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Module 3
EXTERNALITIES
Lecture (8 -14)
Topics
3.1 Externalities
3.2 Definition
3.3 Policy Questions
3.4 Revealed Preference Approach to Measuring the Size of
Externalities
3.5 Economics of Negative Production Externalities
3.6 Production Externality
3.7 Negative Production Externalities
3.8 Positive Externalities
3.9 Externalities and DWL
3.10 Private Solution (Coase Theorem)
3.11 Coarse Theorem Symmetric Solution
3.12 Problems with Coasian Solutions
3.13 Public-Sector Remedies for Externalities
3.14 Corrective Taxation
3.15 Subsidies
3.16 Pigouvian Tax/Subsidy
1
Indian Institute Of Technology, Kanpur
NPTEL-Economics-Public Economics
3.17 Regulation
3.18 Price vs. Quantity Approach
3.19 Model of Pollution Reduction
3.20 Two Firms Emit Pollution
3.21 Price vs. Quantity Approach
3.22 Assigning Permits
3.23 Policy Without Uncertainly
3.24 Optimal Policy With Uncertainly
3.25 Price vs. Quantity Approach
3.25.1 Optimal Policy with Uncertainty
NPTEL-Economics-Public Economics
3
Indian Institute Of Technology, Kanpur
NPTEL-Economics-Public Economics
Module 3
Lecture 8
Topics
3.1 EXTERNALITIES
Externalities arise whenever the actions of one party make another party worse or
better off, yet the first party neither bears the costs nor receives the benefits of
doing so.
A classic example of market failure
Externalities can be negative or positive
Is government intervention necessary to combat externalities
Under what conditions can private markets solve the problem
AN EXAMPLE
Externality in the case of primary education: should the government intervene?
Why or why not?
Equity grounds
Moral grounds
Efficiency?
4
Indian Institute Of Technology, Kanpur
NPTEL-Economics-Public Economics
Figure 8.1
Figure 8.1 shows the trend in global warming over the last century.
Although this warming trend has negative effects overall on society, the distributional
consequences vary.
In much of the United States, warmer temperatures will improve agricultural output and
quality of life.
In Bangladesh, which is near sea-level, much of the country will be flooded by rising sea
levels.
3.2 DEFINITION
An externality arises whenever the utility or welfare or production possibility of an
agent depends directly on the actions of another agent.
A negative production externality is when a firms production reduces the wellbeing of others who are not compensated by the firm.
A negative consumption externality is when an individuals consumption reduces
the well-being of others who are not compensated by the individual.
Important distinction between pecuniary vs. non-pecuniary externalities
Pecuniary externalities create third-party effects through
changes in relative prices or asset prices
No direct resource effect like non-pecuniary externalities
5
Indian Institute Of Technology, Kanpur
NPTEL-Economics-Public Economics
6
Indian Institute Of Technology, Kanpur
NPTEL-Economics-Public Economics
there was another option of taking a bus from the parking that costs less. We would not
know whether people would prefer that to walking.
To recap, cost benefit analysis is basically an appraisal technique that tries to place
monetary values on all benefits arising from a project and then compares the total value
with the project's total cost. It has numerous potential applications although there are
inherent difficulties with the issue of valuation.
7
Indian Institute Of Technology, Kanpur