Unit 6 Chapter 17 Externalities

Discussion Should we as a society strive to eliminate pollution? Should the use of phones in cars be made completely illegal? Should smoking be illegal in all public places?

I. Externalities External costs and external benefits of producing something. The free market fails to include external costs or external benefits.

II. Costs Marginal Social Cost of pollution: additional cost imposed on society as a whole by another unit of pollution. Marginal Social Benefit of pollution: additional benefit to society from another unit of pollution. Socially Optimal Quantity of pollution: quantity of pollution that makes society as well off as possible. Marginal Private Cost: additional cost imposed on the firm by another unit of pollution

Negative Externalities Smog Traffic

III. Negative Externalities External Costs of producing. Ex. Pollution, Oil spill in gulf, Traffic Congestion,

IV. Pollution In the absence of government intervention businesses pollute to much. This is a market failure.

A Market Economy Produces Too Much Pollution Marginal social cost, marginal social benefit MSC of pollution $400 Marginal social cost at QMKT The market outcome is inefficient: marginal social cost of pollution exceeds marginal social benefit 300 Optimal Pigouvian tax on pollution O 200 Figure Caption: Figure 17-2: Why a Market Economy Produces Too Much Pollution In the absence of government intervention, the quantity of pollution will be QMKT, the level at which the marginal social benefit of pollution is zero. This is an inefficiently high quantity of pollution: the marginal social cost, $400, greatly exceeds the marginal social benefit, $0. An optimal Pigouvian tax of $200, the value of the marginal social cost of pollution when it equals the marginal social benefit of pollution, can move the market to the socially optimal quantity of pollution, QOPT. 100 MSB of pollution Marginal social benefit at QMKT Q Q Q Quantity of pollution OPT H M K T emissions (tons) Socially optimal quantity of pollution Market-determined quantity of pollution

Market for Cigarettes P Supply = Marginal Social Cost D= Marginal Socially optimal point D= Marginal Social Benefit Q QFree Market

What will the MC/Supply look like when EXTERNAL costs are factored in? Market for Cigarettes What will the MC/Supply look like when EXTERNAL costs are factored in? P Supply = Marginal Social Cost Supply = Marginal Private Cost D=MSB Q QOptimal QFree Market 10

Market for Cigarettes If the market produces QFM why is it a market failure? P S =MSC S=MPC At QFM the MSC is greater than the MSB. Too much is being produced Overallocation D=MSB Q QOptimal QFree Market 11

Market for Cigarettes What should the government do to fix a negative externality? P S =MSC S=MPC Solution: Tax the amount of the externality (Per Unit Tax) D=MSB Q QOptimal QFree Market 12

Market for Cigarettes What should the government do to fix a negative externality? P S =MSC =MPC MSB = MSC S=MPC Solution: Tax the amount of the externality (Per Unit Tax) D=MSB Q QOptimal QFree Market 13

Thank You for Not Smoking Second-hand smoke is an example of a negative externality. But how important is it? A paper published in 1993 in the Journal of Economic Perspectives found that valuing the health costs of cigarettes depends on whether you count the costs imposed on members of smokers’ families. If you don’t, the external costs of second-hand smoke have been estimated at about only $0.19 per pack smoked. A 2005 study raised this estimate to $0.52 per pack smoked. If you include effects on smokers’ families, the number rises considerably. If you include the effects of smoking by pregnant women on their unborn children’s future health, the cost is immense—$4.80 per pack.

IV. Solutions Coase Theorem: Economy can reach efficient solutions with low transaction costs. Economy can reach solutions on own. Neighbors ex.

