1. Principles of Micro Chapter 10: Externalities by Tanya Molodtsova, Fall 2005

2. We Will Learn: what an externality is what an externality is why externalities can make market outcomes inefficient. why externalities can make market outcomes inefficient. how people can sometimes solve the problem of externalities on their own. how people can sometimes solve the problem of externalities on their own. why private solutions to externalities sometimes do not work. why private solutions to externalities sometimes do not work. the various government policies aimed at solving the problem of externalities the various government policies aimed at solving the problem of externalities

3. Introduction 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 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. But market failures can still happen.

4. Externalities and Market Inefficiency externality: the uncompensated impact of one person’s actions on the well-being of a bystander. externality: the uncompensated impact of one person’s actions on the well-being of a bystander. 1. - If the effect on the bystander is adverse, there is a negative externality. 2. -If the effect on the bystander is beneficial, there is a positive externality

5. Externalities and Market Inefficiency An externality arises... An externality arises...... when a person engages in an activity that influences the well- being of a bystander and yet neither pays nor receives any compensation for that effect. Externalities cause markets to be inefficient, and thus fail to maximize total surplus.

6. Externalities and Market Inefficiency Negative Externalities Negative Externalities Automobile exhaust Automobile exhaust Cigarette smoking Cigarette smoking Barking dogs (loud pets) Barking dogs (loud pets) Loud stereos in an apartment building Loud stereos in an apartment building Positive Externalities Positive Externalities Immunizations Immunizations Restored historic buildings Restored historic buildings Research into new technologies Research into new technologies

7. Welfare Economics: A Recap The Market for Aluminum The Market for Aluminum The quantity produced and consumed in the market equilibrium is efficient (it maximizes the sum of producer and consumer surpluses). The quantity produced and consumed in the market equilibrium is efficient (it maximizes the sum of producer and consumer surpluses). 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. 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.

8. Welfare Economics: A Recap 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 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

9. Pollution and the Social Optimum Equilibrium Quantity of Aluminum 0 Price of Aluminum Demand (private value) Supply (private cost) Social cost Q OPTIMUM Optimum Cost of pollution Q MARKET

10. Negative Externalities The intersection of the demand curve and the social-cost curve determines the optimal output level. The intersection of the demand curve and the social-cost curve determines the optimal output level. The socially optimal output level is less than the market equilibrium quantity. The socially optimal output level is less than the market equilibrium quantity.

11. Negative Externalities Achieving the Socially Optimal Output: Achieving the Socially Optimal Output: The government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity. The government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity. internalizing an externality: altering incentives so that people take account of the external effects of their actions. internalizing an externality: altering incentives so that people take account of the external effects of their actions.

12. Positive Externalities When an externality benefits the bystanders, a positive externality exists. When an externality benefits the bystanders, a positive externality exists. The social value of the good exceeds the private value. The social value of the good exceeds the private value. technology spillover is a type of positive externality that exists when a firm’s innovation not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole. technology spillover is a type of positive externality that exists when a firm’s innovation not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole.

13. Education and the Social Optimum Quantity of Education 0 Price of Education Demand (private value) Social value Supply (private cost) Q MARKET Q OPTIMUM

14. Positive Externalities The intersection of the supply curve and the social-value curve determines the optimal output level. 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 optimal output level is more than the equilibrium quantity. The market produces a smaller quantity than is socially desirable. The market produces a smaller quantity than is socially desirable. The social value of the good exceeds the private value of the good. The social value of the good exceeds the private value of the good.

15. Positive Externalities Internalizing Externalities: Subsidies Internalizing Externalities: Subsidies the primary method for attempting to internalize positive externalities. the primary method for attempting to internalize positive externalities. Industrial Policies: government intervention in the economy that aims to promote technology-enhancing industries Industrial Policies: government intervention in the economy that aims to promote technology-enhancing industries Patent laws: a form of technology policy that give the individual (or firm) with patent protection a property right over its invention. Patent laws: 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 is then said to internalize the externality.

16. Private Solutions to Externalities Government action is not always needed to solve the problem of externalities. Government action is not always needed to solve the problem of externalities. The Types of Private Solutions : The Types of Private Solutions : 1. Moral codes and social sanction 2. Charitable organizations 3. Integrating different types of businesses 4. Contracting between parties

17. The Coase Theorem The Coase theorem: the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own. The Coase theorem: the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own. Example: John owns a dog that disturbs a neighbor (Jane) with its barking. Example: John owns a dog that disturbs a neighbor (Jane) with its barking. a.One possible solution: Jane pays Dick to get rid of the dog. a.One possible solution: Jane pays Dick to get rid of the dog. b.Another solution: Dick could pay Jane to let him keep the dog. b.Another solution: Dick could pay Jane to let him keep the dog.

