1. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Market Efficiency - Market Failures The “invisible hand” leads self-interested buyers and sellers in a market to maximize the total benefit that society gets from a market. But market failures can still happen.

2. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. u Automobile exhaust u Cigarette smoking u Barking dogs (loud pets) u Loud stereos in an apartment building Examples of Negative Externalities

3. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. u Immunizations u Restored historic buildings u My neighbor mowing his lawn u Research into new technologies Examples of Positive Externalities

4. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Example: A Negative Externality The Market for Aluminum Quantity of Aluminum 0 Price of Aluminum Q MARKE T Demand (private value) Supply (private cost) Equilibrium

5. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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 “bystanders” hurt by the pollution.

6. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Q MARKE T Pollution and the Social Optimum... Quantity of Aluminum 0 Price of Aluminum Demand (private value) Supply (private cost) Social cost Q optimum Cost of pollution Equilibrium Optimum

7. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Negative Externalities in Production The intersection of the demand curve and the social-cost curve determines the most efficient output level. u When there are negative externalities, the market produces more than the socially best quantity. u The market produces too much of an offending product.

8. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Achieving the Socially Best Output Internalize an externality: change incentives so that people take the external effects of their actions into account.

9. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Positive Externalities in Production When an externality benefits bystanders, a positive externality exists. u The social costs of production are less than the private costs. u The market produces too little of a good with positive externalities.

10. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Positive Externalities in Production... Quantity of Robots 0 Price of Robot Q OPTIMUM Demand (private value) Supply (private cost) Social cost Q MARKET Value of technology spillover Equilibrium Optimum

11. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Internalizing Production Externalities u Taxes are the primary way to internalize negative externalities. u Subsidies are the primary way to internalize positive externalities.

12. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Consumption Externalities... Quantity of Education 0 Price of Education Q MARKET Demand (private value) Social value Q OPTIMUM (b) Positive Consumption Externality Supply (private cost) Quantity of Alcohol 0 Price of Alcohol Q MARKET Demand (private value) Supply (private cost) Social value Q OPTIMUM (a) Negative Consumption Externality

13. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Types of Private Solutions to Externalities u Moral codes and social sanctions u Charitable organizations u Integrating different types of businesses u Contracting between parties

14. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Coase Theorem The Coase Theorem states that if private parties can bargain without cost over the allocation of resources, then the private market will always solve the problem of externalities on its own and allocate resources efficiently.

15. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Command-and-Control Policies u Usually take the form of regulations: u Forbid certain behaviors. u Require certain behaviors. u Examples: u Requirements that all students be immunized. u Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA).

16. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Market-Based Policies u Government uses taxes and subsidies to align private incentives with social efficiency. u Pigovian taxes are taxes enacted to correct the effects of a negative externality.

17. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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).

18. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Market-Based Policies u Tradable pollution permits allow the voluntary transfer of the right to pollute from one firm to another. u A market for these permits will eventually develop. u 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.

19. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality. u Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity. u Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity.

20. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u Those affected by externalities can sometimes solve the problem privately. u 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.

21. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u When private parties cannot adequately deal with externalities, then the government steps in. u The government can either regulate behavior or internalize the externality by using Pigovian taxes.

22. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Graphical Review

23. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Market for Aluminum... Quantity of Aluminum 0 Price of Aluminum Q MARKE T Demand (private value) Supply (private cost) Equilibrium

24. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Pollution and the Social Optimum... Q MARKE T Quantity of Aluminum 0 Price of Aluminum Demand (private value) Supply (private cost) Social cost Q optimum Cost of pollution Equilibrium Optimum

25. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Positive Externalities in Production... Quantity of Robots 0 Price of Robot Q OPTIMUM Demand (private value) Supply (private cost) Social cost Q MARKET Value of technology spillover Equilibrium Optimum

26. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Consumption Externalities... Quantity of Education 0 Price of Education Q MARKET Demand (private value) Social value Q OPTIMUM (b) Positive Consumption Externality Supply (private cost) Quantity of Alcohol 0 Price of Alcohol Q MARKET Demand (private value) Supply (private cost) Social value Q OPTIMUM (a) Negative Consumption Externality

27. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Equivalence of Pigovian Taxes and Pollution Permits... Quantity of Pollution 0 Price of Pollution P Q Demand for pollution rights Pigovian tax (a) Pigovian Tax 2....which, together with the demand curve, determines the quantity of pollution. 1. A Pigovian tax sets the price of pollution... Quantity of Pollution 0 Q Demand for pollution rights Supply of pollution permits (b) Pollution Permits Price of Pollution P 2....which, together with the demand curve, determines the price of pollution. 1. Pollution permits set the quantity of pollution...