Chapter 10 Externalities © 2002 by Nelson, a division of Thomson Canada Limited

In this chapter you will… Learn the nature of an externality. See why externalities can make market outcomes inefficient. Examine how people can sometimes solve the problem of externalities on their own. Consider why private solutions to externalities sometimes do not work. Examine the various government policies aimed at solving the problem of externalities. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

But market failures can still happen! EXTERNALITIES Recall: Adam Smith’s “invisible hand” of the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society can derive from a market. But market failures can still happen! Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Externalities cause markets to be inefficient, and thus fail. If a market system affects individuals other than buyers and sellers of that market, side-effects are created called Externalities. Externalities cause markets to be inefficient, and thus fail. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

EXTERNALITIES An externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander. Externalities cause markets to be inefficient, and thus fail to maximize total surplus. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

EXTERNALITIES In the presence of externalities, society’s interest in a market outcome extends beyond the well-being of buyers and sellers in the market. . . … the well-being of third parties are considered. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

EXTERNALITIES Positive Externality The uncompensated benefits that are received by individuals who are not directly involved in the production or consumption of goods. The act of producing or consuming goods sometimes generates benefits to others who do not have to pay for them. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

EXTERNALITIES Negative Externality The uncompensated costs that are imposed upon individuals who are not directly involved in the production or consumption of goods. The act of producing or consuming goods sometimes generates costs to others who are not paid to endure them. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

EXTERNALITIES Negative Externality Automobile exhaust Cigarette smoking Positive Externality Immunizations Restored historic buildings Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Welfare Economics: A Recap The Market for Aluminum The demand curve for aluminum reflects the value to consumers of aluminum as measured by the prices they are willing to pay. The supply curve for aluminum reflects the costs of producing aluminum. Qmarket: the quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Figure 10-1: The Market for Aluminium Price of Aluminium Supply (private costs) Demand (private value) Equilibrium Qmarket Quantity of Aluminium Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Welfare Economics: A Recap The Market for Aluminum (cont’d) If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Negative Externalities in Production The Market for Aluminum (cont’d) For each unit of aluminum produced, the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Negative Externalities in Production The Market for Aluminum (cont’d) What quantity of aluminum should be produced? Where the demand curve crosses the social-cost curve. Below Qoptimum the value of the aluminum to consumers exceeds rgw social cost of producing it. Above Qoptimum the social cost of producing additional aluminum exceeds the value to consumers. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Figure 10-2: Pollution and the Social Optimum Price of Aluminium Social costs Cost of pollution Supply (private costs) Demand (private value) Optimum Qoptimum Equilibrium Qmarket Quantity of Aluminium Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Negative Externalities in Production The Market for Aluminum (cont’d) Reducing aluminum production and consumption below the market equilibrium level raises total economic well-being. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Figure 10-3: Deadweight Loss of a Negative Production Externality Total surplus Producer surplus Consumer surplus Change At QOptimum At QMarket Price of Aluminium A + B + C + D D - (A + B + C) E - (B + C + H) A + E A + B + C + H D + A + E - H D + A + E H Social costs Pmarket Qmarket a b D A B C E F G H Poptimum Qoptimum Demand (private value) Quantity of Aluminium Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Negative Externalities in Production The Market for Aluminum (cont’d) How the can social optimum of aluminum production be achieved? Tax the producers of aluminum thus shifting the private supply curve up by the amount of the tax so that it coincides with the social-cost curve. Internalizing an externality involves altering incentives so that people take account of the external effects of their actions. Pigovian taxes are taxes enacted to correct the effects of negative externalities. In Figure 10-3, the Pigovian tax is equal to the distance ab. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Positive Externalities in Production When an externality benefits the bystanders, a positive externality exists. The social value of the good exceeds the private value. Example: A technology spillover is a type of positive externality that exists when a firm’s innovation or design not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Figure 10-4: Technology Spillovers and the Social Optimum Price of Robots Supply (private costs) Value of technology spillover a b Qoptimum Poptimum Social costs Qmarket Pmarket Equilibrium Optimum Deadweight loss Demand (private value) Quantity of Robots Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Positive Externalities in Production The intersection of the supply curve and the social-value curve determines the optimal output level. The optimal output level is more than the equilibrium quantity. The market produces a smaller quantity than is socially desirable. The social value of the good exceeds the private value of the good. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Positive Externalities in Production Internalizing Externalities: Subsidies Used as the primary method for attempting to internalize positive externalities. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

