Externalities

1
Chapter 10

• Externalities
• (Lecture by D. Boldt on 10/18/01 in Econ 2105-06

2
Externality

• Principle 7 (Ch. 1) Governments Can Sometimes
  Improve Market Outcomes
• Government involvement may be needed in case of a
  Market Failure.
• One example of a market failure is a side effect
  of economic activity known as an Externality.

3
Externality - Defined

• The uncompensated effects that the production or
  consumption of goods have on third parties.
• The impact of one persons actions on the
  well-being of a bystander!

4
External Benefits - Positive Externalities

• The uncompensated benefits that are received by
  individuals who are not directly involved in the
  production or consumption of goods.
• The act of producing or consuming goods
  sometimes generates benefits to others who do not
  have to pay for them.

5
External Costs - Negative Externalities

• The uncompensated costs that are imposed upon
  individuals who are not directly involved in the
  production or consumption of goods.
• The act of producing or consuming goods sometimes
  generates costs to others who are not paid to
  endure them.

6
Examples of Negative and Positive Externalities

• Negative Externality
• Air Pollution from a Power Plant
• Cigarette smoking
• Positive Externality
• Immunizations
• Outside Home Improvements

7
Externalities and Market Inefficiency - Negative
Externalities

• Negative externalities lead markets to produce a
  larger quantity than is socially desirable.
• The Social Costs of production or consumption are
  greater than the private cost or private benefit
  by producers and consumers.
• This leads to market failure.

8
Negative Externalities and Market Inefficiency -
Graphical Example

• Assume that the production process emits
  pollution - negative externality.
• The cost to society of production is larger than
  the cost to the producer.
• The Social Cost includes the private costs plus
  the costs to those bystanders adversely affected
  by the pollution.
• Reflects in a new Supply Curve. . .

9
Negative Externalities and Market Inefficiency -
Graphical Example
Supply Private Cost
Market output before accounting for externality.
Demand Private Value
QMarket
10
Negative Externalities and Market Inefficiency -
Graphical Example
Social Cost
Supply Private Cost
Cost of Pollution
Demand Private Value
QMarket
11
Negative Externalities and Market Inefficiency -
Graphical Example
Social Cost
Supply Private Cost
Cost of Pollution
The optimum output accounts for the externality.
Demand Private Value
QOptimum
12
Negative Externalities and Market Inefficiency -
Graphical Example

• The intersection of the demand curve and the
  social-cost curve determines the optimal output
  level - less than equilibrium quantity.

13
Externalities and Market Inefficiency - Positive
Externalities

• Positive externalities sometimes lead markets to
  produce a smaller quantity than is socially
  desirable.
• The Social Costs of production or consumption are
  less than the private cost or private benefit to
  producers and consumers.
• This leads to market failure.

14
Positive Externalities and Market Inefficiency -
Graphical Example
Supply Private Cost
Demand Private Value
QMarket
15
Positive Externalities and Market Inefficiency -
Graphical Example
Supply Private Cost
Market output before accounting for externality.
Demand Private Value
QMarket
16
Positive Externalities and Market Inefficiency -
Graphical Example
Supply Private Cost
Value of Technology Spillover
Demand Private Value
QOptimal
17
Positive Externalities and Market Inefficiency -
Graphical Example

• The intersection of the demand curve and the
  social-cost curve determines the optimal output
  level - more than equilibrium quantity.

18
Private Solutions to Externalities

• Coase Theorem
• If private parties can bargain to their mutual
  advantage without cost, then the private market
  may solve the problem of externalities and
  allocate resources efficiently.
• Private bargaining can internalize the external
  effects, resulting in efficient solutions
  (bargaining with a neighbor)

19
Failure to Private Solutions Approach

• Sometimes the private solution approach will fail
  because
• The transaction costs (bargaining costs) can be
  so high that private agreement is not possible.
• Failure to achieve a private solution may require
  that the government intervene.

20
Public Policy Toward Externalities

• When externalities are significant and when
  private solutions are not possible, government
  may attempt to solve the problem by
• Command-and-Control policies
• Market-Based policies (taxes or tradeable permits)

21
Command-and-Control Policies

• Usually in the form of regulations
• making certain behavior forbidden
• making certain behavior required
• Examples
• All students must be immunized
• Stipulating levels of pollution emissions
• Requiring certain pollution control devices

22
Market-Based Policies

• Taxes In situations where market failure occurs
  because of externalities, the government can
  attempt to internalize the externality by
• imposing a tax on goods with a negative
  externality.
• implementing a subsidy on goods with a positive
  externality.

23
Market-Based Policies

• Tradable Pollution Permits the voluntary
  transfer of the right to pollute from one firm to
  another.
• Pollution permits which results in a new market
  for these permits.
• Firms that can reduce pollution most easily will
  be willing to sell their permit, for whatever
  they can get.