Slide 1
Slide 3
Market Efficiency
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If it is true that:
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Econ 410: Micro Theory
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Market Efficiency & Externalities
Monday, October 15th, 2007
Then the First Fundamental Theorem of
Welfare Economics states that:
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The market allocation of goods & services is
Pareto-efficient.
When do these conditions fail to hold?
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Slide 2
All producers and consumers act as perfect
competitors (without any market power)
A market exists for all commodities
Asymmetric Information
Externalities
Slide 4
Market Efficiency
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Introduction to Welfare Economics
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Pareto Efficiency
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Market Efficiency
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An allocation of goods and services is Pareto
efficient if 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 $1.00
Market Failures
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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
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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 5
Slide 7
Externalities
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Externalities can be positive or negative
Positive Externality Example
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Negative Externalities
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There is a MEC of “annoyance”
from cell phone calls.
The MSC reflects the true cost of
the call. The optimizing caller
will receive q1 calls in class
while the efficient number of
cell phone calls is q*.
MB1
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 6
The optimizing caller will
receive q1 calls in class
MC
Negative Externality Example
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MSC
MB
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.
MEC
q*
q1
Cell Phone Calls
Slide 8
Negative Externalities
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Negative Externalities
Example – Cell phone use
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Marginal Cost of cell phone use (MC)
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MSC
MB
there is a social cost to the class.
MSCC
S = MCC
Aggregate
social cost of
negative
externality
P*
MB1
P1
MSC = MC + MEC
Marginal benefit (MB) – The (private) benefit
you receive from talking on your cell phone.
“Price”
MC
As the call gets longer, the annoyance increases
Marginal social cost of cell phone use (MSC)
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What happens if the whole class
takes cell phone calls? By not producing at the efficient level,
Marginal external cost of cell phone use
(MEC) - The “cost” to each of your classmates
for their annoyance at listening to your call.
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Per-minute charge
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MECC
MEC
D
q* q1
Cell Phone Calls
Q*
Q1
Class calls
Slide 9
Slide 11
Negative Externalities
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Positive Externalities
Negative externalities
encourage inefficient
individuals or firms to
remain in the market
Value
MSB
A self-interested home owner invests
q1 in repairs. The efficient level of
repairs q* is higher. The higher price
P1 discourages repair.
D
This creates excessive
production of a good in
the long run
MC
P1
P*
MEB
q1
Slide 10
When there are positive externalities
(the benefits of repairs to neighbors),
marginal social benefits (MSB) are
higher than marginal benefits (D).
q*
Repair Level
Slide 12
Positive Externalities
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When positive externalities are present,
the market outcome can result in too
little of a good being produced.
Correcting Market Failures
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Book Example – Home Repair
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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.
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MSB = MEB + D
What can we do to correct the potential
market failures that could arise from
externalities?
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Example – Pollution
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Policies that equate the private costs/benefits
of production to the social costs/benefits
The social harms (MSC) from pollution
increase as emissions levels increase. Why?
But, eliminating externalities is costly
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The marginal cost of abatement (MCA), or
reducing emissions, increases with the
amount reduced. Why?
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Slide 15
Correcting Market Failures
Correcting Market Failures
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The efficient level of
emissions is where
MCA = MSC.
Dollars/ Unit
of Emissions
MSC
6
Emissions Standard
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Set a legal limit on emissions at E* (12)
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Enforced by monetary and criminal penalties
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4
At Eo the
marginal cost
of abating
emissions is
greater than
the marginal
social cost.
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At E1 the marginal social
cost is greater than
the marginal benefit.
2
0 2
E0
4 6
8
10
12
E*
14
16
E1
18 20
22
24
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26
Level of Emissions
Slide 14
Emissions Fee
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MCA
Increases the cost of production and the
threshold price to enter the industry
Charge levied on each unit of emission
Both policies are considered to be market
distortions, where the 1st fundamental
welfare theorem does not hold.
Slide 16
Correcting Market Failures
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Several methods for encouraging firms
to reduce emissions have been
attempted, including:
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Emissions standards
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Emissions fees
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Tradable emissions permits
Suppose the government is considering
2 options to reduce emissions:
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Setting an emissions standard
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Charging a “fee” (tax) on emissions
Correcting Market Failures
What are the hidden costs to society associated with an emissions standard?
Dollars/ Unit
of Emissions
MSC
Standard
Fee
3
E*
12
MCA
Level of Emissions
Slide 17
Slide 19
Correcting Market Failures
For next time…
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MSC
Dollars/ Unit
of Emissions
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If a tax of $3
per unit of
emissions is
imposed…
The firm will reduce
emissions until the
marginal cost of
abatement is equal to
the fee for not reducing.
E*
3
Total Fee
of Abatement
Total
Abatement Cost
12
MCA
Level of Emissions
Slide 18
Correcting Market Failures
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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.
We’ll look at the benefits and drawbacks
of using a variety of government policies
to correct externalities
Please read:
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Sections 18.2 and 18.3 of your text
Assignment:
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Due Wednesday at the beginning of class