1. L22
Externalities

2. Externalities So far: utilities on own actions only
Reality: we are not islands
An externality is a cost or a benefit imposed upon someone by actions taken by others.
- benefit - positive externality.
- cost - negative externality.

3. Examples of Negative Externalities
Air or water pollution.
Loud parties next door.
Traffic congestion.
Second-hand cigarette smoke.
Increased insurance premiums due to alcohol or tobacco consumption.
Bad smell!

4. Examples of Positive Externalities
A well-maintained property.
High “human” capital
A pleasant cologne or scent worn by the person seated next to you.
A scientific advance.

5. Today’s questions: Interactions with externalities
Too much or too little activity?
How can we reestablish Pareto efficiency?
taxes
creating markets
social norms

6. Example: Negative externality
Two producers: steel mill and fishery
Steel mill:
Production of steel
level of pollution
The pollution adversely affects a nearby fishery

7. Marginal benefit from pollution

8. 2 Scenarios: In both scenarios producers are small
They maximize profit
Scenario 1: Decentralized free markets
Scenario 2: Social planner

9. Steel mill problem

10. Steel mill problem

11. Fishery problem

12. Pareto efficient pollution

13. Pareto efficient pollution

14. Pareto efficient pollution

15. Comparizon
When negative externality – too much activity in decentralized markets
You will show in PS that when externality if positive – too little activity.

16. Implementation: Pigouvian Tax
Problem: information!

17. Missing markets (Emission markets)

18. Social norms: moral cost
Social norm: “do not pollute”
Moral cost
Many norms can be explained using efficiency argument