NotesAtHKU

Introduction

Externalities

Market failure is a situation where there is inefficient qualitiy of goods in the free market.

Free market is the best, as social welfare is maximized. Any distortion, such as taxes, subsidies and price controls will cause welfare loss.

Important assumptions behind these results:

When all production costs are the responsibility of suppliers
When all consumption benefits are given to buyers

Externalities are the external costs or benefits that doesn't directly accure to buyers or sellers involved.

Example externalities

Negative externalities: Pollution, traffic congestion, noise
Positive externalities: Education, vaccination, R&D

Private is directly incurred by the buyer or seller
External is incurred by a third party
Social is incurred by the society as a whole: $SX=PX+EX, X \in \{C,B\}$

Recall: we should make decision to maximize TES: *Recall: $MB$ and $MC$ can be directly interpreted as the demand and supply curve.

\begin{aligned} \text{(private) Market equilibrium: } MB & = MC (D = S)\\ MSB & = MB + EB = D + EB\\ MSC & = MC + EC = S + EC\\ \text{Social equilibrium: } MSB & = MSC\\ \end{aligned}

Where $MSB$ is the marginal social benefit (demand) and $MSC$ is the marginal social cost (supply).

Deadweight loss when making private decisions

Notice that $MSB, MSC$ is due to a upwards shift of $D$ and $S$ curves respectively.

The deadweight loss (for making private decisions) is the triangle formed by shifting the curve up, with respect to the equilibrium point.

We can let the market solve the problem itself, or have the government intervene.

Implementing tax and subsidies are costly for the government to implement (requires cost to gather info).

If we know value of externalities $\to$ use pigouvian taxes/subsidies. If we know social optimal output $\to$ use tradable permits.

Property rights

Legal rules stating what people or firms may do with their property.

Coase theorem

Externalities can be solved by market exchange if property rights are well defined and transaction costs are low, regardless of the initial allocation of property rights.

Transaction costs are the cost of making an exchange (deal). It is propto the number of parties involved.

Property rights does not affect efficiency of outcome, but affects distribution of welfare.

Pigouvian taxes and subsidies

We can help achieve the social optimal outcome by providing a tax or subsidy the same as the externality:

ts = E

Note that $E$ should be negative if it is a cost (tax), and positive if it is a benefit (subsidy).

Externalities

Introduction

Externalities

Private, external, social cost and benefit

Social optimality: Decision by margin

Deadweight loss when making private decisions

Achieving social optimality

Property rights

Coase theorem

Pigouvian taxes and subsidies

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