Externalities

What is an externality?  the uncompensated impact of one person's actions on the well- being of a bystander (or 3 rd party) Two Types of Externalities  Negative Externality  If the impact on the bystander is adverse, it is called a negative externality.  Positive Externality  If the impact on the bystander is beneficial, it is called a positive externality.

Examples Negative Externalities  pollution from power plants  exhaust from automobiles  noise from airplanes or barking dogs Positive Externalities  restored historic buildings  new technologies  inoculations

Examples How does an externality create a market failure?  Supply and demand do not account for the external effects on 3 rd parties. If they did, equilibrium would change.

Price Quantity S (private cost) D Market for Aluminum Q MARKET S (social cost: private cost + external cost) External Cost Q OPTIMAL Note: The market quantity is above the optimal quantity. Society produces too much! (Society over-allocates resources to this activity) Note: The market quantity is above the optimal quantity. Society produces too much! (Society over-allocates resources to this activity) Note: When considering the external costs, the last consumer at the equilibrium quantity is not willing to pay the costs to society for producing that same quantity.

Price Quantity S D (private value) Market for Flu Shots Q MARKET D (private value + social benefit) External Benefit Note: The market quantity is Below the optimal quantity. Society produces too little! (Society under-allocates resources to this activity) Note: The market quantity is Below the optimal quantity. Society produces too little! (Society under-allocates resources to this activity) Q OPTIMAL Note: At the market equilibrium, there are still more Pareto Improvements to be made.

Correcting Externalities Negative Externalities  Society produces too much Positive Externalities  Society produces too little With too much or too little, we have a market failure.  What can be done?  Public Solutions  Command & Control Policies, Market Based Solutions  Private Solutions  Moral codes and social sanctions, Charities, Contracts

Correcting Externalities Command and Control Policies  In other words, government regulations  Many government regulations attempt to correct negative externalities by making the activity illegal.  (example: against the law to dump poison into the city’s water supply)

Correcting Externalities Market based solutions  In other words, government taxes and subsidies  Usually considered to be a “corrective tax” or “corrective subsidy” Negative Externalities  Pigovian taxes (ideally a corrective tax would be imposed exactly equal to the external cost) Positive Externalities  Pigovian subsidy (ideally a corrective subsidy would be imposed exactly equal to the external benefit)

Price Quantity S (private cost) D Market for Aluminum Q MARKET S (social cost: private cost + social cost) Q OPTIMAL How large of a Pigouvian tax is required to correct this negative externality? $50 $45 $40

Objections to the Economic Analysis of Pollution "We cannot give anyone the option of polluting for a fee.“ -- Senator Edmund Muskie Economists have little sympathy for this type of argument. To economists, good environmental policy begins by acknowledging the first of the Ten Principles of Economics in Chapter 1: People face trade-offs. Consider transportation. All forms of transportation produce pollution, even horses! We should weigh the benefits and costs in determining policy toward externalities

Private Solutions to Externalities Moral codes and social sanctions “Do unto others as you would have them do unto you” Charities Appalachian Mountain Club, Appalachian Trail Conservancy, Appalachian Voices, etc… Contracts The parties involved my enter into a contract in an attempt to make everyone agree to a situation in which they are all better-off.

Private Solutions to Externalities Coase Theorem suggests that private market solutions to externalities can be very effective in some circumstances The Coase theorem says that private economic actors can potentially solve the problem of externalities among themselves. Whatever the initial distribution of rights, the interested parties can reach a bargain in which everyone is better off and the outcome is efficient. (Note: Coase Theorem generally requires bargaining with zero opportunity cost, such as not hiring a lawyer at $100 an hour)