Chapter 10 Externalities

Objectives 1.) Learn the concepts of external costs and external benefits. 2.) Understand why the presence of externalities can produce market failures. 3.) Recognize when private agreement can and cannot effectively solve problems associated with externalities.

Market Efficiency: Chapter 7 u Under the assumptions of perfect competition and no externalities, the economic well-being of a society is measured as: The sum of consumer and producer surplus! u The invisible hand is powerful but not omnipotent, which leads to market failure.

Market Failure u 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.

Externality - Defined u The uncompensated effects that the production or consumption of goods have on third parties. u The impact of one person’s actions on the well-being of a bystander!

Externality - Effect on Society u In the presence of externalities, society’s interest in a market outcome extends beyond the well-being of buyers and sellers in the market... u … the well-being of bystanders are considered.

External Benefits - Positive Externalities u The uncompensated benefits that are received by individuals who are not directly involved in the production or consumption of goods. u The act of producing or consuming goods sometimes generates benefits to others who do not have to pay for them.

External Costs - Negative Externalities u The uncompensated costs that are imposed upon individuals who are not directly involved in the production or consumption of goods. u The act of producing or consuming goods sometimes generates costs to others who are not paid to endure them.

Negative Externality u Automobile exhaust u Cigarette smoking Positive Externality u Immunizations u Restored historic buildings Identify Some Negative and Positive Externalities

u Automobile exhaust u Cigarette smoking u Barking dogs (loud pets) u Loud stereos in an apartment building Examples of Negative Externalities

u Immunizations u Restored historic buildings u Research into new technologies Examples of Positive Externalities

Externalities and Market Inefficiency - Negative Externalities u Negative externalities in production or consumption sometimes lead markets to produce a larger quantity than is socially desirable. u The Social Costs of production or consumption are greater than the private cost or private benefit by producers and consumers. This leads to market failure.

Negative Externalities and Market Inefficiency - Graphical Example u Assume that the production process emits pollution - negative externality. u The cost to society of production is larger than the cost to the producer. u The Social Cost includes the private costs plus the costs to those bystanders adversely affected by the pollution. Reflects in a new Supply Curve...

Negative Externalities and Market Inefficiency - Graphical Example Supply Private Cost Demand Private Value Q Market Market output before accounting for externality.

The Market for Aluminum and Welfare Economics The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus.

The Market for Aluminum and Welfare Economics 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.

The Market for Aluminum and Welfare Economics 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.

Negative Externalities and Market Inefficiency - Graphical Example Cost of Pollution Demand Private Value Q Market Supply Private Cost Social Cost

Negative Externalities and Market Inefficiency - Graphical Example Cost of pollution Demand Private Value Supply (private cost) Social Cost The optimum output accounts for the externality. Q Optimum

u Internalizing an externality is altering incentives so that people take account of the extreme effects of their actions

Negative Externalities and Market Inefficiency - Graphical Example u The intersection of the demand curve and the social-cost curve determines the optimal output level - less than equilibrium quantity. Attainment of the Optimal Output The government can internalize the externality by imposing a tax on the producer.

Externalities and Market Inefficiency - Positive Externalities u Positive externalities in production or consumption sometimes lead markets to produce a smaller quantity than is socially desirable. u The Social Costs of production or consumption are less than the private cost or private benefit to producers and consumers. This leads to market failure.

Positive Externalities in Production 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.

Positive Externalities and Market Inefficiency - Graphical Example Supply Private Cost Demand Private Value Q Market

Supply Private Cost Demand Private Value Q Market Market output before accounting for externality. Positive Externalities and Market Inefficiency - Graphical Example

Supply Private Cost Demand Private Value Positive Externalities and Market Inefficiency - Graphical Example Value of Technology Spillover Q Optimal Social Cost

Positive Externalities in Production The intersection of the demand curve and the social-cost curve determines the optimal output level. u The optimal output level is more than the equilibrium quantity. u The market produces a smaller quantity than is socially desirable. u The social costs of production are less than the private cost to producers and consumers.

Internalizing Externalities: Subsidies Government many times uses subsidies as the primary method for attempting to internalize positive externalities.

Technology Policy Government intervention in the economy that aims to promote technology- enhancing industries is called technology policy.

Technology Policy u Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention. u The patent is then said to internalize the externality.