Policies Toward Pollution Environmental standards are rules that protect the environment by specifying actions by producers and consumers. Generally such standards are inefficient because they are inflexible. An emissions tax is a tax that depends on the amount of pollution a firm produces. Tradable emissions permits are licenses to emit limited quantities of pollutants that can be bought and sold by polluters. Taxes designed to reduce external costs are known as Pigouvian taxes. 16

Positive Externalities

Positive Externalities Situations that result in a BENEFIT for someone other than the original decision maker. (EX: Flu Vaccines, Education, Home Renovation)

The Impeccable Economic Logic of Early Childhood Intervention Programs One problem facing any society is how to break what researchers call the “cycle of poverty.” Children who grow up with disadvantaged socioeconomic backgrounds are far more likely to also be poor adults. A 2006 study found that high-quality early childhood programs focused on education and health care lead to significant advantages for kids. Children in programs were less likely to engage in destructive behaviors and more likely to end up with a job and to earn a higher salary later in life. Another study in 2003 looked at early childhood intervention programs from a dollars-and-cents perspective, finding from $4 to $7 in benefits for every $1 spent on early childhood intervention programs.

D=Marginal Private Benefit Market for Flu Shots The marginal private benefit doesn’t include the additional benefits to society. P S = MSC D=Marginal Private Benefit Q QFree Market 20

Market for Flu Shots What will the MB/D look like when EXTERNAL benefits are factor in? P S = MSC D=Marginal Social Benefit D=Marginal Private Benefit Q QFM QOptimal 21

Market for Flu Shots If the market produces QFM why is it a market failure? P S = MSC D=Marginal Social Benefit D=MSB Q QFM QOptimal 22

Market for Flu Shots At QFM the MSC is less than the MSB. Too little is being produced P S = MSC D=Marginal Social Benefit Underallocation Q QFM QOptimal 23

Market for Flu Shots What should the government do to fix a negative externality? P Subsidize the amount of the externality (Per Unit Subsidy) S = MSC D=MSB =MPB D=MPB Q QFM QOptimal 24

Positive Externalities and Consumption (a) Positive Externality (b) Optimal Pigouvian Subsidy Price, marginal social benefit of flu shot Price of flu shot Marginal external benefit S S Price to producers after subsidy P MSB O O P OPT Optimal Pigouvian subsidy P E E MKT MKT MKT MSB of flu shots Figure Caption: Figure 17-4: Positive Externalities and Consumption Consumption of flu shots generates external benefits, so the marginal social benefit curve, MSB, of flu shots, corresponds to the demand curve, D, shifted upward by the marginal external benefit. Panel (a) shows that without government action, the market produces QMKT. It is lower than the socially optimal quantity of consumption, QOPT, the quantity at which MSB crosses the supply curve, S. At QMKT, the marginal social benefit of another flu shot, PMSB, is greater than the marginal benefit to consumers of another flu shot, PMKT. Panel (b) shows how an optimal Pigouvian subsidy to consumers, equal to the marginal external benefit, moves consumption to QOPT by lowering the price paid by consumers. Price to consumers after subsidy D D Q Q Q Q MKT OPT Quantity of flu shots MKT OPT Quantity of flu shots

2008 FRQ 2. Vaccinations for contagious diseases benefit the consumers as well as others in the community. Assume that vaccines are produced in a competitive market. (a) Draw a correctly labeled graph of supply and demand, and (i) label the market price “Pm ”, and label the market output “Qm ”. (ii) label the socially efficient level of output “Qs”. (iii) shade the area of the deadweight loss. (b) Is marginal social cost greater than, less than, or equal to marginal social benefit at the market output? (c) How will a tax on producers of the vaccines affect the deadweight loss that you identified in part (a) (iii) ? Explain.

Question 2 6 points (3 + 1 + 2) (a) 3 points: • One point is earned for the correctly labeled graph with Qm and Pm correctly identified. • One point is earned for correctly identifying QS. • One point is earned for shading the area of the deadweight loss. (b) 1 point: • One point is earned for stating that the MSC is less than the marginal social benefit. (c) 2 points: • One point is earned for stating that the tax will increase the deadweight loss. • One point is earned for the explanation that the tax raises the cost and causes output of vaccine to fall.