Chapter 5: Externalities, Environmental Policy, and Public Goods

5.1 Externalities and Economic Efficiency

Externalities occur when the actions of buyers or sellers have unintended side effects on third parties not directly involved in the transaction. These spillover effects can lead to market failure, where resources are not allocated efficiently.

• Externality: A cost or benefit from a market activity that affects individuals not directly involved in the transaction.

• Negative externality: Imposes costs on others (e.g., pollution, cigarette smoke).

• Positive externality: Confers benefits on others (e.g., education, vaccines).

• Private cost: Cost directly incurred by the producer.

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

• Private benefit: Benefit received by the consumer.

• Social benefit: 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 fail to achieve economic efficiency when external costs or benefits are not reflected in market prices.

Example: A factory emitting pollution imposes health costs on nearby residents, which are not reflected in the price of the factory's product.

5.2 Private Solutions to Externalities: The Coase Theorem

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

• Coase Theorem: If transaction costs are low, information is complete, and property rights are clearly defined, parties can negotiate to reach an efficient outcome regardless of who holds the rights initially.

• Conditions for success:

  1. Low transaction costs (negotiation is easy and inexpensive).

  2. Full information about costs and benefits.

  3. Clearly defined property rights.

• Key takeaway: When these conditions are met, private solutions can internalize externalities.

Example: If a passenger wishes to prevent the person in front from reclining their airplane seat, they could offer compensation if the cost to them exceeds the benefit to the recliner.

5.3 Government Policies to Deal with Externalities

When private solutions are not feasible, government intervention can help align private incentives with social costs and benefits.

• Corrective (Pigovian) taxes: Taxes imposed on producers generating negative externalities, forcing them to internalize the external cost.

• Subsidies: Financial incentives provided to encourage activities with positive externalities.

Examples:

• A tax on factory emissions equal to the external damage caused by pollution.

• Subsidies for education or vaccination programs to promote beneficial behaviors.

5.4 The Four Categories of Goods

Goods can be classified based on whether they are excludable and rivalrous. This classification helps explain issues like the free rider problem and the tragedy of the commons.

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

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

Chapter 6: Elasticity – The Responsiveness of Demand and Supply

6.1 The Price Elasticity of Demand and Its Measurement

Price elasticity of demand measures how much the quantity demanded of a good responds to a change in its price. It is a key concept for understanding consumer behavior and market outcomes.

• Formula:

• Interpret using the absolute value (ignore the negative sign).

• Elasticity categories:

  • Elastic demand: Greater than 1 (quantity demanded changes by a larger percentage than price).

  • Inelastic demand: Less than 1 (quantity demanded changes by a smaller percentage than price).

  • Unit elastic demand: Equal to 1 (quantity demanded changes by the same percentage as price).

  • Perfectly elastic: Demand curve is horizontal (consumers are extremely price-sensitive).

  • Perfectly inelastic: Demand curve is vertical (quantity demanded does not change with price).

• Graphical interpretation:

  • Steep demand curve – inelastic demand.

  • Flat demand curve – elastic demand.

Example: If the price elasticity of demand is −2, a 1% increase in price leads to a 2% decrease in quantity demanded.

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 (e.g., a specific brand) are more elastic than broadly defined categories.

• Share of income: Goods that take a larger share of income have more elastic demand.

• Necessities vs. luxuries:

  • Necessities (e.g., milk, bread) – inelastic demand.

  • Luxuries (e.g., restaurant meals, designer bags) – elastic demand.

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

Example: The demand for gasoline is more elastic over several years than in the short term, as consumers can switch to more fuel-efficient cars or public transport.

6.3 The Relationship between Price Elasticity of Demand and Total Revenue

Total revenue is the product of price and quantity sold. The price elasticity of demand determines how changes in price affect total revenue.

• Formula:

• Elastic demand (elasticity > 1):

  • Price increase → total revenue decreases.

  • Price decrease → total revenue increases.

• Inelastic demand (elasticity < 1):

  • Price increase → total revenue increases.

  • Price decrease → total revenue decreases.

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

6.4 Other Demand Elasticities

Other types of elasticity measure responsiveness to factors besides price.

• Income Elasticity of Demand:

  • Measures how quantity demanded changes with income.

  • Formula:

  • Positive value: Normal good.

    • Between 0 and 1: Necessity (e.g., bread, milk).

    • Greater than 1: Luxury (e.g., caviar).

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

• Cross-Price Elasticity of Demand:

  • Measures how the quantity demanded of one good responds to the price change of another good.

  • Formula:

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

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

  • Zero: Unrelated goods.

6.6 The Price Elasticity of Supply and Its Measurement

Price elasticity of supply measures how much the quantity supplied responds to a change in price. It is important for understanding producer behavior and market adjustments.

• Formula:

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

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

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

Example: Agricultural products often have inelastic supply in the short run, but more elastic supply in the long run as farmers can plant more crops.