EXTERNALITIES

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EXTERNALITIES

• ENVIRONMENTAL ECONOMICS

Dr. Fidel Gonzalez Department of Economics and
Intl. Business Sam Houston State University
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MARKET FAILURES EXTERNALITIES
Up to this point we have seen that the market
provides the most efficient allocation.
Now, we will see that some cases the market does
not achieve an efficient allocation
We this happens we call it Market Failure the
market does not achieve an efficient allocation
In these cases there is a good reason for the
government to intervene.
One reason why we have a market failure is
because of externalities.
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MARKET FAILURES EXTERNALITIES
Externalities the uncompensated impact of a
person or firms activity on the well-being of a
bystander.
The key word of this definition is
uncompensated.
Imagine a Steel factory outside Detroit.
When the factory produces steel emits CO2 that is
harmful to the inhabitants of the city.
In this case, the market will not generate an
efficient allocation. Why? Lets see.
Benefits
The consumers of steel benefit from steel
production because the steel is useful to build
houses, buildings, cars, etc.
Costs
It is costly to produce steel, the firm has to
use resources to produce.
Also, the production of steel is costly because
it produces emissions and that damages peoples
health.
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MARKET FAILURES EXTERNALITIES
The private benefits is the benefit to the person
or firm undertaking the activity.
Social Benefit is the benefit to everyone in the
society from the production of steel.
Since the only one that gets a benefit from the
production of steel are the consumers in this
case the private benefit is equal to social
benefit.
The first set of cost of producing steel are
private because the firm is the only paying for
them.
The second set of costs (health damages) are paid
by everyone that lives in Detroit regardless of
whether they work in the factory or not.
In this case
private cost lt social cost
Social Cost
Private Cost

• The cost to produce steel
• Health Damages to the city

• The cost to produce steel

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MARKET FAILURES EXTERNALITIES
Social Cost
Private Cost
Private Benefit

• The cost to produce the cigarette.
• Health Damage to City

• The cost to produce steel

• Using steel

Only consumers of steel get it.
These are paid for by the firm.
These are paid for by the firm and the city
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MARKET FAILURES EXTERNALITIES
When the firm and consumer decides how much to
produce and buy they will only consider their
own marginal cost and marginal benefit.
Q Using our previous numbers what will be the
amount of steel produced ?
A Remember to find the quantity at which the
marginal cost marginal benefit
In this case, the production is 3 tons of steel
P
SMC
P3
DMB
D1
steel
3
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MARKET FAILURES EXTERNALITIES
This quantity of cigarettes in the market is not
efficient.
As a society we want the marginal benefit of any
activity to be equal to the marginal cost
In other words as a society we want the social
marginal cost social marginal benefit
The market will produce too much steel (3)
compared to the socially optimal level (2)
Social Marginal Cost
P
SPrivate Marginal Cost
Pe4
P3
DMB
D1
steel
3
2
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MARKET FAILURES EXTERNALITIES
Consumers and Produces only consider their
private cost and benefit when deciding how much
to buy and produce.
They do not consider the external effect, that is
the effect of pollution to the other people in
Detroit.
Social Marginal Cost
P
SPrivate Marginal Cost
P3
DMB
D1
steel
3
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MARKET FAILURES EXTERNALITIES
The total damage to the city is the area under
the Social Marginal Cost and the Marginal Private
Cost
The marginal environmental damage (MED) is the
vertical distance, for a given level of steel,
between the SMC and the PMC In the graph on the
left only the red part of the line is the (MED)
of the second first unit. As you can see the sum
of all these lines is equal to the shaded blue
area. Hence, we can state that
Shaded area is the total environmental damage of
still production
SMC
P
SPMC
P3
DMB
steel
3
1
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TYPES OF EXTERNALITIES
Externalities can be divided in many different
ways. On the type of effect.
1) Type of effect imposed on the bystander
A) A negative externality imposes a negative
uncompensated effect on the bystander
- Smoking in a closed space - Water
pollution from a factory - Crying baby in an
airplane - Air pollution from a
refinery - Pollution from driving a car -
Sick student
Our example with Jay and Tony illustrates a
negative externality
private cost lt social cost.
private marginal cost lt marginal social cost.
The market provides a too much of this activity
compared to the socially optimal level. Ex
Market produces 3 tons of steel instead of 2
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TYPE OF EXTERNALITIES
B) A positive externality imposes a positive
uncompensated effect on the bystander.
- Vaccination - An improvement in the façade
of my neighbor house - Education - Research
in new technologies
private benefit lt social benefit
private marginal benefit lt marginal social
benefit.
In the case of positive externalities, the market
will get Q but the socially efficient allocation
is Qe.
SPrivate Marginal Cost
P
Pe
The market provides a low level of education
compared to the socially optimal level.
P
Social Marginal Benefit
DPrivate Marginal Benefit
Education
Q
Qe
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EXTERNALITY TYPES
We can also divide externalities based on the
type of activity
1) Type of activity
A) Consumption externality the externality
affects the consumption of the bystander in a
positive or negative way.

