Download - Session 8 externalities
Session 8Session 8
ExternalitiesExternalitiesExternalitiesExternalities
©© 2002 by Nelson, a division of Thomson Canada Limited 2002 by Nelson, a division of Thomson Canada Limited©© 2002 by Nelson, a division of Thomson Canada Limited 2002 by Nelson, a division of Thomson Canada Limited
Lectured by Prof. Dr. Ferdinand D. Saragih, MA
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 2
• Learn the nature of an externality.• See why externalities can make market
outcomes inefficient.• Examine how people can sometimes solve
the problem of externalities on their own.• Consider why private solutions to
externalities sometimes do not work.• Examine the various government policies
aimed at solving the problem of externalities.
• Learn the nature of an externality.• See why externalities can make market
outcomes inefficient.• Examine how people can sometimes solve
the problem of externalities on their own.• Consider why private solutions to
externalities sometimes do not work.• Examine the various government policies
aimed at solving the problem of externalities.
In this chapter you will…In this chapter you will…In this chapter you will…In this chapter you will…
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 3
• 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!
• 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!
EXTERNALITIESEXTERNALITIESEXTERNALITIESEXTERNALITIES
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 4
• If a market system affects individuals other than buyers and sellers of that market, side-effects are created called Externalities.– Externalities cause markets to
be inefficient, and thus fail.
• If a market system affects individuals other than buyers and sellers of that market, side-effects are created called Externalities.– Externalities cause markets to
be inefficient, and thus fail.
EXTERNALITIESEXTERNALITIESEXTERNALITIESEXTERNALITIES
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 5
• An externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander.
• Externalities cause markets to be inefficient, and thus fail to maximize total surplus.
• An externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander.
• Externalities cause markets to be inefficient, and thus fail to maximize total surplus.
EXTERNALITIESEXTERNALITIESEXTERNALITIESEXTERNALITIES
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 6
• In the presence of externalities, society’s interest in a market outcome extends beyond the well-being of buyers and sellers in the market. . .
• … the well-being of third parties are considered.
• In the presence of externalities, society’s interest in a market outcome extends beyond the well-being of buyers and sellers in the market. . .
• … the well-being of third parties are considered.
EXTERNALITIESEXTERNALITIESEXTERNALITIESEXTERNALITIES
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 7
• Positive Externality• 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.
• Positive Externality• 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.
EXTERNALITIESEXTERNALITIESEXTERNALITIESEXTERNALITIES
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 8
• Negative Externality• 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.
• Negative Externality• 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.
EXTERNALITIESEXTERNALITIESEXTERNALITIESEXTERNALITIES
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 9
Negative Externality• Automobile exhaust• Cigarette smoking
Positive Externality• Immunizations• Restored historic buildings
Negative Externality• Automobile exhaust• Cigarette smoking
Positive Externality• Immunizations• Restored historic buildings
EXTERNALITIESEXTERNALITIESEXTERNALITIESEXTERNALITIES
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 10
• The Market for Aluminum – The demand curve for aluminum
reflects the value to consumers of aluminum as measured by the prices they are willing to pay.
– The supply curve for aluminum reflects the costs of producing aluminum.
– Qmarket: the quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus.
• The Market for Aluminum – The demand curve for aluminum
reflects the value to consumers of aluminum as measured by the prices they are willing to pay.
– The supply curve for aluminum reflects the costs of producing aluminum.
– Qmarket: the quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus.
Welfare Economics: A RecapWelfare Economics: A RecapWelfare Economics: A RecapWelfare Economics: A Recap
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 11
Demand (private value)
Supply (private costs)
0
Equilibrium
QmarketQuantity of Aluminium
Price of Aluminium
Figure 10-1: The Market for AluminiumFigure 10-1: The Market for AluminiumFigure 10-1: The Market for AluminiumFigure 10-1: The Market for Aluminium
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 12
• The Market for Aluminum (cont’d)
– 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.
• The Market for Aluminum (cont’d)
– 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.
Welfare Economics: A RecapWelfare Economics: A RecapWelfare Economics: A RecapWelfare Economics: A Recap
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 13
• The Market for Aluminum (cont’d)– 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.
• The Market for Aluminum (cont’d)– 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.
Negative Externalities in Negative Externalities in ProductionProduction
Negative Externalities in Negative Externalities in ProductionProduction
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 14
• The Market for Aluminum (cont’d)– What quantity of aluminum should
be produced?• Where the demand curve crosses the
social-cost curve. • Below Qoptimum the value of the
aluminum to consumers exceeds social cost of producing it.
