Warm-Up PHATS=$2; Wage rate=$15

Warm-Up Answers

CHAPTER 17: EXTERNALITIES (PAGES 434-440; 446-450) Introduction to Externalities CHAPTER 17: EXTERNALITIES (PAGES 434-440; 446-450)

Private vs. Social Impacts Decisions can have PRIVATE and EXTERNAL impacts EXAMPLE: Home Improvement Private = nicer house for you External = higher property values

Externalities Occur when there are external impacts Can be either positive and negative Negative = external cost Positive = external benefit

What Type of Externality? Negative

What Type of Externality? Negative

What Type of Externality? Positive

Externalities = Inefficiency Marginal social cost, marginal social benefit Marginal social cost, MSC, of pollution Socially optimal point O $200 Marginal social benefit, MSB, of pollution Q Quantity of pollution OPT emissions (tons) Socially optimal quantity of pollution

Externalities = Inefficiency 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 O 200 100 MSB of pollution Q Q Q Quantity of pollution OPT H M K T emissions (tons) Socially optimal quantity of pollution Market-determined quantity of pollution

Negative Externality

Positive Externality

How can we overcome the inefficiencies?!? In general … Negative externalities = overproduction of goods Positive externalities = underproduction of goods How can we overcome the inefficiencies?!?

Coase Theorem Private markets arrive at efficient outcomes if… Property rights are clearly defined Transaction costs are low Parties need to INTERNALIZE externalities

Coase Theorem Fails When… Communication costs are high Legally-binding agreements are costly Delays increase cost of bargaining

Private vs. External Benefits Marginal social benefit (MSB) consists of marginal benefit to consumers and society When there are no externalities MSB = MPB = D MSB = MPB + MEB

Marginal external benefit Example: Flu Shots Deadweight Loss P, MSB of flu shots Marginal external benefit S PMSB POPT PMKT MSB of flu shots D QMKT QOPT Quantity of flu shots

How to Eliminate DWL… Use a PIGOUVIAN SUBSIDY Payment that encourages activity with external benefits External actors pay portion of cost Reduces cost of optimal behavior

Private vs. External Costs Marginal social cost (MSC) consists of marginal cost to consumers and society When there are no externalities MSC = MPC = S MSC = MPC + MEC

Example: Livestock S D MSC of livestock PMSC POPT PMKT QOPT QMKT P, MSC of livestock S PMSC POPT PMKT D QOPT QMKT Quantity of livestock

How to Eliminate DWL… Use a PIGOUVIAN TAX Payment that discourage activity with external costs Consumers pay portion of cost Increases cost of sub-optimal behavior

Pigouvian Subsidy/Tax 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 subsidy/tax O 200 100 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