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Externalities

EXTERNALITIES AND MARKET

INEFFICIENCY(FAILURE)

 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.

EXAMPLES OF NEGATIVE EXTERNALITIES

 Negative Externalities  Automobile exhaust  Cigarette smoking  Barking dogs (loud pets)  Loud stereos in an apartment building

EXAMPLES OF POSITIVE

EXTERNALITIES

 Positive Externalities  Immunizations  Restored historic buildings  Research into new technologies

CASE: POLLUTION EMITTED FROM

ALUMINUM FACTORIES

 The Market for Aluminum  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.

ALUMINUM: CONTINUED

• 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.

SOCIALLY OPTIMUM

 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.

INTERNALIZING NEGATIVE

EXTERNALITY

 Internalizing an externality involves altering incentives so that people take account of the external effects of their actions.  To achieve the socially optimal output…  the government can internalize a negative externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity.

Quantity of Education 0 Price of Education Demand (private value) Supply (private cost) Q MARKET Social value (private and external benefit) External benefit Equilibriu m Optimum Q OPTIMUM

SOCIAL OPTIMUM

 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.

PRIVATE SOLUTIONS: THE COASE

THEOREM

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

WHY PRIVATE SOLUTIONS DO NOT

ALWAYS WORK

 Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible.

COMMAND-AND-CONTROL POLICIES:

REGULATION

 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).

MARKET-BASED POLICY 1: CORRECTIVE

TAXES AND SUBSIDIES

 Government uses taxes and subsidies to align private incentives with social efficiency.  Corrective taxes are taxes enacted to correct the effects of a negative externality.  Also called Pigovian taxes