Externalities Chapter 10

EXTERNALITIES An externality is the uncompensated impact of one person’s actions on another person –Both positive & negative externalities exist All externalities cause markets to be inefficient –That is, markets do not maximize total surplus (welfare)

Negative Externalities –Automobile exhaust –Cigarette smoking –Barking dogs –Loud stereos in an apartment building –Noisy Students –Neighbor’s poorly maintained property

Positive Externalties –Immunizations –Restored historic buildings –Research into new technologies –Neighbor’s well maintained property

MARKET INEFFICIENCY Negative externalities lead markets to overproduce Positive externalities lead markets to under-produce MC = MB Supply Curve = Marginal Cost Curve Demand Curve = Marginal Benefit Curve

Spillover Costs & Benefits Spillover Costs- costs not captured by supply curve (MC) –Costs are understated Spillover Benefits- benefits not captured by demand curve (MB) –Benefits are understated

Negative Externality: Pollution Equilibrium MC = MB Quantity of Aluminum 0 Price of Aluminum Demand = MB ( private value ) Supply = MC P ( private cost ) MSC (social cost) Q OPTIMUM Optimum Q MARKET Spillover Cost External social Cost P1P1

Positive Externality: Neighbor paints House Quantity 0 Price MB MC Q MARKET External social benefit Equilibrium Optimum Q OPTIMUM Spillover Benefit MSB P1P1

Solutions to Externalities Internalizing an externality involves altering incentives Government Methods –Taxes (corrective taxes), Subsidies –Patents –Laws (immunization laws, pollution laws) Free market solution: –Trading pollution credits

Worksheet Externalities

Taxing Negative Externalities Impose Tax = spillover cost Shifts Supply Curve left Reach social optimal output Total Cost = Total Benefit Total Cost = MSC (MC P + MC S )

Subsidizing Positive Externalities Impose Subsidy = spillover benefit Shifts demand curve right Reach social optimal output Total Cost = Total Benefit Fuel Efficient Cars

Day #2 Practice Test

Factory A Factory B

Cap & Trade Analysis D S Goal: to reduce CO 2 emissions Trading System Pollution Credits