principles of microeconomics - externalities

8/3/2019 Principles of Microeconomics - Externalities

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Externalities

Dr. Katherine Sauer

Principles of Microeconomics

ECO 2020


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In the eastern part of the Pacific Ocean, there is a floating garbage

patch that is twice the size of Texas.

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Plastic

Consumers get the benefit of buying things that contain plastic,

and they have to pay for that benefit.

Producers get the benefit of selling an item that people want, and

they incur the costs of producing it.

But,there are *extra* costs to society as a whole.


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When you drive your car, you are emitting carbon dioxide, a known

greenhouse gas, into the air.

http://www.boxoid.org/?p=86


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Gasoline

Consumers get the benefit of driving their cars, and they have to

pay for the cost of gasoline.

Producers get the benefit of producing/selling gasoline, and they

have to incur the cost of producing it.

But,

there are *extra* costs to society as a whole.


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Education

Consumers (students) get benefits like a higher future salary and

an increase in skills and experience, and must pay the cost in the

form of tuition.

Producers (colleges) get benefits like selling a service that

consumers want but also must incur the costs of production.

But,

there are *extra* benefits to society as a whole.


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Historic buildings allow a glimpse into the past.

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Historic Buildings

The owner of the building gets the benefit from owning the

building, and incurs the cost of renovation / upkeep.

But,

there are *extra* benefits to society as a whole.


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The Market Outcome

Recall:

The Demand curve represents the value (benefit) to consumers.The Supply curve represents the production cost.

Market equilibrium is efficient (it maximizes total surplus).

In reality, sometimes the total benefits are not reflected in the demand

curve and the total costs are not reflected in the supply curve.


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I. Externalities are the uncompensated impact of ones actions on the

well-being of abystander or society as a whole.

ex: factory emissions, barking dogs, flu shots, flower gardens

Externalities can be positive or negative.

Positive externalities mean that the third party has in some

way benefited.

Negative externalities mean that the third party has in someway been harmed.


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Note: If a party engages in an activity that harms/benefits

themselves, that is not part of the externality.

ex: You smoke cigarettes. (benefit to you)

- You pay for cigarettes. (cost to you, not an externality)

- You spend money on gum and mouthwash. (cost to you,

not an externality)

- You will probably face some health issues in the future.

(cost to you, not an externality)

-You smoke around a non-smoker and it bothers them.

(negative externality)

-You eventually end up with Medicare paying your healthcosts. (negative externality)

-You die younger than a non-smoker and stop drawing

Social Security. (positive externality)


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A. Negative Externalities

Ex: pollution from the production of coal-fired electricity

- you pay for electricity and get its benefits

- the power plant incurs production costs and receives

payment for the electricity it sells

- pollution from the power plant harms the environment and

bothers people

The social cost of coal-fired electricity is greater than the privatecost of coal-fired electricity.

social cost = production costs + externality costs


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Price

Quantity of Megawatts

Supply

(private

cost)

Demand

(private

benefit =

social benefit)

Qm

Pm

The market outcome

will be where supply

and demand are equal.

The market ignores

externalities.

The private cost plus theexternality cost is the

true cost to society of

the action.

The socially optimaloutcome is a lower

quantity and higher

price.

Social Cost

externality costs

Pso

Qso


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B. Positive Externalities

Ex: K-12 education (in many nations it is not free)

- student pays for education and gets its benefits

- school incurs production costs and receives payment for

services

- society as a whole benefits by having more educated

residents

The social benefits of education are greater than the private benefitsof education.

social benefit = private benefit + externality benefit


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Price

Quantity

Supply(private

cost =

social

cost)

Social

Benefit

Qso

Pso

The market outcome will

be where supply and

demand are equal.

The market ignores

externalities.

The private benefit plusthe externality benefit is

the true benefit to society

of the action.

The socially optimaloutcome is a higher

quantity and higher

price.

Demand (private benefit)

external benefit

Qm

Pm


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II. Public Policy: Government responses to externalities

If the market ignores externalities, then perhaps there is reason

for the government to step in.

Two common types of government responses to externalities:

1. command and control

2. market based


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1. Command and Control = regulate the behaviordirectly

Ex: laws against dumping untreated water into riversEx: must attend school until you are 16

2. market based =provide incentives so people/firms choose to

change behaviorEx: gasoline tax

Ex: flu shot subsidies

Market based solutions allow the externality to be internalized.

- alter the incentives so that people/firms take the

external effects of an action into account


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Price

Quantity of

Megawatts

Supply

(private

cost)

Demand

(private

benefit =

social benefit)

Qm

Pm

Anegative externality can

be internalizedby imposing

a corrective tax on the

good.

Recall, a tax shifts the

supply curve to the left by

the amount of the tax.

If the tax was set at the

same amount as the

externality cost, the supply

curve would then coincidewith the social cost curve.

Now the market outcome is

socially optimal.

Social Cost

externality costs

Pso

Qso

a. Internalizing a negative externality

tax

= supply + tax


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Price

Quantity

Supply(private

cost and

social

cost)

Social Benefit

Qso

Pso

Apositive externality

can be internalizedby

subsidizing the good.

A subsidy can be used to

shift the demand curve

to the right.

If the subsidy was set at

the same amount as the

externality benefit, the

demand curve would

then coincide with thesocial benefit curve.

Now the market outcome

is socially optimal.

Demand

(private benefit)

external benefit

Qm

Pm

b. Internalizing a positive externality

subsidy

= demand +

subsidy


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III. Private Solutions (non-government solutions)

We do not necessarily need government involvement to correct

externalities.

Types of private solutions:

1. moral codes

ex: the Golden Rule

2. nonprofits and charities

ex: Sierra Club, UniversityAlumni Foundation

3. self-interest / contracts


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How well does the private sector do when dealing with

externalities?

- depends on how well property rights are defined

- depends on ease of bargaining (how many parties?)

- depends on transaction costs

The Coase Theorem: If property rights are well-defined and if

private parties can bargain costlessly, then the private market willsolve the externality problem.


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Chapter Summary:

When a transaction between a buyer and seller affects a third

party, that effect is called an externality.

If an activity yields negative externalities, the socially optimalquantity in a market is less than the equilibrium quantity.

If an activity yields positive externalities, the socially optimal

quantity is greater than the equilibrium quantity.


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Governments use various policies to remedy the inefficiencies

caused by externalities.

- regulation

- corrective taxes- subsidies

In certain situations, people can solve externality issues

without government intervention.

principles of microeconomics - externalities

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