Today Externalities

Externality When an individual course of action affects others beyond the amount considered by that individual.

Negative externality The individual course of action imposes costs on others.

Example: Bob’s smoking Costs to Bob Cost of cigarettes Cost to own health Cost of keeping home and clothes clean Costs to others from Bob’s smoking Health costs from second-hand smoke Cost of cleaning home, clothes Increased price of health insurance due to inclusion of smokers in group rates.

Social Costs The social cost of the activity is the private cost plus the external cost. The social cost of one person smoking includes the costs to the smoker plus the costs to others.

Social Benefits The social benefits are equal to the private benefits plus any external benefits. Assume no external benefits from Bob smoking. Note: if there are external benefits, that is a positive externality, see below. Then the social benefits of Bob smoking are just the private benefits that Bob gets.

Costs versus Benefits How much will Bob smoke? How much is optimal? $/Cigarette How much will Bob smoke? How much is optimal? Marginal Benefit (Bob) Marginal Social Cost (to Bob & to others) Marg. Ext. Cost Marginal Private Cost (to Bob)

Bob’s choice versus society’s $/Cigarette How can society get Bob (& others) to smoke less? Marginal Benefit Social costs exceed benefits. Marginal Social Cost Marginal Private Cost Cigarettes/day Bob’s choice Optimal for society

A Tax to Correct Negative Externalities Society wants Bob to internalize the external costs of his smoking. One way to do that is to tax cigarettes. The amount of the tax per cigarette should equal the costs to others from Bob’s smoking.

A Tax on Cigarettes $/Cigarette Use a tax to force Bob to pay the full costs of his smoking. Marginal Benefit Marginal Social Cost = Marg. Private Cost + tax Tax per cig. Marginal Private Cost Cigarettes/day Optimal Bob’s choice if taxed

Pollution as a Negative Externality Industrial production often creates pollution of air or water as a by-product. Public policy options for dealing with pollution Ban pollution Tax pollution Establish maximum rates of pollution per firm Issue a limited number of permits to pollute, allow them to be traded. (Used for CO2 in US)

The Tragedy of the Commons Why is the copier always out of paper or in a paper jam?

“The Commons” Historically, refers to common grazing land for a town. In economics, refers to any situation in which a resource is used by many people, none of whom owns the resource.

What happened in “The Commons”? The private cost of grazing your sheep in the commons was zero. The social cost wasn’t, because once your sheep ate the grass, it wasn’t there for the next farmer. The commons were routinely over-grazed, because nobody had an incentive to make sure the grass had time to grow back.

Current “Tragedies” Fishing in the ocean The shared copier There are no property rights to fishing grounds in international waters. Fisherman have no incentive to let the population recover. The shared copier The cost of fixing the paper jam is higher than the benefits one person expects to get out it. Tendency to move on to another machine, or wait until someone else fixes the problem.

Other Tragedies Air Quality Use of Outer Space Public restrooms We drive our cars without regard to the marginal cost to society of the air pollution. Gasoline taxes help. Use of Outer Space Without some sort of controls, likely to see so much debris and so many satellites that the use of space is impaired. Public restrooms

Positive externality: The individual course of action imposes benefits on others. The social benefit of an activity is greater than the private benefit.

Examples of Positive Ext. Education: Makes people better citizens. These benefits are in addition to the private benefits. Attractive architecture, landscaping, etc. at your house increases the value of the neighbors’ houses. Vaccinations: When one person is vaccinated, it helps the rest of us because we are less likely to catch the disease.

The Role of the Government & Externalities Governments can use taxes to discourage activities with negative externalities. They can use subsidies to encourage activities with positive externalities.

Government Regulation Planning commissions or architectural review boards are used to create positive externalities rather than negative ones. Commercial activities tend to be zoned separately from residential neighborhoods. Property owners may be required to preserve historic buildings or to complement existing buildings.

Coming Up Review for third midterm exam

Group Work-Externalities List 3 examples of negative externalities (not already mentioned in class). How does society address each? List 3 examples of positive externalities (not already mentioned in class). How does society address each? Write out your answers.