Chapter 5: Externalities, Environmental Policy, and Public Goods

5.1 Externalities and Economic Efficiency

Externalities are a central concept in microeconomics, describing situations where the actions of individuals or firms have effects on third parties not directly involved in the transaction. These effects can lead to market failures, where resources are not allocated efficiently.

• Externality: A cost or benefit arising from an economic activity that affects third parties.

• Negative externalities: Harmful effects, such as pollution or cigarette smoke.

• Positive externalities: Beneficial effects, such as education or vaccination.

• Private cost: The cost incurred by the producer.

• Social cost: The total cost to society, including both private and external costs.

• Private benefit: The benefit received by the consumer.

• Social benefit: The total benefit to society, including both private and external benefits.

• Graphical interpretation:

  • For negative externalities, the Social Cost curve lies above the Private Cost curve, leading to overproduction and deadweight loss.

  • For positive externalities, the Social Benefit curve lies above the Private Benefit curve, leading to underproduction and deadweight loss.

• Key idea: Markets are not economically efficient when external costs or benefits are not reflected in prices.

Example: Pollution from a factory imposes costs on nearby residents, which are not accounted for in the factory's production decisions.

5.2 Private Solutions to Externalities: The Coase Theorem

The Coase Theorem suggests that private bargaining can resolve externality problems without government intervention, provided certain conditions are met.

• Coase Theorem: Efficient outcomes can be achieved through negotiation if transaction costs are low, information is complete, and property rights are clearly defined.

• Conditions for success:

  1. Low transaction costs

  2. Full information about costs and benefits

  3. Clearly defined property rights

• Key takeaway: The allocation of property rights does not affect efficiency if these conditions hold.

Example: If a passenger reclines their airplane seat and it bothers you, you could pay them not to recline if your discomfort exceeds their benefit.

5.3 Government Policies to Deal with Externalities

When private solutions are not feasible, government intervention can help correct externalities and improve economic efficiency.

• Corrective (Pigovian) taxes: Taxes imposed on activities that generate negative externalities, forcing producers to internalize external costs.

• Subsidies: Financial incentives for activities that generate positive externalities, encouraging beneficial behaviors.

Example: A tax on factory emissions equal to the external damage caused, or subsidies for education and vaccination programs.

5.4 The Four Categories of Goods

Goods are classified based on whether they are excludable and rivalrous, which affects how they are provided and consumed.

• Excludable: Non-payers can be prevented from using the good.

• Rivalrous: One person's use reduces another's ability to use the good.

Example: National defense is a public good; everyone benefits regardless of payment.

Chapter 6: Elasticity - The Responsiveness of Demand and Supply

6.1 The Price Elasticity of Demand and Its Measurement

Price elasticity of demand quantifies how sensitive the quantity demanded of a good is to changes in its price. This concept is crucial for understanding consumer behavior and for firms setting prices.

• Definition: The percentage change in quantity demanded divided by the percentage change in price.

• Formula:

• Interpret using absolute value.

• Elasticity categories:

  • Elastic (>1): Quantity demanded changes by a larger percentage than price.

  • Inelastic (<1): Quantity demanded changes by a smaller percentage than price.

  • Unit elastic (=1): Quantity demanded changes by the same percentage as price.

  • Perfectly elastic: Demand curve is horizontal.

  • Perfectly inelastic: Demand curve is vertical.

• Graphical interpretation:

  • Steep demand curve: Inelastic demand.

  • Flat demand curve: Elastic demand.

Example: If price elasticity of demand = -2, a 1% increase in price causes quantity demanded to decrease by 2%.

6.2 Determinants of the Price Elasticity of Demand

Several factors influence how responsive consumers are to price changes.

• Availability of substitutes: More substitutes make demand more elastic.

• Definition of the market: Narrowly defined goods are more elastic than broadly defined categories.

• Share of income: Goods that take a large share of income are more elastic.

• Necessities vs. luxuries: Necessities are inelastic; luxuries are elastic.

• Time horizon: Demand becomes more elastic in the long run as consumers adjust.

Example: Demand for Starbucks coffee is more elastic than for coffee in general.

6.3 The Relationship between Price Elasticity of Demand and Total Revenue

Total revenue is affected by the price elasticity of demand, which determines how changes in price impact sales revenue.

• Total Revenue (TR): Price multiplied by quantity sold.

• Elastic demand (>1):

  • Price increase: TR decreases.

  • Price decrease: TR increases.

• Inelastic demand (<1):

  • Price increase: TR increases.

  • Price decrease: TR decreases.

• Unit elastic (=1): Price changes do not affect total revenue.

Example: If demand is elastic, lowering price increases total revenue.

6.4 Other Demand Elasticities

Elasticity concepts extend beyond price, including income and cross-price elasticities.

• Income Elasticity of Demand: Measures how quantity demanded changes with income.

• Formula:

• Positive value: Normal good.

• Positive but <1: Necessity (e.g., bread, milk).

• Positive and >1: Luxury (e.g., caviar).

• Negative value: Inferior good (e.g., second-hand clothes).

• Cross-Price Elasticity of Demand: Measures how quantity demanded of one good responds to price changes of another.

• Formula:

• Positive: Substitutes (e.g., Coke and Pepsi).

• Negative: Complements (e.g., coffee and cream).

• Zero: Unrelated goods.

Example: If the price of Pepsi rises, demand for Coke increases (substitutes).

6.6 The Price Elasticity of Supply and Its Measurement

Price elasticity of supply measures how responsive producers are to price changes, affecting market outcomes and resource allocation.

• Definition: The percentage change in quantity supplied divided by the percentage change in price.

• Formula:

• Elastic supply: Quantity supplied changes significantly with price; supply curve is flatter.

• Inelastic supply: Quantity supplied changes little with price; supply curve is steeper.

• Time horizon: Supply becomes more elastic in the long run as producers adjust production.

Example: Agricultural products have inelastic supply in the short run but more elastic supply in the long run.