Externalities

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B B = '
B = C D
Externalites
= ~ _ ' - - = ``
_- ' -- ~ -`- =
= ``
-' - ' ~ A -' B
=`
-' A -' - B - -
( =` -`= = ) `
-' -~ A -' - = B ` '
= ``
` -- = -=- - ~ _- = ``
.-- =-

_ -~- .= A - - .--
-' B -` ` =- -~ -
= `` = - ~ .-- ~
2
( _ ) -=
(- ) -~
.`
setilanretxE
= ``
Mu oI good 1
Mu oI good 2
~ .- u
E
-- x
EE
~ .- u
E
-- x
E?
X
E?
- 1
X
EE

) 1 ( Person
-~ =-
) 2 ( Person
F
E

~
F
?

1 -= Altruistic - ~
E E G
E
HxI J x
EE
x
E?
K x
?E
L
E
HE@ M @ H
2 SelIish - ~

? G
E
HxI J F
EE
F
E?
K F
?E
L
?
HE@ M @I
.` ~ -
G
E
HFI J F
EE
F
E?
K F
?E


N J F
EE
F
E?
K E@ $ F
EE

Pareto optimal allocation .- -= ` *
Where locus oI tangency point oI two individuals
indeIerence curve
MRS Ior peson 1

3
O
where
F
?E
J E@ $ F
EE P
F
??
J E@ $ F
E? Q
N
E
?
ymonoce egnahcxe na ni seitilanretxE

Mu oI good 2 ~ .- u2 -- x
??
~ .- u
?
--
?E
x
X
EE
X
??
E@ $ F
E?
10 X
11
P2
P2
` .`
MRS MRS
F
E?
R E
X
EE
E@ $ F
E?
10 X
11

10
Mu oI good 1
?E
x
Q

MRS Ior peson 2





-= F
??
10 F
E?
~

-= F
?E
10 F
EE
~
. - ~




X
EE
HE@ $ F
E?
I J HE@ $ F
EE
I HF
E?
$ E H
E@ x
EE
$ F
EE
F
E?
J E@ F
E?
$ E@ $ F
EE
F
E?
K F
EE
SF
EE
K E@ J E@ F
E?
F
E?
J E K F
EE
EIIicency locus I there is externality
he eIIiciency locus must have this euation

A
Q
P
O A
T
F
?E
Person
P>Q

ind the pareto optimality solution oI this example
o calulate a competitive euilirium

We assume that person and price taers
We assume that person does not now that

= G
E
Hx H
~ U (giIt ~ = ` (


` _--
Where V
E
price oI good 1
Where V
?
price oI good 2
Person ?
F
?
?
Pareto
optimal
angency
points
( externality )
( no externality)
iI the two
consumer have
F
EE
J F
E?

Q
P>Q
Q

F
E
?
E
F
EE
E E ?
?
E F
??
J E@ $ F
E?
E
WersXn
n _= ` ~ - F
?E
?
W
E
F
EE
K V
?
F
E?
K V
E
U J E@V
E
W
E
F
?E
K V
?
F
??
J E@V
?
Q
Q>Q
X
E?
- 1
?F
EE
J E@ F
EE
J Q
~
10

10


.` - =`~` = ` 1 - F
E?
.` -= =`~` = 1 - E
Where Mu oI good 1 Ior person 1
YX ZX[Vetiti\e e]^ili_ri^[ is
P ( 11 (
~ --``
.` W
E
F
EE
K W
?
F
E?
K U J E@ W
E
Where P
1
1 P
2
1
U J `erX
F
EE
J F
E?
So F
EE
K F
E?
K `erX J E@
F
EE
J F
E?
So
` -- .`-
W
E
F
?E
K W
?
F
??
J E@ W
?
F
?E
K F
??
J E@
F
E?
J E K F
EE
ow consider the allocation y deIined y -
a
E?
J E K

a
EE
Where y is some allocation

I a
EE
J Q

I F
?E
1
Person 1 will choose U J @
` -~ =
F
EE
J F
E?
J F
?E
J F
??
J Q
U J `erX
b b b b
?F
?E
J E@ F
?E
J Q
T
S
E@
so a
E?
J E K

cQ J Q>Q

deere is tfX teeXrg Rh
1 - it is not pareto optimal when there are externalities present
2 - any Pareto optimal point can e viewed as acompetitive
euilirium allocation given appropriate cash transIers

.-= .= . -`= - =- pareto optimality
1 - -`= cash transIer
2 ` susidiy

a
EE
a
E?
i

jirst kase transler
X
E?
1
X
EE
E@ $ F
??
R E S $ F
??

E@ R F
?E
E@ $ F
?E
F
?E
X
??
MRS
.`
MRS
`
~
S $ F
??

E@ $ F
?E
F
??

F
?E

P
1
P
2

10
~` -
P
2
10 P
1
P
2
10 P
21
F
??

F
?E

10

W
E
W
?
Price taer W
E
W
?
10 ~` - W
?
J 10 W
E
W
?
10 W
?

W
E
F
EE
K W
?
F
E?
K W
E
U m E@ W
E
K d
E
.`
W
E
F
?E
K W
?
F
??
K m E@ W
?
K d
?
`
1 ~ 2 . =~-
ompetitive mechanism with cash transIer
~ Page 2
MRS Ior peson 1
"# 1# F
EE
J E@ $ F
?E
F
?E
J E@ $ F
EE
F
E?
J E@ $ F
??
F
??
J E@ $ F
E?


MRS Ior peson 2

A O
O
P
Q
A
S
E@
EE
F
??
F
?E

10
F
??

10

F
?E
HS $ F
??
I J F
??
HE@ $ F
?E
H
S F
?E
$ F
?E
F
??
J E@ F
??
$ F
?E
F
??
S F
?E
J E@ F
??
_ = - 2 . a
?
Person 2 want to maximie G
?
HFI J F
?E
F
??

Y^_neZt tX eis _^oet W
E
F
?E
K W
?
F
??
m E@ W
?
K d
?
So

So Irom euation 11
So F
??

W
E

x
?E
J Q
F
E?
$ E
F
EE
- 1

10
X
EE
10
11
10 10
X
E?
11

- .=
W
E
J S M W
?
J E@ M F
?E
J Q M F
??
J P>Q
Person 2 udgets is W
E
F
?E
K W
?
F
??
J E@W
?
K d
?
I S c Q I K H E@ c P>Q J H E@ c E@ K d
?
PQ K PQ J E@@d
?
YX d
?
J $ E@
- ~` -` W
E
J S
W
?
J E@
) =- .` ( 1 = g
W
E
J S M W
?
J E@ M F
EE
J Q M F
E?
J Q>Q
Person 1 udgets is W
E
F
EE
K W
?
F
E?
J E@W
E
K d
E
- U J `erX
I S c Q I K H E@ c Q>Q J H E@ c S K d
E
PQ K QQ J S@ K d
E
YX d
E
J E@
MRS Ior peson 1

But his private MRS
So private MSR Ior person 1 p price ratio

p
So he will never choose a
E
when P ( 10 (
10

10
11
10

udget
udget
But
MRS Ior person 2 = price ratio

So person 2 will choose g
?
when P ( 10 (
- ash transIer . Pareto optimalit
_ =`~ ' -- = `` `
) ' --~ d) Simple cash transIer - .- `
Pareto allocation
~`- =- --= - ` `
- .`
2 1 == ` -= 1
2 1 -= ` ~
== `
-= ` ~ 2 . 1
Person 1 W
E
F
EE
K W
?
F
E?
m E@W
E
K d
E

Person 2 HW
E
$ sI F
?E
K W
?
F
??
m E@W
?
Kd
?
` -= =` 1 ~ ~ 1 -- 2
11
YeZXno WiUX^\ian taxes ano s^_sioes

F
E?
F
EE

11
10
F
E?
F
EE

10
11 W
E
W
?

11
10

or example suppose that

a
E
J HQ M Q>QI M a
?
J HQ M P>Q H

.` --
is udget is W
E
F
EE
K W
?
F
E?
J E@W
E
K d
E
I d
E
ero so W
E
F
EE
K W
?
F
E?
J E@W
E
-= - F
EE
J Q F
E?
J Q>Q
YX QW
E
K Q>QW
?
J E@W
E
QV
E
J Q>QW
?
W
E
J W
?
~ - .= - W
?
10
I W
?
10 W
E
c 10 11

Private MRS Ior person 1
So Private MRS Ior person 1 Price ratio

So person 1 will choose y
1
when p ( 10 (
Because there is the marginal rate oI sustition condition
` --
his udget is HW
E
$ YI F
?E
K W
?
F
??
J E@W
?
K d
?

note that its udget aIter susidy
ow W
E
J EE M W
?
J E@ M F
?E
J Q x
??
J PQ
) 11 s) (10 * ) 10 * 10
2
s 100 d
?
YX d
?
J R Qs
12
F
??
F
?E

10
W
E
R s
W
?
11 - s
10
W
E
R s
W
?
11 - 2
10

10
10

10

MRS Ior person 2

Price ratio
I Y J ? So

So private MRS Ior person 2 Price ratio

YX VersXn ? fill ZeXXse g
?
feen V J H S M E@ H
dee ZX[Vetiti\e [eZeanis[ fill taqe tee eZXnX[g tX VaretX
XVti[al allXZatiXn g
YX s^_siog is tee linq _etfeen ZX[Vetiti\e ano XVti[alitg

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