Externalities (a short presentation)

WHY EXTERNALITIES ARE IMPORTANT? Adam Smith’s “invisible hand”: self-interested buyers and sellers maximize the total benefit that society can derive from a market. This is true ONLY if there are no market failures

EXTERNALITIES AND MARKET INEFFICIENCY An externality refers to the uncompensated impact of one person/firm’s actions on the well-being of another person/firm When the impact is adverse, the externality is called a negative externality (smoking; loud stereo; etc.) When the impact is beneficial, the externality is called a positive externality (vaccination; research; etc.) Externalities cause markets to be inefficient, and thus fail to maximize total surplus.

EXTERNALITIES AND MARKET INEFFICIENCY RESULTS in the presence of externalities Negative externalities lead markets to produce a larger quantity than is socially desirable. Positive externalities lead markets to produce a smaller quantity than is socially desirable. Let’s see WHY

Figure 1 The Market for Aluminum Price of Aluminum Supply (private cost) Demand (private value) QMARKET Equilibrium Quantity of Aluminum Copyright © 2004 South-Western

Welfare Economics: A Recap EXAMPLE: The Market for Aluminum The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus. If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers. SOCIAL COST: include the individual cost plus the cost for the society (the negative externality )

Figure 2 Pollution and the Social Optimum Price of Social cost Aluminum Cost of pollution Demand (private value) Supply (private cost) Optimum QOPTIMUM Equilibrium QMARKET Quantity of Aluminum Copyright © 2004 South-Western

Negative Externalities EXAMPLE: The Market for Aluminum SOCIAL OPTIMUM: The intersection of the demand curve and the social-cost curve RESULT: in the presence of a negative externality, the socially optimal output level is less than the market equilibrium quantity.

Negative Externalities How to achieve Socially Optimal Output Internalizing an externality: altering incentives so that people take account of the external effects of their actions. EXAMPLE: government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity.

Positive Externalities POSITIVE EXTERNALITY We have a positive externality when the externality benefits other persons/firms In this case, the social value of the good exceeds the private value. EXAMPLE technology spillover is a type of positive externality that exists when a firm’s innovation not only benefits the firm, but increases society’s pool of technological knowledge and thus benefits society as a whole.

Figure 3 Innovation and the Social Optimum Price of Innovation Social value Supply (private cost) Demand (private value) QOPTIMUM QMARKET Quantity of Innovation Copyright © 2004 South-Western

Positive Externalities HOW TO SOLVE THE MARKET FAILURE Internalizing Externalities Subsidies are the primary method for attempting to internalize positive externalities. Example: Government intervention in the economy that aims to promote technology-enhancing industries Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention. The patent is then said to internalize the externality.

The role of Government When private parties cannot adequately deal with externalities, then the government steps in. The government can either regulate behavior or internalize the externality by using taxes or by issuing permits.