Supply (Private Cost) Demand (Private Value) Consumption Externalities Q Optimal Negative Consumption Externality Q Market Social value Price of Alcohol 0 Quantity of Alcohol

Supply (Private Cost) Demand (Private Value) Consumption Externalities Q Optimal Positive Consumption Externality Q Market Social value Price of Education 0 Quantity of Education

Positive Externalities and Market Inefficiency - Graphical Example u The intersection of the demand curve and the social-cost curve determines the optimal output level - more than equilibrium quantity. Attainment of the Optimal Output The government can internalize the externality by subsidizing the production - paying the producer to produce more than the equilibrium.

Government Policy Toward Externality u In situations where market failure occurs because of externalities, the government will attempt to internalize the externality by: –imposing a tax on goods with a negative externality. –implementing a subsidy on goods with a positive externality.

Quick Quiz u Given an example of a negative externality and a positive externality. u Explain why market outcomes are inefficient in the presence of externalities.

Private Solutions to Externalities u Government action is not always needed to solve a problem of externalities. u Alternative private solutions: –Moral codes and social sanctions –Charitable organizations focused on dealing with an externality. u Examples of private solutions...

Private Solutions to Externalities u Coase Theorem: –If private parties can bargain to their mutual advantage without cost, then the private market will always solve the problem of externalities and allocate resources efficiently. –Private bargaining can internalize the external effects, resulting in efficient solutions.

Failure to Private Solutions Approach u Sometimes the private solution approach will fail because: –The transaction costs can be so high that private agreement is not possible. v Transaction costs are the costs that parties must incur to agree and follow through on a bargain.

Quick Quiz u Give an example of a private solution to an externality. u What is the Coase theorem? u Why does the private solution approach often fail?

Public Policy Toward Externalities u When externalities are significant and when private solutions are not possible or incomplete, government may attempt to solve the problem by: –Command-and-Control policies –Market-Based policies

Command-and-Control Policies u Usually in the form of regulations: –making certain behavior forbidden –making certain behavior required u Examples: –All students must be immunized –Stipulating levels of pollution emissions

Market-Based Policies u Government use of taxes and subsidies to align private incentives with social efficiency. –Pigovian Taxes: designed to reflect the social costs of a negative externality and internalize the external cost to the offending entity.

Examples of Regulation versus Pigovian tax If the EPA decides it wants to reduce the amount of pollution coming from a specific plant. The EPA could…  tell the firm to reduce its pollution by a specific amount (i.e. regulation).  levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian tax).

Market-Based Policies u Tradable Pollution Permits: the voluntary transfer of the right to pollute from one firm to another. –Pollution permits which results in a new market for these permits. –Firms that can reduce pollution most easily will be willing to sell their permit, for whatever they can get.

Demand for pollution rights The Equivalence of Pigovian Taxes and Pollution Permits Pigovian Tax Q Pigovian tax Price of Pollution 0 Quantity of Pollution P

Demand for pollution rights The Equivalence of Pigovian Taxes and Pollution Permits Pigovian Tax Q Pigovian tax Price of Pollution 0 Quantity of Pollution P 1. A Pigovian tax sets the price of pollution

Demand for pollution rights The Equivalence of Pigovian Taxes and Pollution Permits Pigovian Tax Q Pigovian tax Price of Pollution 0 Quantity of Pollution P which together with the demand curve, determines the quantity of pollution

Demand for pollution rights Q Supply of pollution permits Price of Pollution Quantity of Pollution P The Equivalence of Pigovian Taxes and Pollution Permits Pollution Permits

Demand for pollution rights Q Supply of pollution permits Price of Pollution 0 Quantity of Pollution P 1. Pollution permits set the quantity of pollution... The Equivalence of Pigovian Taxes and Pollution Permits Pollution Permits

Demand for pollution rights The Equivalence of Pigovian Taxes and Pollution Permits Pollution Permits Q Supply of pollution permits Price of Pollution 0 Quantity of Pollution P which together with the demand curve, determines the price of pollution

Externalities - Conclusion u Uncompensated effects that the production or consumption of goods have on third parties are called externalities. –Negative externalities: results in market equilibrium beyond the social optimum. –Positive externalities: results in market equilibrium short of social optimum.

Externalities - Conclusion u Solutions to externalities can be accomplished: –through private agreements or government intervention