CASE STUDY: The Debate Over Technology Policy Government intervention in the economy that aims to promote technology-enhancing industries Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention. The patent is then said to internalize the externality. The patent system gives firms a greater incentive to engage in research and other activities that advance technology. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Externalities in Consumption Some externalities are associated with consumption. Figure 10-5 (a) shows a market with a negative consumption externality such as the market for alcoholic beverages. Figure 10-5 (b) shows a market with a positive consumption externality such as the market for education. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Figure 10-5: Consumption Externalities (a) Negative Consumption Externalities (b) Positive Consumption Externalities Price of Alcohol Supply (private cost) Quantity of Education Price of Education Social value Demand (private value) Supply (private cost) Qoptimum Qmarket Qmarket Qoptimum Demand (private value) Social value Quantity of Alcohol Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

PRIVATE SOLUTIONS TO EXTERNALITIES Government action is not always needed to solve the problem of externalities, which cause markets to be inefficient. People can develop private solutions. Moral codes and social sanctions Charitable organizations Integrating different types of businesses Contracting between parties Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

The Coase Theorem The Coase Theorem is a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own. Private bargaining can internalize the external effects, resulting in efficient solutions. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Why Private Solutions Do Not Always Work In the real world bargaining does not always work. Transactions Costs Transaction costs are the costs that parties incur in the process of agreeing to and following through on a bargain. Bargaining breaks down. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

PUBLIC POLICIES TOWARDS EXTERNALITIES When externalities are significant and private solutions are not found, government may attempt to solve the problem through . . . Command-and-control policies that regulate behaviour directly. Market-based policies that provide incentives so that private decisions makers will choose to solve the problem on their own. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

PUBLIC POLICIES TOWARDS EXTERNALITIES Command-and-Control Policies Usually take the form of regulations: Forbid certain behaviors. Require certain behaviors. Examples: Requirements that all students be immunized. Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA). Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

PUBLIC POLICIES TOWARDS EXTERNALITIES Market-Based Policies Government can internalize an externality by using taxes and subsidies to align private incentives with social efficiency. Pigovian taxes are taxes enacted to correct the effects of a negative externality. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

CASE STUDY: Why Is Gasoline Taxed So Heavily? Why are gasoline taxes so common? They are a Pigovian tax aimed at correcting three negative externalities: Congestion Accidents Pollution The tax makes the economy work better. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

PUBLIC POLICIES TOWARDS EXTERNALITIES Market-Based Policies Tradable pollution permits allow the voluntary transfer of the right to pollute from one firm to another. A market for these permits will eventually develop. A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

PUBLIC POLICIES TOWARDS EXTERNALITIES Market-Based Policies Reducing pollution using permits is quite similar to imposing a Pigovian tax. In both cases it is the firm who pays its pollution. With Pigovian taxes, polluting firms must pay the government. With pollution permits, polluting firm must pay to buy the permit. See Figure 10-6 for an illustration of the similarities. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Figure 10-6: The Equivalence of Pigovian Taxes and Pollution Permits. (a) Pigovian Tax (b) Pollution Permits Price of Pollution Supply of pollution permits 1. … Pollution permits set the quantity of pollution… Q Demand for pollution rights Q 2. … which together with the demand curve, determines the price of pollution… Demand for pollution rights P Pigovian Tax P 1. A Pigovian sets the price of pollution… 2. … which together with the demand curve, determines the quantity of pollution… Quantity of Pollution Quantity of Pollution Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Summary When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality. Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity. Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Summary Those affected by externalities can sometimes solve the problem privately. The Coase theorem states that if people can bargain without a cost, then they can always reach an agreement in which resources are allocated efficiently. When private parties cannot adequately deal with externalities, then the government steps in. The government can either regulate behavior or internalize the externality by using Pigovian taxes or by issuing pollution permits. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

The End Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition