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 P Q S (MC) D (MB) QLQL A Suppose Q = Q L. Then NB = TB - TC = area A. Note: we are not specifying a P, so we say anything about the distribution of A. Yes. If we  Q, then NB will . – NB  because TB  by more than VC  (because MB > MC). True until Q  to Q E. Similarly, if Q = Q H, if we  Q, then NB will . – NB  because TB  by less than VC  (because MB < MC). QEQE QHQH Question: Can we make NB bigger by choosing a different Q? But recall: distribution does not matter for efficiency.

3 Topic 1(e): Three normative questions P Q S (MC) D (MB) Only when MB = MC for the last unit produced and consumed is it true that NB is maximized. 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. QEQE Maximized NB

4 Topic 1(e): Three normative questions P Q S (MC) D (MB) QLQL A For instance, if Q = Q L, then DWL = A. NB could  by A if Q  to Q E. Note: the existence of DWL  potential for an increase in NB 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 QEQE  Actual NB < potential NB. Consumers’ willingness to pay for extra Q > VC of production, by the area A.

5 Topic 1(e): Three normative questions Recall the normative questions : 1.Who should consume them? –MB A = MB B 2.What quantity of goods should be produced? –MC = MB 3.Who should produce them? –MC A = MC B

6 Topic 1(f): Market successes Positive questions: 1.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. 2.Who does produce them? –Each producer choose Q where P cuts S.  MC A = P & MC B = P  MC A = MC B if producers all face the same price. 3.Who does consume them? –Each consumer choose Q where P cuts D.  MB A = P & MB B = P  MB A = MB B if 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.