Ch 10 Externalities

Externality

The uncompensated impact of one person’s actions on the well being of a bystander; cause markets to be inefficient and thus, fail to maximize total surplus

"Invisible Hand"

Theory by Adam Smith; the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society can derive from a market

An externality arises when…

a person engages in activity that influence the well being of a bystander and yet neither pays nor receives any compensation for the effect

Negative externality

When the impact on the bystander is adverse. They lead markers to produce a larger quantity than socially desirable ex: -Pollution -Automobile exhaust -Cigarette smoking -Barking dogs (loud pets) -Loud stereos in an apartment building -Sriracha Sauce

Positive externality

When the impact on the bystander is beneficial; the social value of the good exceeds the private value. Lead markets to produce a smaller quantity than is socially desirable ex: -Immunizations -Restored historic buildings -Research into new technologies -Education

EX: The Market for Aluminum
Assumption is that firms only care about revenue

-The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus. -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. -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 on graphs

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

Optimal Quantity Price
External Cost = Supply Quantity

Set Social Cost = Demand (private value) where social cost = private cost (supply curve) + External cost

Internalizing an externality

Involves altering incentives so that people take account of the external effects of their actions. -achieving the social optimal output -The government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity.

Examples of Positive Externalities

-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. -Impact of the internet, computing technology -Created knowledge spillovers to other firms

Positive Externalities on graphs

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.

Internalizing Externalities Cont

By subsidies–Used as the primary method for attempting to internalize positive externalities. Ex: Mexico and Opportunidades Industrial Policy, government intervention in the economy that aims to promote technology-enhancing industries Ex: 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.

Public Policy Towards Externalities

When externalities are significant and private solutions are not found, government may attempt to solve the problem through . . . -command-and-control policies, these usually take the form of regulations ex: requirement that all students be immunized -Market based policies, government uses taxes and subsidies to align private incentives with social efficiency; Cap and Trade-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

Pigovian taxes

Taxes enacted to correct the effects of a negative externality. Ex: 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). NAAQS or… -levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian tax). Gas tax, cigarette tax

Private Solutions to Externalities

Government action is not always needed to solve the problem of externalities. Moral codes and social sanctions Charitable organizations (Bill and Melinda Gates) Contracting between parties (Coase Theorem)

Coase Theorem

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. They can arrive at an efficient (least cost) solution That solution may have undesirable distributional outcomes

Transaction Costs

the costs that parties incur in the process of agreeing to and following through on a bargain.

Problems with Private Solutions to Externalities

Sometimes the approach fails because transaction costs can be so high that private agreement is not possible/difficult to negotiate/hard to assign property rights

Which of the following is an example of a positive externality?
a) Bob mows Hillary’s lawn and is paid $100 for preforming the service
b) While mowing the lawn, Bob’s lawnmower spews out smoke that Hillary’s neighbor Kris has to breathe
c) Hillary’s newly cut lawn makes her neighborhood more attractive
d) Hillary’s neighbors pay her if she promises to get her lawn cut on a regular basis

c) Hillary’s newly cut lawn makes her neighborhood more attractive

If the production of a good yields a negative externality, then the social cost curve lie_____the supply curve, and the socially optimal quantity is ______then the equilibrium quantity
a) above, greater
b) above, less
c) below, greater
d) below, less

b) above, less

When the government levies a tax on a good equal to the external cost associated with the good’s production, it _____the price paid by consumers and makes the market outcome ________ efficient
a) increases, more
b) increases, less
c) decreases, more
d) decreases, less

b) increases, less

Which of the following statements about corrective taxes is NOT true?
a) Economists prefers them to command-and-control regulation
b) They raise government revenue
c) They cause deadweight losses
d) They reduce the quantity sold in a market

c) They causes deadweight losses

The government auctions off 500 units of pollution rights. They sell for $50 per unit, raising total revenue of $25,000. This policy is equivalent to a corrective tax of _____per unit of pollution
a) $10
b) $50
c) $450
d) $500

b) $50

The Coase Theorem does NOT apply if
a) there is a significant externality between two parties
b) the court system vigorously enforces all contracts
c) transaction cost make negotiating difficult
d) both parties understand the externality fully

c)