1 Externalities

2 By the end of this Section you should be able to: ► Define and describe an externality (both + and -) and its effects of social welfare. ► Evaluate 3 of the possible solutions for an externality:  Private Solution  Pigouvian Tax  Tradable Permit Market

3 Externalities ► An externality is an uncompensated impact of one person’s actions on the well-being of a bystander. ► Externalitites can be + (a benefit for the bystander) or – (a cost for the bystander). ► Examples:  Pollution from manufacturing  Exhaust from automobiles  Knowledge to everyone from scientific discoveries  Sprinklers in your yard hitting the clean laundry set out to dry by your next door neighbor

4 Recall a Competitive Equilibrium ► If the market is producing at Q*,P* then social welfare is maximized. ► This assumes there is no externality. Demand = Marginal Benefit Supply = Marginal Cost Q* P* Price Quantity

5 Two Types of Externalities ► Type 1: Negative Externality  A negative externality exists when production or consumption activity creates an external cost.

6 What happens when there is a Negative Externality ► When there is a negative externality, there exists a marginal external cost.  Marginal External Cost – the cost of producing an additional unit of output or service that falls on people other than just the producer. ► Marginal Cost + Marginal External Cost = Marginal Social Cost.  Marginal Social Cost – the marginal cost occurred by the entire society.

7 Negative Externality’s effect on the Competitive Equilibrium ► When there exists an externality, the marginal cost/supply curve is shifted to reflect the cost of producing to everyone. ► The market is then not producing at the equilibrium anymore as the equilibrium is now Qsc*, Psc*. ► Producing at Q*, P* instead of Qsc*, Psc* causes a DWL.  Because it does not take into account total social cost.  MSC>MB so there is a loss in total surplus. Demand = Marginal Benefit Supply = Marginal Cost Q* P* Marginal Social Cost = Marginal Cost + Marginal External Cost Qsc* Psc* Price Quantity

8 Two Types of Externalities ► Type 2: Positive Externality  A positive externality exists when production or consumption activity creates an external benefit.

9 What happens when there is a Positive Externality ► When there is a positive externality, there exists a marginal external benefit.  Marginal External Benefit – the benefit of an additional unit that other people (other than those enjoying the output or service) enjoy. ► Marginal Benefit + Marginal External Benefit = Marginal Social Benefit.  Marginal Social Benefit – the marginal benefit of consumption of a good or service to society.

10 Positive Externality’s effect on the Competitive Equilibrium ► When there exists an externality, the marginal benefit/demand curve is shifted to reflect the benefit of producing to everyone. ► The market is then not producing at the equilibrium anymore as the equilibrium is now Qsb*, Psb*. Producing there maximizes surplus. ► Producing at Q*, P* instead of Qsb*, Psb* causes a DWL.  Because it does not take into account total social benefit.  There exists under production so total surplus is subtracted from. Demand = Marginal Benefit Supply = Marginal Cost Q* P* Marginal Social Benefit = Marginal Benefit + Marginal External Benefit Qsb* Psb* Price Quantity

11 How to solve for an externality: ► “Solving” for an externality is how we get the market to produce at equilibrium. ► There exists many solutions, we will examine 3 of them. 1. Private Solution: have the effected parties work out their problems between them selves. ► Coase Theorem: if private parties can bargain without cost over the allocation of resources they can solve the problem of externality on their own.  Requirements for the Coase Theorem to work: 1. Property rights are defined. 2. Small number of people negotiating. ► Examples: Sprinkler and laundry, loud party and sleeping neighbors, etc.

12 How to solve for an externality: 2. Pigouvian Tax: A tax enacted on producers that produce a negative externality.  Causes firms to pay for the right to pollute  Internalizes the social cost and shifts the supply curve of the firm so that it equals the Marginal Social Cost.  Problem: hard to enforce. ► How it works: a tax is put on each ton of emissions due to production of a good.  The tax is equal to the marginal external cost.  So the Marginal Social Cost is equal to the Marginal Cost Price Quantity MB MC MSC = MC + MEC tax MSC = MC + tax

13 How to solve for an externality: 3. Tradable Permits: Government issued permits that allows them to pollute to a certain limit. Firms then buy and sell the permits amongst themselves.  The firms for which it is cheap to decrease pollution now have an incentive to decrease pollution as much as possible and make money selling permits.  In addition the firms for which it is expensive for them to decrease pollution can buy permits from other firms.

14 Comparison between Pigouvian Tax and Tradable Permits Pigouvian Tax Tradable Permit Price of Pollution Quantity of Pollution Demand for Pollution Rights P Q pollution tax A pollution tax sets the price of pollution per ton of emissions with which the demand curve sets the Q of pollution demanded. Demand for Pollution Rights Supply of Permits P permit market A permit market sets the quantity of pollution with which the demand curve sets the P of pollution.