSB* = MPB* = P* = MPC* = MSC * èMSB = MSC • Externalities: Free market equilibrium is not efficient.– MSC ≠ MPC or MSB ≠MPB è At Q*: MSB ≠ MSCMarket Equilibrium: Negative & Positive Externalities• MEE = marginal externality effect ~ Negative or PositiveThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.– Socially relevant but outside the market– Negative: MEE = MECPositive: MEE = MEB – Negative: MSC = MPC + MEC Positive: MSB = MPB + MEB• Market equilibrium (Q*) with negative externality– MSB* = MPB* = P* = MPC* <MSC * èMSB <MSC – Activity level should be reduced: Q* is larger than efficient level.• Market equilibrium (Q*) with positive externality– MSB* >MPB* = P* = MPC* = MSC * èMSB >MSC – Activity level should be increased: Q* is smaller than efficient level.Welfare Analysis of Activity Reduction ~ ElectricityBecause Costs avoided are larger than Benefits lost, the reduction of Q improves efficiency. Net Gain is the yellow triangle between MSC and S: ΔabcReducing electricity is both bad and good.Community loses some benefits, but also avoids some costs.Benefits lost are shown by area below D (blue area).Costs avoided are shown by: (a) area below S (grey area ~ production costs) (b) area between MPC and MSC (yellow area ~ environmental


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ISU ECON 201 - Externalities

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