Microeconomics 2 John Hey. Lecture 32 Externalities – where the actions of one agent directly affects the welfare of another (not indirectly through a.

Microeconomics 2

John Hey

Lecture 32

• Externalities – where the actions of one agent directly affects the welfare of another (not indirectly through a market).

• In consumption…• …can be positive (nice smells from someone else)…• …or negative.• In production…• …can be positive (my factory provides heat to yours)…• …or negative.• In this lecture I will just analyse negative externalities.

Bari"Se Parigi avesse il mare, sarebbe una piccola Bari"

• My first example is inspired by my 7 years in Bari. (pictures courtesy of Wikipedia – except the last which is mine)

Externalities in Consumption

• Bad music…

• I like silence. So I do not like bad music played at high volume…

• … but my (mercifully ex-) neighbours in Bari loved terribly bad music at high volume.

• So when they played very loud music it was a negative externality for me.

• What happened? • What should have happened? (Depends on the law.)

• Let’s go to Maple...

Externalities in Production

• Two firms…• One is a steel producer...• …the other is a fishery.• They are both located on the banks of a river.• With the steel producer upstream of the

fishery…• …polluting the river…• …and creating a negative externality for the

fishery.• Let’s return to Maple...

Summary

• The existence of an externality can result in an inefficiency.

• The assignment of property rights, combined with competitive exchange, can eliminate this inefficiency.

• There are clearly other ways; for example in production:• The government can tax the polluter and pay the

proceeds to the polluted (implicitly creating a price for pollution – but not one driven by efficiency).

• The two firms can merge.• The government can issue pollution permits that firms

can trade.

Lecture 31

• Goodbye!