• Above Qoptimum the social cost of producing additional aluminum exceeds the value to consumers.
• The Market for Aluminum (cont’d)– What quantity of aluminum should
be produced?• Where the demand curve crosses the
social-cost curve. • Below Qoptimum the value of the
aluminum to consumers exceeds social cost of producing it.
• Above Qoptimum the social cost of producing additional aluminum exceeds the value to consumers.
Negative Externalities in Negative Externalities in ProductionProduction
Negative Externalities in Negative Externalities in ProductionProduction
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 15
Demand (private value)
Supply (private costs)
0
Equilibrium
QmarketQuantity of Aluminium
Price of Aluminium
Social costs
Qoptimum
Cost of pollution
Optimum
Figure 10-2: Pollution and the Social Figure 10-2: Pollution and the Social OptimumOptimumFigure 10-2: Pollution and the Social Figure 10-2: Pollution and the Social OptimumOptimum
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 16
• The Market for Aluminum (cont’d)– Reducing aluminum production and
consumption below the market equilibrium level raises total economic well-being.
• The Market for Aluminum (cont’d)– Reducing aluminum production and
consumption below the market equilibrium level raises total economic well-being.
Negative Externalities in Negative Externalities in ProductionProduction
Negative Externalities in Negative Externalities in ProductionProduction
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 17
0 Quantity of Aluminium
Price of Aluminium
Social costs
Demand (private value)
Poptimum
Qoptimum
Figure 10-3: Deadweight Loss of a Negative Figure 10-3: Deadweight Loss of a Negative Production Externality Production Externality Figure 10-3: Deadweight Loss of a Negative Figure 10-3: Deadweight Loss of a Negative Production Externality Production Externality
Pmarket
Qmarket
a
b
HD + A + ED + A + E - H
A + B + C + HA + EE - (B + C + H)
- (A + B + C)DA + B + C + D
Total surplus
Producer surplus
Consumer surplus
ChangeAt QOptimumAt QMarket
D
A B C
E
F G
H
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 18
• The Market for Aluminum (cont’d)– How the can social optimum of aluminum
production be achieved?• Tax the producers of aluminum thus shifting the
private supply curve up by the amount of the tax so that it coincides with the social-cost curve.
– Internalizing an externality involves altering incentives so that people take account of the external effects of their actions.
– Pigovian taxes are taxes enacted to correct the effects of negative externalities.
– In Figure 10-3, the Pigovian tax is equal to the distance ab.
• The Market for Aluminum (cont’d)– How the can social optimum of aluminum
production be achieved?• Tax the producers of aluminum thus shifting the
private supply curve up by the amount of the tax so that it coincides with the social-cost curve.
– Internalizing an externality involves altering incentives so that people take account of the external effects of their actions.
– Pigovian taxes are taxes enacted to correct the effects of negative externalities.
– In Figure 10-3, the Pigovian tax is equal to the distance ab.
Negative Externalities in Negative Externalities in ProductionProduction
Negative Externalities in Negative Externalities in ProductionProduction
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 19
• When an externality benefits the bystanders, a positive externality exists.– The social value of the good exceeds the
private value.• Example:• A technology spillover is a type of positive
externality that exists when a firm’s innovation or design not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole.
• When an externality benefits the bystanders, a positive externality exists.– The social value of the good exceeds the
private value.• Example:• A technology spillover is a type of positive
externality that exists when a firm’s innovation or design not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole.
Positive Externalities in Positive Externalities in ProductionProduction
Positive Externalities in Positive Externalities in ProductionProduction
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 20
0
Optimum
Quantity of Robots
Price of Robots
Demand (private value)
Social costs
a
b
Qoptimum
Poptimum
Qmarket
Pmarket Equilibrium
Supply (private costs)Value of technology spillover
Deadweight loss
Figure 10-4: Technology Spillovers and the Figure 10-4: Technology Spillovers and the Social Optimum Social Optimum Figure 10-4: Technology Spillovers and the Figure 10-4: Technology Spillovers and the Social Optimum Social Optimum
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 21
• 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 market produces a smaller quantity
than is socially desirable. – The social value of the good exceeds
the private value of the good.
• 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 market produces a smaller quantity
than is socially desirable. – The social value of the good exceeds
the private value of the good.
