Externalities Chapter 10

EXTERNALITIES An externality is the uncompensated impact of one person’s actions on another person –Both positive & negative externalities exist Externalities cause markets to be inefficient –That is, markets do not maximize total surplus

Negative Externalities –Automobile exhaust –Cigarette smoking –Barking dogs (loud pets) –Loud stereos in an apartment building –Noisy Students –Neighbor’s poorly maintained property

Positive Externalties –Immunizations –Restored historic buildings –Research into new technologies –Neighbor’s well maintained property

MARKET INEFFICIENCY Negative externalities lead markets to overproduce Positive externalities lead markets to under-produce MC = MB

Negative Externality: Pollution Equilibrium MC = MB Quantity of Aluminum 0 Price of Aluminum Demand = MB P ( private value ) Supply = MC P ( private cost ) MC T = MC P + MC S Q OPTIMUM Optimum Q MARKET Spillover Cost External social Cost

Positive Externality: Neighbor paints House Quantity 0 Price Demand = MB P (private value) Supply = MC P (private cost) Q MARKET External social benefit Equilibrium Optimum Q OPTIMUM Spillover Benefits MB T = MB P + MB S

Solutions to Externalities Internalizing an externality involves altering incentives Government Methods –Taxes (corrective taxes) –Subsidies –Patents –Laws (immunization laws, pollution laws) Free market solution: –Trading pollution credits

Taxing Negative Externalities Impose Tax = spillover cost Shifts Supply Curve left Reach social optimal output Total Cost = Total Benefit Total Cost = MC P + MC S

Subsidizing Positive Externalities Impose Subsidy = spillover benefit Shifts demand curve right Reach social optimal output Total Cost = Total Benefit

Worksheet Externalities