1. Externalities
AKA
Spillovers

2. When Markets Work
(a) Producers are responsible for all costs & those costs are reflected in the price of the good or service. P
S =Marginal Social Cost (MSC)
=Marginal Private Cost (MPC) P
The private costs and social costs are both reflected in the supply curve
Everything we’ve learned up until now assumes that the market is working to produce the
Market equilibrium which is the most efficient level of Price and Quantity. However, reality
Is always messier than our economic models and sometimes markets do not produce the
Optimal P&Q. When that happens we call it a market failure. Externalities are a form of
Market failure. Basically an externality occurs when there is additional benefit or cost to
society that is not covered by the price of the product. But, to understand what goes
wrong we have to take a quick look at the details f a working market so we can understand
what isn’t working.
First, (CLICK), when markets work.. Read (a)
When condition A is met, (CLICK) read blue text
The private cost is the cost to the firm, the social cost is the cost to other people/society
(CLICK)
Cost are always associated with the supply curve (CLICK)
D =Marginal Social Benefit (MSB)
=Marginal Private Benefit (MPB) Q Q

3. When Markets Work
(a) Producers are responsible for all costs & those costs are reflected in the price of the good or service.
(b) Paying customers are the only beneficiaries of the good or service. P
S=Marginal Social Cost (MSC)
=Marginal Private Cost (MPC)
The private benefits and social benefits are both reflected in the demand curve P
Second, (CLICK), when markets work.. Read (b)
When condition B is met, (CLICK) read blue text
The private benefit is the benefit to the individual/customer,
the social benefit is the benefit to other people/society
(CLICK)
Benefits are always associated with the Demand curve (CLICK)
D =Marginal Social Benefit (MSB)
=Marginal Private Benefit (MPB) Q Q

4. When Markets Don’t Work
Market Failure
Externalities
When someone other than the buyer and seller receives a cost or benefit for which they didn’t ask/pay
When markets don’t work, it’s called Market Failure (CLICK)
One type of market failure is when there is an externality. (CLICK)
Read Slide (CLICK) Give time for students to copy

5. When Markets Don’t Work
Market Failure
Externalities
AKA
Spillover
or Third Party
These are sometimes also called spillover or third party cost/benefits
Give students time to write AKA names
Costs/Benefits

6. Negative Externality (or spillover)
Example:
Factory pollution contaminating water supply
Let’s start with Negative externalities.
When social costs are greater than the private cost it’s called a Negative Externality
Or negative spillover (CLICK)
For Example: (CLICK) read slide, (CLICK) Read slide
The firm is passing on – externalizing- the cost to villagers

7. Negative Externality Example: Factory Pollution MSC > MPC
Marginal Social Cost (MSC)
Psocial
Qso
MSC > MPC P
Marginal Private Cost (MPC)
There is an OVERALLOCATION (making too much) of the good at too low a price
Pmarket
Lets look at the graph (CLICK)
The marginal social cost is greater than the marginal private cost
This means (CLICK) there is an over allocation of the good, they are
Making too much of the good at too low a price
D =Marginal Social Benefit (MSB)
=Marginal Private Benefit (MPB) Qm Q

8. Negative Externality Why is this bad? Deadweight loss MSC P MPC
TO FIND THE AREA OF THE DEADWEIGHT LOSS FOLLOW THE MARKET Q UP TO THE MSC CURVE. IT’S THE AREA BETWEEN MSC, MSB AND QMARKET
Pso Pm
Why is this bad? (CLICK) it creates a deadweight loss to society
(CLICK) read instructions on how to find the area
MSB
Qso Qm Q

9. Why does this happen? Negative Externality Why is this bad?
Deadweight loss
MSC P
MPC
TO FIND THE AREA OF THE DEADWEIGHT LOSS FOLLOW THE MARKET Q UP TO THE MSC CURVE. IT’S THE AREA BETWEEN MSC, MSB AND QMARKET
Pso Pm
MSB
Qso Qm Q

10. Where there is no clear ownership of rights to a natural resource,
Tragedy of the Commons
Where there is no clear ownership
of rights to a natural resource,
the users of the resource are
likely to overexploit it.

11. Tragedy of the Commons
Drilling for Oil

13. Tragedy of the Commons Pump as much oil as fast as you can to get the
oil before someone else does--

14. Private Bathroom in Doctor’s office
Private property
Private Bathroom in Doctor’s office

15. Access is restricted

16. Clean, decorated, well stocked

17. Public High School Bathroom

19. Tragedy of the Commons

20. Negative Externality Possible Solutions:
Property Rights: establishing ownership can provide motivation to include external costs into the price

21. Buffaloes used to roam the west.
But hunters started over hunting them

22. Tragedy of the Commons The herds get smaller. The hunters shoot
The hunters shoot
the buffalo.
You better quick and hunt them before someone
beats you to the punch.

