Externalities

 Remember: there are 3 reasons for market failure, and government intervention  One is the existence of public goods  The next one we will discuss is the presence of externalities  An externality = when the cost or benefit of producing a good/service spills over to individuals who are not producing or consuming the good  Which key economic principle is at work here?  Spillover Principle Externalities

 Why do we use the term “externality”?  Some of the costs/benefits are external to the producer/consumer  What is an example of an externality?  The production of goods that cause pollution  Automobiles add a cost to people in the area who suffer from low air quality, even if they do not drive  There are two types of externalities:  Positive  Negative Externalities

 Negative externalities = a situation in which costs spill over onto someone not involved in producing/consuming the good  Considered an inefficient market  Why?  The projected cost of individual firms in the market (the costs we have been considering so far) we will now refer to as the marginal private cost  Negative externalities increase the costs to other firms  This increases the marginal social cost Negative Externalities

 Marginal social cost = the marginal cost of production as viewed by society as a whole  Found by adding the marginal private cost, and the external costs  Example: Consider a firm that produces electricity, but releases a lot of air pollution in the process  Externality = the extra cost to all firms as a result of the pollution  The social cost will be higher then the private cost calculated by the electrical firm Negative Externalities

 The deadweight loss due to the externality  Too much is produced, because projected costs are lower then actual costs  This generates a new equilibrium price = the socially efficient price Negative Externalities

 Positive Externalities = a situation in which the activity of one firm either decreases costs, or increases benefits to other firms not involved in producing producing the good  Example: Education  One effect of education is more skilled and capable citizens, leading to further innovations and benefits to society  More educated people have better hygiene and are less of a burden on health care  There is also deadweight loss when there is a positive externality  Why? Positive Externalities

 Has an impact on the quantity produced  Not enough is produced when there is a positive externality  Either costs have decreased, or benefit has increased  Therefore, firms have more capital available to pay for inputs and should increase output  Results in a new equilibrium price = the socially efficient price Positive Externalities

 Too much is produced, because projected costs are higher then actual costs OR projected benefits are lower then actual benefits  This generates a new equilibrium price = the socially efficient price Positive Externalities

 Some externalities spread across international borders  For example: sulphur dioxide from electricity generation travels high in the air over large distances  Eventually it falls back to the Earth in the form of acid rain, damaging forests, lakes, etc  Another major externality is global warming and climate change International Externalities

 How can the loss associated with externalities be reduced or eliminated?  In most cases, when externalities are present, production is still provided privately (not by the gov’t)  The government will attempt to influence the behavior of these firms, so that the extra costs are taken into account  internalize = the process of providing incentive so that externalities are taken into account internally by firms or consumers Remedies for Externalities

 There are four ways to return efficiency when there is an externality 1.Private remedies 2.Command and control remedies 3.Taxes and subsidies 4.Tradable permits Remedies for Externalities

 Involves agreements between individual firms/consumers in order to account for the extra cost  Could involve an exchange of services  NO GOVERNMENT INTERVENTION  In order to determine who is at fault, and who is the victim being affected by the externality, we must investigate property rights.  Property rights = rights over the use, sale, and proceeds from a good or resource  Property rights are used to determine who actually pays for the adjustment that fixes an externality Private Remedies

Command and Control Remedies  Restrictions and regulations placed on individuals or firms  Example: a cap on the amount of pollution that can be emitted Taxes and Subsidies  A good that produces an externality, such as coal, is given a tax to increase the price Tradable Permits  A firm receives a permit in order to generate a certain amount of an externality (such as pollution)  If they can reduce the externality, they can then sell their permit Government Intervention

 You will write a proposal to the Canadian government advising them on ways in which the countries current emissions of carbon dioxide can be reduced  CO 2 is a greenhouse gas responsible for global warming  Your proposal must include:  Explain how carbon dioxide is a negative externality  4 ways to account for this externality (one for each method in the previous slides) Activity