Positive Externalities in Positive Externalities in ProductionProduction
Positive Externalities in Positive Externalities in ProductionProduction
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 22
• Internalizing Externalities: Subsidies– Used as the primary method for
attempting to internalize positive externalities.
• Internalizing Externalities: Subsidies– Used as the primary method for
attempting to internalize positive externalities.
Positive Externalities in Positive Externalities in ProductionProduction
Positive Externalities in Positive Externalities in ProductionProduction
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 23
– Government intervention in the economy that aims to promote technology-enhancing industries
• Patent laws are 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 system gives firms a greater incentive to engage in research and other activities that advance technology.
– Government intervention in the economy that aims to promote technology-enhancing industries
• Patent laws are 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 system gives firms a greater incentive to engage in research and other activities that advance technology.
CASE STUDY:CASE STUDY: The Debate Over Technology The Debate Over Technology PolicyPolicyCASE STUDY:CASE STUDY: The Debate Over Technology The Debate Over Technology PolicyPolicy
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 24
• Some externalities are associated with consumption.
• Figure 10-5 (a) shows a market with a negative consumption externality such as the market for alcoholic beverages.
• Figure 10-5 (b) shows a market with a positive consumption externality such as the market for education.
• Some externalities are associated with consumption.
• Figure 10-5 (a) shows a market with a negative consumption externality such as the market for alcoholic beverages.
• Figure 10-5 (b) shows a market with a positive consumption externality such as the market for education.
Externalities in ConsumptionExternalities in ConsumptionExternalities in ConsumptionExternalities in Consumption
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 25
(a) Negative Consumption Externalities (b) Positive Consumption Externalities
Price of Alcohol
Quantity of Alcohol
0 0
Social value
Demand (private value)
Supply (private cost)
Quantity of Education
Price of Education
Social value
Demand (private value)
Supply (private cost)
Qmarket QoptimumQoptimum Qmarket
Figure 10-5: Consumption Externalities Figure 10-5: Consumption Externalities Figure 10-5: Consumption Externalities Figure 10-5: Consumption Externalities
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 26
• Government action is not always needed to solve the problem of externalities, which cause markets to be inefficient.
• People can develop private solutions.– Moral codes and social sanctions– Charitable organizations– Integrating different types of
businesses– Contracting between parties
• Government action is not always needed to solve the problem of externalities, which cause markets to be inefficient.
• People can develop private solutions.– Moral codes and social sanctions– Charitable organizations– Integrating different types of
businesses– Contracting between parties
PRIVATE SOLUTIONS TO PRIVATE SOLUTIONS TO EXTERNALITIESEXTERNALITIES
PRIVATE SOLUTIONS TO PRIVATE SOLUTIONS TO EXTERNALITIESEXTERNALITIES
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 27
• The Coase Theorem is a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.
• Private bargaining can internalize the external effects, resulting in efficient solutions.
• The Coase Theorem is a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.
• Private bargaining can internalize the external effects, resulting in efficient solutions.
The Coase TheoremThe Coase TheoremThe Coase TheoremThe Coase Theorem
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 28
• In the real world bargaining does not always work.– Transactions Costs
• Transaction costs are the costs that parties incur in the process of agreeing to and following through on a bargain.
– Bargaining breaks down.
• In the real world bargaining does not always work.– Transactions Costs
• Transaction costs are the costs that parties incur in the process of agreeing to and following through on a bargain.
– Bargaining breaks down.
Why Private Solutions Do Not Why Private Solutions Do Not Always WorkAlways Work
Why Private Solutions Do Not Why Private Solutions Do Not Always WorkAlways Work
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 29
• When externalities are significant and private solutions are not found, government may attempt to solve the problem through . . .– Command-and-control policies that
regulate behaviour directly.– Market-based policies that provide
incentives so that private decisions makers will choose to solve the problem on their own.
• When externalities are significant and private solutions are not found, government may attempt to solve the problem through . . .– Command-and-control policies that
regulate behaviour directly.– Market-based policies that provide
incentives so that private decisions makers will choose to solve the problem on their own.
PUBLIC POLICIES TOWARDS PUBLIC POLICIES TOWARDS EXTERNALITIESEXTERNALITIES
PUBLIC POLICIES TOWARDS PUBLIC POLICIES TOWARDS EXTERNALITIESEXTERNALITIES
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 30
• Command-and-Control Policies– Usually take the form of regulations:
• Forbid certain behaviors.• Require certain behaviors.
