Chapter 4: External costs
We have just seen, in Chapter 3, one reason why market prices may not reflect costs, that is, because markets may be imperfect. When external effects exist, even perfect market prices may be incorrect indicators of social value. The competitive market equilibrium output with external effects could be under or over the level that is most desirable. We first define an external effect and explain how this drives a wedge between private and social evaluations. We next look at the relation between external effects and markets. Then we extend the analysis to consider external effects when there are two interdependent markets and accommodate situations where external effects vary over time. The theory and the applications mainly focus on the external costs involved with alcohol-related driving accidents and the external benefits of preventing contagious diseases.
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