harcourt brace & company chapter 10 externalities (lecture by d. boldt on 10/18/01 in econ...

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Chapter 10

Externalities(Lecture by D. Boldt on 10/18/01

in Econ 2105-06

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Externality

• Principle #7 (Ch. 1) Governments Can Sometimes Improve Market Outcomes

• Government involvement may be needed in case of a Market Failure.

• One example of a market failure is a side effect of economic activity known as an Externality.

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Externality - Defined• The uncompensated

effects that the production or consumption of goods have on third parties.

• The impact of one person’s actions on the well-being of a bystander!

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External Benefits - Positive Externalities

• The uncompensated benefits that are received by individuals who are not directly involved in the production or consumption of goods.

• The act of producing or consuming goods sometimes generates benefits to others who do not have to pay for them.

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External Costs - Negative Externalities

• The uncompensated costs that are imposed upon individuals who are not directly involved in the production or consumption of goods.

• The act of producing or consuming goods sometimes generates costs to others who are not paid to endure them.

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Negative Externality• Air Pollution from a Power Plant• Cigarette smoking

Positive Externality• Immunizations• Outside Home Improvements

Examples of Negative and Positive Externalities

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Externalities and Market Inefficiency - Negative Externalities

• Negative externalities lead markets to produce a larger quantity than is socially desirable.

• The Social Costs of production or consumption are greater than the private cost or private benefit by producers and consumers.

This leads to market failure.

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Negative Externalities and Market Inefficiency - Graphical Example

• Assume that the production process emits pollution - negative externality.

• The cost to society of production is larger than the cost to the producer.

• The Social Cost includes the private costs plus the costs to those bystanders adversely affected by the pollution.

Reflects in a new Supply Curve. . .

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Negative Externalities and Market Inefficiency - Graphical Example

SupplyPrivate Cost

DemandPrivate Value

QMarket

Market output before accounting

for externality.

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Negative Externalities and Market Inefficiency - Graphical Example

SupplyPrivate Cost

DemandPrivate Value

QMarket

Cost of

Pollutio

nSocial

Cost

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Negative Externalities and Market Inefficiency - Graphical Example

SupplyPrivate Cost

DemandPrivate Value

Cost of

Pollutio

nSocial

Cost

The optimum outputaccounts for the

externality.

QOptimum

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Negative Externalities and Market Inefficiency - Graphical Example

The intersection of the demand curve and the social-cost curve determines the optimal output level - less than equilibrium quantity.

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Externalities and Market Inefficiency - Positive Externalities

• Positive externalities sometimes lead markets to produce a smaller quantity than is socially desirable.

• The Social Costs of production or consumption are less than the private cost or private benefit to producers and consumers.

This leads to market failure.

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Positive Externalities and Market Inefficiency - Graphical Example

SupplyPrivate Cost

DemandPrivate Value

QMarket

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SupplyPrivate Cost

DemandPrivate Value

QMarket

Market output before accounting

for externality.

Positive Externalities and Market Inefficiency - Graphical Example

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SupplyPrivate Cost

DemandPrivate Value

Positive Externalities and Market Inefficiency - Graphical Example

Value of TechnologySpillover

QOptimal

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Positive Externalities and Market Inefficiency - Graphical Example

• The intersection of the demand curve and the social-cost curve determines the optimal output level - more than equilibrium quantity.

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Private Solutions to ExternalitiesCoase Theorem:

– If private parties can bargain to their mutual advantage without cost, then the private market may solve the problem of externalities and allocate resources efficiently.

– Private bargaining can internalize the external effects, resulting in efficient solutions (bargaining with a neighbor)

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Failure to Private Solutions Approach

Sometimes the private solution approach will fail because:– The transaction costs (bargaining costs)

can be so high that private agreement is not possible.

– Failure to achieve a private solution may require that the government intervene.

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Public Policy Toward Externalities

When externalities are significant and when private solutions are not possible, government may attempt to solve the problem by:– Command-and-Control policies

– Market-Based policies (taxes or tradeable permits)

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Command-and-Control Policies

• Usually in the form of regulations: – making certain behavior forbidden

– making certain behavior required

• Examples:– All students must be immunized

– Stipulating levels of pollution emissions

– Requiring certain pollution control devices

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Market-Based PoliciesTaxes: In situations where market

failure occurs because of externalities, the government can attempt to internalize the externality by:– imposing a tax on goods with a negative

externality.

– implementing a subsidy on goods with a positive externality.

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Market-Based PoliciesTradable Pollution Permits: the

voluntary transfer of the right to pollute from one firm to another. – Pollution permits which results in a new

market for these permits.

– Firms that can reduce pollution most easily will be willing to sell their permit, for whatever they can get.