23. Did barb wire help
or hurt the buffalo
population?
Barb wire saved the buffalo by establishing
property rights at a relatively low cost. Prior to
barb wire, it was too expensive to establish property
rights.

24. But, this often isn’t a plausible option
Negative Externality
Possible Solutions:
Property Rights: establishing ownership can provide motivation to include external costs into the price
Coase Theorem: as long as transaction costs are low, it doesn’t matter which party has property rights, they will negotiate a solution to the externality without the need for gov’t intervention.
There are several solutions that might correct a negative externality
(CLICK) Property rights are incredible important for the market to work properly
If someone owns the problem area, they will be motivated to fix it
Logically, you’d want to give the property rights to the producer,
So they will fix it and incorporate the cost into the price (CLICK)
But, Ronald Coase came up with an interesting theory that it doesn’t matter who
gets the property rights….. Read slide
Let’s take the factory pollution example:
If the factory gets property rights to the river, they will be motivated to install a filtration system
If the Villagers get property rights, they will either build the filter/negotiate or be able to take
Legal action against the company to make them do it.
(CLICK)
Read slide … take the next slide for example (click)
Ronald H. Coase
But, this often isn’t a plausible option

25. Property rights of smoking have changed over the years.
Read slides
It used to be,
“Would you like
a smoke”?
Then it became,
“Do you mind if I smoke”?

26. Then it became, “Thank you for not smoking.”
Finally, an outright
ban on smoking.

28. Negative Externality Possible Solutions: Government intervention:
1. Tax – could pay for fixing extra cost
– or at least decrease Q
2. Q Restriction – establish a law to force correction
3. Price Control – establish an effective price floor
4. Permits – i.e.. pollution permits that can be bought and sold among polluters

29. Pass out Negative Externalities Homework
& do example together
& do example together

30. Start with a base S/D graph, except label supply MPC and demand MSB
ABC Plastics is polluting the ground water surrounding it’s factory. The Gov’t decides to tax their product and use the $ to treat the area. Graph the externality including the tax.
Start with a base S/D graph, except
label supply MPC and demand MSB
Label P&Q - Pm & Qm P
MPC Pm
MSB Qm Q

31. Add in the social cost (MSC) line
ABC Plastics is polluting the ground water surrounding it’s factory. The Gov’t decides to tax their product and use the $ to treat the area. Graph the externality including the tax.
MSC
Add the externality P
MPC
Add in the social cost (MSC) line
Pso
Draw social equilibrium lines and labels Pso & Qso Pm
MSB
Add arrow to show direction of change in cost lines, P’s and Q’s
Qso Qm Q

32. You have drawn the Externality, now add the tax
ABC Plastics is polluting the ground water surrounding it’s factory. The Gov’t decides to tax their product and use the $ to treat the area. Graph the externality including the tax.
MSC
You have drawn the Externality, now add the tax P
MPC
TAX
Pso
4. Shade in the area of the tax and label it
You can either write it inside the shaded area or outside with an arrow Pm
MSB
Qso Qm Q

33. Positive Externality (or spillover) Market Failure
When Markets Don’t Work
Example:
Getting a vaccine for a contagious disease
Ask the students When markets don’t work, what is it called? (CLICK) Market Failure
Now we are going to talk about positive externalities. (CLICK)
They are when the social benefits are greater than the private benefits
For Example: (CLICK) read slide, (CLICK) Read slide
The rest of the population benefits from the protect, but doesn’t pay for it.

34. Positive Externality Example: Vaccinations
MSB > MPB
Marginal Social Benefit (MSB)
Qso
Psocial
Marginal Social Cost (MSC)
There is an UNDERALLOCATION (making too little) of the good at too high a price
Pmarket
Lets look at the graph (CLICK)
The marginal social benefit is greater than the marginal private benefit
This means (CLICK) there is an under allocation of the good, they are
Making too little of the good at too high a price
Marginal Private Benefit (MPB) Qm Q

35. Positive Externality Why is this bad? Deadweight loss P MSC
TO FIND THE AREA OF THE DEADWEIGHT LOSS FOLLOW THE MARKET Q UP TO THE MSC CURVE. IT’S THE AREA BETWEEN MSC, MSB AND QMARKET
Pso Pm
Why is this bad? (CLICK) it creates a deadweight loss to society
(CLICK) read instructions on how to find the area
MSB
MPB Qm
Qso Q