• Listening to loud music affects the consumption
  of peace time.
• Pollution from driving a car affects the
  consumption of clean air

B) Production externality the externality
affects the production relationship of a good or
service produces in a positive or negative way.

• Electricity using carbon fuel can makes the
  production of clean clothes (laundry) more
  difficult since it makes the clothes dirtier
• Pesticides to produce some goods pollute water
  and that affects the production of fish.

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EXTERNALITY TYPES

• Imagine that SHSU decides to buy a car for all
  the students and faculty. As you can imagine this
  will increase the demand for cars and the market
  price for cars will increase.
• Consumers of cars not related to SHSU will be
  affected as they will have to pay higher prices.
• This is a negative effect on a bystander.
• Question How does this compare to the case of
  the bystander that live in Detroit and have to
  suffer the pollution of the steel factory?
• These are two different types of externalities
  pecuniary and technological.
• Pecuniary the primary effect of the externality
  is in the price this is the case of SHSU buying
  cars for students and faculty.
• Technological the effect of the externality is
  on real variables this is the case of the
  pollution.

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PECUNIARY EXTERNALITIES
Pecuniary externality is not really a problem
because the market still allocates goods and
services in an efficient way. At the equilibrium
point SMCPMCPMBSMB. Look at the production
possibility frontier of an economy that can
choose between cars and computers
Cars
When SHSU decides to buy the cars the number of
cars produced in the economy increases and the
number of computers decreases, it goes from point
A to point B. However, the economy moves along
the PPF, so it is still an efficient allocation
of resources.
B
A
Computers
Hence, we will not study Pecuniary externalities
but it is important that you know the difference.
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TECHNOLOGICAL EXTERNALITIES
Technological externalities are a problem because
they affect the social benefits and costs.
Positive Technological Externality PMB
ltSMB. Negative Technological Externality PMC lt
SMC The market solution is PMCPMB but it is
SMC?SMB. Hence the market is not
efficient. Observe the PPF in the presence of
technological externality
The car production pollutes the environment and
reduces the amount of clean air that we can all
enjoy. This reduces the curvature of the PPF. The
only two point where the two PPFs are the same
are at the x and y intercept. That is, the
maximum amount produced of each good is still
possible.
Cars
PPF original
PPF exter
Clean Air
Negative technological externalities are bad
because they reduce the PPF and we are at a point
that before the externality war inefficient. In
general when we talk about technological
externalities we called them just externalities.
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EXTERNALITY SOLUTIONS
How can we solve the problems of externalities?
In other words, how can we get to the point where
social marginal cost social marginal benefit
1) Tax or subsidy government imposes a tax
(subsidy) to reduce (increase) the quantity in
the market and set the social marginal cost equal
to the social marginal benefit.
2) Permits government sets the quantity produced
in the market and issues permits to undertake the
activity producing the externality.
3) Private solution (coase theorem) if the
government defines the rights of the parties
involved there will be no externality.
4) Command and Control Policies the government
decides the activities taken by the firms.
Solutions 1 and 2 are called market based because
the government uses market instruments to obtain
the optimal level of pollution.