– Examples:• Requirements that all students be
immunized.• Stipulations on pollution emission levels set
by the Environmental Protection Agency (EPA).
• Command-and-Control Policies– Usually take the form of regulations:
• Forbid certain behaviors.• Require certain behaviors.
– Examples:• Requirements that all students be
immunized.• Stipulations on pollution emission levels set
by the Environmental Protection Agency (EPA).
PUBLIC POLICIES TOWARDS PUBLIC POLICIES TOWARDS EXTERNALITIESEXTERNALITIES
PUBLIC POLICIES TOWARDS PUBLIC POLICIES TOWARDS EXTERNALITIESEXTERNALITIES
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 31
• Market-Based Policies– Government can internalize an
externality by using taxes and subsidies to align private incentives with social efficiency.
– Pigovian taxes are taxes enacted to correct the effects of a negative externality.
• Market-Based Policies– Government can internalize an
externality by using taxes and subsidies to align private incentives with social efficiency.
– Pigovian taxes are taxes enacted to correct the effects of a negative externality.
PUBLIC POLICIES TOWARDS PUBLIC POLICIES TOWARDS EXTERNALITIESEXTERNALITIES
PUBLIC POLICIES TOWARDS PUBLIC POLICIES TOWARDS EXTERNALITIESEXTERNALITIES
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 32
• Why are gasoline taxes so common?• They are a Pigovian tax aimed at
correcting three negative externalities:– Congestion– Accidents– Pollution
• The tax makes the economy work better.
• Why are gasoline taxes so common?• They are a Pigovian tax aimed at
correcting three negative externalities:– Congestion– Accidents– Pollution
• The tax makes the economy work better.
CASE STUDY:CASE STUDY: Why Is Gasoline Taxed So Why Is Gasoline Taxed So Heavily?Heavily?CASE STUDY:CASE STUDY: Why Is Gasoline Taxed So Why Is Gasoline Taxed So Heavily?Heavily?
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 33
• Market-Based Policies– 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 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.
• Market-Based Policies– 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 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.
PUBLIC POLICIES TOWARDS PUBLIC POLICIES TOWARDS EXTERNALITIESEXTERNALITIES
PUBLIC POLICIES TOWARDS PUBLIC POLICIES TOWARDS EXTERNALITIESEXTERNALITIES
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 34
• Market-Based Policies– Reducing pollution using permits is quite
similar to imposing a Pigovian tax. – In both cases it is the firm who pays its
pollution. – With Pigovian taxes, polluting firms must pay
the government.– With pollution permits, polluting firm must pay
to buy the permit. – See Figure 10-6 for an illustration of the
similarities.
• Market-Based Policies– Reducing pollution using permits is quite
similar to imposing a Pigovian tax. – In both cases it is the firm who pays its
pollution. – With Pigovian taxes, polluting firms must pay
the government.– With pollution permits, polluting firm must pay
to buy the permit. – See Figure 10-6 for an illustration of the
similarities.
PUBLIC POLICIES TOWARDS PUBLIC POLICIES TOWARDS EXTERNALITIESEXTERNALITIES
PUBLIC POLICIES TOWARDS PUBLIC POLICIES TOWARDS EXTERNALITIESEXTERNALITIES
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 35
(a) Pigovian Tax (b) Pollution Permits
Price of Pollution
Quantity of Pollution
0
Pigovian Tax
P
1. A Pigovian sets the price of pollution…
2. … which together with the demand curve, determines the quantity of pollution…
Demand for pollution rights
QQuantity of
Pollution
0
Supply of pollution permits
1. … Pollution permits set the quantity of pollution…
Q
2. … which together with the demand curve, determines the price of pollution…
Demand for pollution rights
P
Figure 10-6: The Equivalence of Pigovian Figure 10-6: The Equivalence of Pigovian Taxes and Pollution Permits. Taxes and Pollution Permits. Figure 10-6: The Equivalence of Pigovian Figure 10-6: The Equivalence of Pigovian Taxes and Pollution Permits. Taxes and Pollution Permits.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 36
• 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.
• Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity.
• 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.
• Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity.
SummarySummarySummarySummary
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 37
• 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.
• 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 Pigovian taxes or by issuing pollution permits.
• 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.
• 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 Pigovian taxes or by issuing pollution permits.
SummarySummarySummarySummary
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 38
The EndThe EndThe EndThe End