36. Why does this happen? Positive Externality Why is this bad?
Deadweight loss P
MSC
TO FIND THE AREA OF THE DEADWEIGHT LOSS FOLLOW THE MARKET Q UP TO THE MSC CURVE. IT’S THE AREA BETWEEN MSC, MSB AND QMARKET
Pso Pm
Why is this bad? (CLICK) it creates a deadweight loss to society
(CLICK) read instructions on how to find the area
MSB
MPB Qm
Qso Q

37. "Free" Rider Problem
When the accessible and desirable nature of public goods inclines people to use these goods, sometimes without paying for the privilege

38. Public vs. Private Goods
"Free" Rider Problem
Public vs. Private Goods
Private goods
1. Exclusionary – owner can exclude those who don’t pay for it
2. Rival – consuming it prevents others from doing the same
Example:
Can of soda

39. Public vs. Private Goods
"Free" Rider Problem
Public vs. Private Goods
Public goods
1. Non-exclusionary – owner cannot exclude those who don’t pay for it
2. Nonrival – consuming it doesn’t prevent others from doing the same

40. Public vs. Private Goods
"Free" Rider Problem
Public vs. Private Goods
Public goods
Examples:
Lighthouses
All the captains use it to keep from crashing, but they don’t pay for it and there isn’t a good way to make them

41. Public vs. Private Goods
"Free" Rider Problem
Public vs. Private Goods
Public goods
Examples:
Street Light Systems
Anyone walking by benefits from the light, but does not have to pay for the benefit

42. Public vs. Private Goods
"Free" Rider Problem
Public vs. Private Goods
Public goods
The market will not provide optimum amounts of these good, or provide them at all because there is no way to make a profit from them.
The production of public goods results in positive externalities which are not paid for, so there is less incentive to produce it.

43. In a family of four, there are two cops and two
robbers. Who are the “free” riders and why?

44. What’s Wrong with this picture?
It wouldn’t work because Sunsets are a non-excludable good, in that non-payers can't be prevented from enjoying them. 

45. Interstate Highway System
Positive Externality
Possible Solutions:
1. Government Production: have the gov’t produce the good using tax dollars
Examples:
Interstate Highway System
National Defense

46. Why do governments pay for mosquito spraying
of neighborhoods? Why isn’t this privatized?

47. Free Rider Problem

48. Positive Externality Possible Solutions:
1. Government Production: have the gov’t produce the good using tax dollars
2. Subsidy: to either producer or consumer of the product
3. Legal Mandate: legally require consumption or production of the good

49. Positive Externality Possible Solutions: Example:
Education – all 3 are used
The more education a person has, the less likely they are commit crimes & the more likely they are to solve problems, help people….contribute to society

50. Positive Externality Possible Solutions: Example:
Education – all 3 are used
Education produces a positive externality
It is under produced or underallocated at too high a price

51. Positive Externality Possible Solutions: Example:
Education – all 3 are used
The gov’t produces it (public schools)
They subsidize consumers (low cost student loans & scholarships) They subsidize producers (fed grants)
Require it 5-18yrs olds

52. Pass out Negative Externalities Homework
& do example together
& do example together

53. Start with a base S/D graph, except label supply MSC and demand MPB
The government decides to subsidize consumers for tuberculosis vaccinations by issuing discount coupons to parents of school children. Graph the externality including the subsidy.
Start with a base S/D graph, except
label supply MSC and demand MPB
Label P&Q - Pm & Qm P
MSC Pm
MPB Qm Q

54. Add in the social benefit (MSB) line
The government decides to subsidize consumers for tuberculosis vaccinations by issuing discount coupons to parents of school children. Graph the externality including the subsidy.
Add the externality P
Add in the social benefit (MSB) line
MSB
MSC
Add arrow to show direction of change in lines, P’s and Q’s
Draw social equilibrium lines and labels Pso & Qso
Qso
Pso Pm Qm Q

55. You have drawn the Externality, now add the subsidy
The government decides to subsidize consumers for tuberculosis vaccinations by issuing discount coupons to parents of school children. Graph the externality including the subsidy.
You have drawn the Externality, now add the subsidy P
MSC
Pso
4. Shade in the area of the subsidy and label it
You can either write it inside the shaded area or outside with an arrow Pm
SUBSIDY
MSB Qm
Qso Q