Externalities

1. Externalities Negative and Positive Market Failures

6. Negative Externalities • Are spillover effects of the actions of an individual person, or of a good or firm in the market. • The effect of that action transfers a cost to others. • The people affected did not participate in the original transaction; they are call “bystanders.”

7. Externalities are Market Failures • The private costs and benefits do not account for the social costs or benefits. • Negative externalities: Unaccounted-for costs mean that the good/action is overproduced; the socially optimum level of production is always less than the private market Q. • Positive externalities: Resources for that good are under-allocated; the socially optimum amount is greater than the private market Q.

9. Solutions to Negative Externalities • Private Solutions • