Lecture Notes: Externalities and Market Efficiency

Introduction

• Markets and Gains from Trade: Markets maximize gains from trade.
  • Exchange occurs when the value to consumers exceeds the cost to producers.
• Externalities: Costs or benefits affecting someone not directly involved in consumption or production.
  • Can be negative or positive.

Negative Externalities

• Definition: Additional costs other than those borne by producers and consumers.
• Examples:
  • Pollution: Using electricity creates pollution, affecting people's health.
  • Antibiotic Use: Increases chance of antibiotic-resistant diseases, affecting future patients.
  • Loud Music: Roommate's loud music benefits them but imposes a cost on you.

Private vs Social Costs and Benefits

• Private Costs: Costs borne by the producer.
• Private Benefits: Value received by the consumer.
• Social Costs: Total cost including external costs (e.g., pollution).
• Social Benefits: Total benefits including external benefits.

Example: Roommate's Loud Music

• Demand Curve: Represents marginal private benefit (willingness to pay per hour).
• Supply Curve: Represents marginal private cost (cost per hour).
• Private Equilibrium: Point where marginal private benefit equals marginal private cost.
  • Example: 6 hours of loud music.
• Marginal External Cost: Impact on others (e.g., $6 discomfort per hour).
• Marginal Social Cost: Marginal private cost plus marginal external cost.
  • It is higher than marginal private cost by the amount of external damage.
• Social Equilibrium: Optimal point where marginal benefit equals marginal social cost.
  • Example: 4 hours of music.
• Deadweight Loss: Loss of surplus when the marginal benefit is less than the marginal social cost.
  • Occurs due to overconsumption ignoring negative externalities.

Conclusion

• Not All Exchanges Have Externalities: Only those with impacts outside the market.
• Example of Tacos:
  • Increase in demand raises prices but doesn't create a market inefficiency.
  • Marginal benefits still equal marginal costs; no external damage.
• Market Inefficiency: Occurs when prices don't reflect externalities (e.g., pollution).