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Externalities

Externalities. Chapter 10. EXTERNALITIES. An externality is the uncompensated impact of one person’s actions on another person Both positive & negative externalities exist All externalities cause markets to be inefficient That is, markets do not maximize total surplus (welfare).

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Externalities

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  1. Externalities Chapter 10

  2. EXTERNALITIES • An externalityis the uncompensated impact of one person’s actions on another person • Both positive & negative externalities exist • All externalities cause markets to be inefficient • That is, markets do not maximize total surplus (welfare)

  3. Negative Externalities • Automobile exhaust • Cigarette smoking • Barking dogs • Loud stereos in an apartment building • Noisy Students • Neighbor’s poorly maintained property

  4. Positive Externalties • Immunizations • Restored historic buildings • Research into new technologies • Neighbor’s well maintained property

  5. MC = MB MARKET INEFFICIENCY • Negative externalities lead markets to overproduce • Positive externalities lead markets to under-produce Supply Curve = Marginal Cost Curve Demand Curve = Marginal Benefit Curve

  6. Spillover Costs & Benefits • Spillover Costs-costs not captured by supply curve (MC) • Costs are understated • Spillover Benefits-benefits not captured by demand curve (MB) • Benefits are understated

  7. Supply = MCP External social Cost (private cost) Optimum Spillover Cost Equilibrium MC = MB Demand = MB (private value) QOPTIMUM QMARKET Negative Externality: Pollution MSC (social cost) Price of Aluminum P1 Quantity of 0 Aluminum

  8. External social benefit MC Optimum Equilibrium Spillover Benefit MB QOPTIMUM QMARKET Positive Externality: Neighbor paints House Price P1 MSB Quantity 0

  9. Solutions to Externalities • Internalizing an externality involves altering incentives • Government Methods • Taxes (corrective taxes), Subsidies • Patents • Laws (immunization laws, pollution laws) • Free market solution: • Trading pollution credits

  10. Worksheet • Externalities

  11. Taxing Negative Externalities Impose Tax = spillover cost Shifts Supply Curve left Reach social optimal output Total Cost = Total Benefit Total Cost = MSC (MCP + MCS)

  12. Subsidizing Positive Externalities Fuel Efficient Cars Impose Subsidy=spillover benefit Shifts demand curve right Reach social optimal output Total Cost = Total Benefit

  13. Day #2 • Practice Test

  14. Factory A Factory B

  15. Cap & Trade Analysis Goal: to reduce CO2 emissions Pollution Credits Trading System S D

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