Part

III
Imperfectly Compe00ve Markets

Playconomics, LHS 1
 Imperfect vs. Perfect
Im-perfect = Perfect except that one or more of
the following assump?ons apply:
Consumers/suppliers are price-takers, or
Goods are homogeneous, or
There externali?es, or
Goods are excludable and rival, or
(not full) informa?on, or
free entry and exit.

Playconomics, LHS 2
 Imperfect vs. Perfect
Im-perfect = Perfect except that one or more of
the following assump?ons apply:
Consumers/Suppliers are NOT price-takers,
Goods are NOT homogeneous, or
There ARE externali0es, or
Goods are NOT excludable and rival, or
Imperfect (not full) informa?on, or happens?
So what
NO free entry and exit.

Playconomics, LHS 3
Chapter 9: Externali0es

Playconomics, LHS 4
 Posi?ve Consump?on Externality

Assume Maia likes perfume

Maia derives Marginal Benet from wearing perfume
How much perfume should Maia wear?

Assume Benji siTng next to Maia LOVES Maias perfume
(cant get enough!)
Benji derives External Marginal Benet from Maia wearing perfume
How much perfume should Maia wear?

Playconomics, LHS 5
 Posi?ve Consump?on Externality

Deni0on:
A Posi0ve Consump0on Externality represents a
benet accrued to someone who is not involved
in the consump?on of a given good.

Playconomics, LHS 6
 Posi?ve Consump?on Externality
Say = $2

Playconomics, LHS 7
 Posi?ve Consump?on Externality
Say External Marginal Benet = $2, = $8

Q*priv=4 ! MBsocial=MBpriv+MBext= ! doesnt MAX social surplus

Playconomics, LHS 8
 Posi?ve Consump?on Externality
Say External Marginal Benet = $2, = $8

How about Q*priv=5? ! MBsocial= ! $1 surplus for the 5th unit

How about Q*priv=6? ! MBsocial= ! Max social surplus!!!

Playconomics, LHS 9
 Posi?ve Consump?on Externality
Making consump?on decisions without accoun?ng for their
external benet doesnt allow to max social surplus!
!!
Private op?mal consump?on = 4 units
Social op?mal consump?on = 6 units

Invisible Hand Principle fails!!

Solu0on:

Playconomics, LHS 10
 Posi?ve Consump?on Externality
Benji lets Maia know he likes the perfume
Start :
Maia oers to consume 2 extra units (6 instead of 4) of perfume
in exchange for Benji paying her $2 per each extra unit
MBpriv -5th unit+TransferMaia=$7+$2 >Price($8)
MBpriv -6th unit+TransferMaia=$6+$2 =Price($8)
Benji accepts because the price Maia asks is exactly equal to the
external benet of consuming 2 more units

NO Government!! ! Coase Theorem

Playconomics, LHS 11
 Posi?ve Consump?on Externality

Coase theorem:
If trade in an externality is possible and there
are no transac1on costs, bargaining will lead to
an ecient outcome regardless of the ini?al
alloca?on of property rights.

Playconomics, LHS 12
 Posi?ve Consump?on Externality
Some :
Fitness ac1vi1es
Vaccina1ons
Bike to work
Educa1on
Social networking
Fire protec1on services

Playconomics, LHS 13
 Nega?ve Produc?on Externality

Assume Benji sells hot-dogs

Benji incurs a Marginal Cost for producing hot-dogs
How many hot-dogs should Benji produce?

Assume Maia dislikes the pollu?on Benji produces
Maia incurs an External Marginal Cost from Benjis hot-dog produc?on
How many hot-dogs should Benji produce?

Playconomics, LHS 14
 Nega?ve Produc?on Externality

Deni0on:
A Nega0ve Produc0on Externality represents a
cost incurred by someone who is not involved in
the produc?on of a given good.

Playconomics, LHS 15
 Nega?ve Produc?on Externality
Say = $1

Playconomics, LHS 16
 Nega?ve Produc?on Externality
Say External Marginal Cost = $1, = $3

Q*priv=3 ! MCsocial=MCpriv+MCext= ! doesnt MAX social surplus

Q*priv=2? ! MCsocial=
Playconomics, LHS 17
 Nega?ve Produc?on Externality
Making consump?on decisions without accoun?ng for
their external costs doesnt allow to max social surplus!
!!
Private op?mal produc?on = 3 units
Social op?mal produc?on = 2 units

Invisible Hand Principle fails!!

Solu0on:

Playconomics, LHS 18
 Nega?ve Produc?on Externality
Maia lets Benji know she dislike the pollu?on
Start :
Benji oers to decrease produc?on by 1 unit (2 instead of 3) in
exchange for Maia paying him $1
Benji is strictly beher o with this deal in place. The marginal benet
from the 3rd unit ($3) minus the marginal cost ($3) would have
provided Benji with a surplus equal to $0, which is lower than the
transfer ($1) he receives from Maia. So forgoing the 3rd unit in
exchange for $1 is a good deal for him!
Maia accepts because the price Benji asks is exactly equal to the
external cost she has to incur for 1 extra hot-dog.

NO Government (again)!!
Playconomics, LHS 19
 Nega?ve Produc?on Externality
Some :
Harmful produc1on ac1vi1es (global warming)
Excessive risk-taking
Over-shing

Playconomics, LHS 20
 Externali?es in Large Markets
Many buyers & sellers
smooth private D & private S curves

Playconomics, LHS 21
 Externali?es in Large Markets
Many buyers & sellers smooth private D & private S curves
add externali?es smooth social D & social S curves

Coase condi0ons do not apply anymore!!!

Playconomics, LHS 22
 Externali?es in Large Markets

Coase condi0ons do not apply anymore (high transac0on

costs) ! Government must intervene (subsidy or tax)!
Playconomics, LHS 23
 Externali?es in Large Markets

Subsidy = MBext Tax = MCext

Coase condi0ons do not apply anymore (high transac0on

costs) ! Government must intervene (subsidy or tax)!
Playconomics, LHS 24
Nega?ve Consump?on Externality

Deni0on:
A Nega0ve Consump0on Externality represents
a cost incurred by someone who is not involved
in the consump?on of a given good.

Playconomics, LHS 25
 Nega?ve Consump?on Externality
Some :
Smoking
Alcohol abuse
Driving

Playconomics, LHS 26
 Posi?ve Produc?on Externality

Deni0on:
A Posi0ve Produc0on Externality represents a
benet accrued to someone who is not involved
in the produc?on of a given good.

Playconomics, LHS 27
 Posi?ve Produc?on Externality
Some :
Benecial produc1on ac1vi1es
New produc1on technologies
On-the-job training

Playconomics, LHS 28