Chapter 4: External Costs
4.1 INTRODUCTION We have just seen 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 accommodate situations where external eﬀects vary over time. The theory and the applications focus on the external costs involved with alcohol related driving accidents and the external beneﬁts of preventing contagious diseases. 4.1.1 Deﬁning an Externality External eﬀects occur whenever someone other than the parties directly involved with a trade or transaction is aﬀected. In the health care context, we can think of patients as the ﬁrst party and the physicians and hospitals providing the care as the second party. Then third parties would be everyone else, i.e., the friends and families of the patients, other patients, other doctors and hospitals, and the rest of society. In developing countries, a very important external eﬀect of female education is that women can read labels on medications and thus take only the appropriate tablets. Infant mortality rates decline signiﬁcantly when mothers have had just one year’s education. External eﬀects can be...
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