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Topic 1(e): Three normative questions

Topic 1(e): Three normative questions. What have we learned about efficiency so far? If we take as given the quantity of a good, we should: distribute that quantity among consumers such that MBs are equal.

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Topic 1(e): Three normative questions

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  1. Topic 1(e): Three normative questions • What have we learned about efficiency so far? • If we take as given the quantity of a good, we should: • distribute that quantity among consumers such that MBs are equal. • or, more strictly, keep allocating the good towards the high MB consumer and away from the low MB consumer, so long as such reallocations are feasible. • have that quantity produced in such a way that MCs are equal • or, strictly, keep allocating responsibility for production towards the low MC firm and away from the high MC firm, so long as such reallocations are feasible. • But what quantity of the good should be produced? • The efficient quantity is that where MB=MC. • or, strictly, we should produce more a good if MB > MC, and less of a good if MB < MC.

  2. Topic 1(e): Three normative questions Suppose Q = QL. Then NB = TB - TC = area A. Note: we are not specifying a P, so we say anything about the distribution of A. P S (MC) A But recall: distribution does not matter for efficiency. D (MB) Question: Can we make NB bigger by choosing a different Q? Q QE QL QH • Yes. If we Q, then NB will . • NB because TB by more than VC (because MB > MC). • True until Q to QE. • Similarly, if Q = QH, if we Q, then NB will . • NB because TB by less than VC (because MB < MC).

  3. Topic 1(e): Three normative questions Only when MB = MC for the last unit produced and consumed is it true that NB is maximized. P S (MC) Maximized NB D (MB) Q QE Note that this means that the NB generated by the last increment to Q = 0. Can define Marginal NB (MNB) = MB - MC.  The efficient level of output is where MNB = 0.

  4. Topic 1(e): Three normative questions P For instance, if Q = QL, then DWL = A. NB could  by A if Q to QE. Note: the existence of DWL  potential for an increase in NB S (MC) A D (MB) Consumers’ willingness to pay for extra Q > VC of production, by the area A. Q QE QL Some terminology: If we have a situation that is inefficient, we know that NB are not maximized. Difference between potential NB and actual NB = measure of efficiency loss. Deadweight loss (DWL) = potential NB - actual NB  Actual NB < potential NB.

  5. Topic 1(e): Three normative questions • Recall the normative questions : • Who should consume them? • MBA = MBB • What quantity of goods should be produced? • MC = MB • Who should produce them? • MCA = MCB

  6. Topic 1(f): Market successes • Positive questions: • What quantity of goods is produced? • S = D • If S curve reflects all costs of production and D curve reflects all benefits from consumption, then MC = MB. • Who does produce them? • Each producer choose Q where P cuts S.  MCA = P & MCB = P  MCA = MCBif producers all face the same price. • Who does consume them? • Each consumer choose Q where P cuts D.  MBA = P & MBB = P  MBA = MBBif consumers all face the same price. Tells us the conditions that must hold for market outcomes (i.e. equilibrium) to be efficient (i.e., for markets to succeed).

  7. Topic 1(f): Market successes • Our focus will be on instances where • The S curve does not really measure all costs • The D curve does not really measure all benefits. • That is, our focus is on markets in which there are externalities. • Externality: When activities within a market affect those not directly participating in the market. • An externality can be negative or positive. • Externalities can be caused by production or consumption behavior. • We will focus on negative production externalities. • Specifically, where there are environmental costs that firms might not account for of their own accord.

  8. Topic 1(f): Market successes • Our focus will thus be on instances where market outcomes may not be efficient. • That is, examples of market failures. • Our focus will be on market failures arising because some environmental costs (and benefits) are not accounted for within markets. • We will also: • Examine various policy instruments designed to correct these market failures. • Think about ways in which environmental costs and benefits can be measured.

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