Beruflich Dokumente
Kultur Dokumente
1 Public bads
1.1 What is an externality?
• An externality arises when the actions of one economic actor affect
DIRECTLY the utility function or production function of another eco-
nomic actor (i.e. not through a market transaction)
• Examples:
Effect on
Direct/Market?
others?
Roommate plays loud rock music X Direct
Consumption of pharmaceuticals con- X Direct
taminates fish stocks
Microsoft hires 10,000 new software X Market
engineers
Company invents drug that makes X Market
people 10x smarter
• First two examples are externalities since they directly affect others.
• Last two examples are not externalities since they impact others take
place through the market
– Negative
– Non-targeted (i.e. affect either all consumers, or all firms, or both)
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• Examples:
• Simple model:
• Market equilibrium:
• Consumer’s problem:
• Firm’s problem:
max pq − µq
q≥0
2
• As before:
0
if p < µ
S
q (p) = anything if p = µ
∞ if p > µ
• Optimal allocations:
• RESULT:
– q ∗ > q opt
– DW L > 0
3
D
– Aggregate demand function: qmkt (p) = 1000 − p
– 10 identical firms with cost function c(qj ) = 5qj2 + eqj , so that
M C(qj |e) = 10qj + e
• Firm’s problem:
• Market equilibrium:
– Equilibrium conditions:
D
1. Prices adjust so that qmkt (p∗ ) = qmkt
S
(p∗ )
2. e∗ = qmkt
S
(p∗ )
S p
– Supply function plus (2) imply that in equilibrium qmkt (p) = 2
p
– Then the market clearing condition is given by 1000 − p = 2
– It follows that
2000 ∗ 1000
p∗ = ,q =
3 3
• Optimality:
– q opt given by M SB = M SC
– M SB = M P B = pDmkt = 1000 − q (where M P B = marginal
private benefit)
– M SC:
∗ cost function convex, so optimal to split production equally
across firms 2
q q q
∗ Total social cost: T SC(q) = 10c 10 = 10 5 100 + q 10 =
3 2
2
q
∗ =⇒ M SC = 3q
– FOCs:
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• Marginal social cost vs. marginal private cost
– M SC = 3q
1000
– M P C = pSmkt (q) = q + e = q + 3
• Why?
5
∗ Externality from consumers to consumers
∗ N consumers with U (q, m, e) = B(q) + m − γD(e)
∗ F firms with M C = µ
∗ N consumers
– Pigouvian tax: τ ∗ = γN D0 (q opt ) imposed on consumers (per unit
of good q)
– Consumer’s problem:
max B(q) − pq − τ ∗ q − γD(e)
q≥0
• Intuition:
• Remarks:
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2.2 Permit markets
• Policy:
• Why?
7
– In equilibrium, p = µ (by CRS cost function of firms)
– q-market: demand curve with permits is demand curve without
permits shifted down by pΠ .
– Then, if pΠ = γN D0 (q opt ), the inverse demand function with per-
mits = M SB, and thus in equilibrium q ∗ = q opt
– r-market: inverse demand curve for permits is equal to demand
curve for q without permits, shifted down by p = µ. Supply fixed
at Π∗ = q opt .
– From the FOCs of the utility maximization problem we get that
p∗Π = γN D0 (q opt ).
– Intuition: cost of permits acts as a per-unit tax, but now the size
of the tax is determined endogenously in the permit market
• Why?
• Why?
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– For both, total revenue raised = q opt γN D0 (q opt ), and thus can
support identical lump-sum transfers to consumers
• Remarks:
3 Public goods
• Key features:
• Examples:
• Simple model:
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• RESULT: q ∗ < q opt ; i.e., there is underproduction of the public good.
• See video lecture for graphical analysis of equilibrium and DWL
• Corrective policy: Pigouvian subsidies
– Policy:
1. Subsidize sale/purchase of good q with subsidy σ ∗ = γN G0 (q opt )
2. Subsidy financed with lump-sum taxes
– RESULT: Optimal Pigouvian subsidy system restores optimality
4 Summary
• With externalities, first welfare theorem fails:
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