18. Why Private Solutions Do Not Always Work transaction costs: the costs that parties incur in the process of agreeing and following through on a bargain. Coordination of all of the interested parties may be difficult so that bargaining breaks down. This is especially true when the number of interested parties is large. Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible. Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible.

19. Public Policies toward Externalities When externalities are significant and private solutions are not found, government may attempt to solve the problem through... When externalities are significant and private solutions are not found, government may attempt to solve the problem through... Command and control policies: regulate behavior directly. Command and control policies: regulate behavior directly. market-based policies: provide incentives so that private decisionmakers will choose to solve the problem on their own. market-based policies: provide incentives so that private decisionmakers will choose to solve the problem on their own.

20. Public Policies toward Externalities Command-and-Control Policies Command-and-Control Policies Usually take the form of regulations: Usually take the form of regulations: Forbid certain behaviors. Forbid certain behaviors. Require certain behaviors. Require certain behaviors. Examples: Examples: Requirements that all students be immunized. Requirements that all students be immunized. Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA). Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA).

21. Public Policies toward Externalities Market-Based Policies Market-Based Policies Government uses taxes and subsidies to align private incentives with social efficiency. Government uses taxes and subsidies to align private incentives with social efficiency. Pigovian taxes are taxes enacted to correct the effects of a negative externality. Pigovian taxes are taxes enacted to correct the effects of a negative externality.

22. Public Policies toward Externalities Examples of Regulation versus Pigouvian Tax Examples of Regulation versus Pigouvian Tax If the EPA decides it wants to reduce the amount of pollution coming from a specific plant. The EPA could… 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). 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). levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian tax).

23. Public Policies toward Externalities Market-Based Policies: Market-Based Policies: Tradable pollution permits allow the voluntary transfer of the right to pollute from one firm to another. 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 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. 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.

24. The Equivalence of Pigovian Taxes and Pollution Permits Quantity of Pollution 0 Price of Pollution Demand for pollution rights P Pigovian tax (a) Pigouvian Tax 2.... which, together with the demand curve, determines the quantity of pollution. 1.A Pigovian tax sets the price of pollution... Q

25. The Equivalence of Pigovian Taxes and Pollution Permits Quantity of Pollution 0 Demand for pollution rights Q Supply of pollution permits (b) Pollution Permits Price of Pollution 2.... which, together with the demand curve, determines the price of pollution. 1.Pollution permits set the quantity of pollution... P

26. Pigouvian Taxes and Subsidies These taxes are preferred over regulation, because firms that can reduce pollution with the least cost are likely to do so (to avoid the tax) while firms that encounter high costs when reducing pollution will simply pay the tax. These taxes are preferred over regulation, because firms that can reduce pollution with the least cost are likely to do so (to avoid the tax) while firms that encounter high costs when reducing pollution will simply pay the tax. Unlike other taxes, Pigouvian taxes do not cause a reduction in total surplus. In fact, they increase economic well-being by forcing decisionmakers to take into account the cost of all of the resources being used when making decisions. Unlike other taxes, Pigouvian taxes do not cause a reduction in total surplus. In fact, they increase economic well-being by forcing decisionmakers to take into account the cost of all of the resources being used when making decisions.

27. The Equivalence of Pigovian Taxes and Pollution Permits Tradable pollution permits and Pigouvian taxes are similar in effect. In both cases, firms must pay for the right to pollute. Tradable pollution permits and Pigouvian taxes are similar in effect. In both cases, firms must pay for the right to pollute. In the case of the tax, the government sets the price of pollution and firms then choose the level of pollution (given the tax) that maximizes their profit. In the case of the tax, the government sets the price of pollution and firms then choose the level of pollution (given the tax) that maximizes their profit. If tradable pollution permits are used, the government chooses the level of pollution (in total, for all firms) and firms then decide what they are willing to pay for these permits. If tradable pollution permits are used, the government chooses the level of pollution (in total, for all firms) and firms then decide what they are willing to pay for these permits.

28. Summary When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality. 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. 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. Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity.

29. Summary Those affected by externalities can sometimes solve the problem privately. 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. 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.

30. Summary When private parties cannot adequately deal with externalities, then the government steps in. 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 Pigouvian taxes or by issuing pollution permits. The government can either regulate behavior or internalize the externality by using Pigouvian taxes or by issuing pollution permits.