1. Warm-Up
PHATS=$2; Wage rate=$15

2. Warm-Up Answers

3. CHAPTER 17: EXTERNALITIES (PAGES 434-440; 446-450)
Introduction to
Externalities
CHAPTER 17: EXTERNALITIES (PAGES ; )

4. Private vs. Social Impacts
Decisions can have PRIVATE and EXTERNAL impacts
EXAMPLE: Home Improvement
Private = nicer house for you
External = higher property values

5. Externalities Occur when there are external impacts
Can be either positive and negative
Negative = external cost
Positive = external benefit

6. What Type of Externality?
Negative

7. What Type of Externality?
Negative

8. What Type of Externality?
Positive

9. Externalities = Inefficiency
Marginal social cost, marginal social benefit
Marginal social cost, MSC, of pollution
Socially optimal point O
$200
Marginal social benefit, MSB, of pollution Q
Quantity of pollution
OPT
emissions (tons)
Socially optimal quantity of pollution

10. Externalities = Inefficiency
Marginal social cost, marginal social benefit
MSC of pollution
$400
Marginal social cost at QMKT
The market outcome is inefficient: marginal social cost of pollution exceeds marginal social benefit
300 O
200
100
MSB of pollution Q Q Q
Quantity of pollution
OPT H M K T
emissions (tons)
Socially optimal quantity of pollution
Market-determined quantity of pollution

11. Negative Externality

12. Positive Externality

13. How can we overcome the inefficiencies?!?
In general …
Negative externalities = overproduction of goods
Positive externalities = underproduction of goods
How can we overcome the inefficiencies?!?

14. Coase Theorem Private markets arrive at efficient outcomes if…
Property rights are clearly defined
Transaction costs are low
Parties need to INTERNALIZE externalities

15. Coase Theorem Fails When…
Communication costs are high
Legally-binding agreements are costly
Delays increase cost of bargaining

16. Private vs. External Benefits
Marginal social benefit (MSB) consists of marginal benefit to consumers and society
When there are no externalities MSB = MPB = D
MSB = MPB + MEB

17. Marginal external benefit
Example: Flu Shots
Deadweight Loss
P, MSB of flu shots
Marginal external benefit S
PMSB
POPT
PMKT
MSB of flu shots D
QMKT
QOPT
Quantity of flu shots

18. How to Eliminate DWL… Use a PIGOUVIAN SUBSIDY
Payment that encourages activity with external benefits
External actors pay portion of cost
Reduces cost of optimal behavior

19. Private vs. External Costs
Marginal social cost (MSC) consists of marginal cost to consumers and society
When there are no externalities MSC = MPC = S
MSC = MPC + MEC

20. Example: Livestock S D MSC of livestock PMSC POPT PMKT QOPT QMKT
P, MSC of livestock S
PMSC
POPT
PMKT D
QOPT
QMKT
Quantity of livestock

21. How to Eliminate DWL… Use a PIGOUVIAN TAX
Payment that discourage activity with external costs
Consumers pay portion of cost
Increases cost of sub-optimal behavior

22. Pigouvian Subsidy/Tax
Marginal social cost, marginal social benefit
MSC of pollution
$400
Marginal social cost at QMKT
The market outcome is inefficient: marginal social cost of pollution exceeds marginal social benefit
300
Optimal Pigouvian subsidy/tax O
200
100
MSB of pollution
Marginal social benefit at QMKT Q Q Q
Quantity of pollution
OPT H M K T
emissions (tons)
Socially optimal quantity of pollution
Market-determined quantity of pollution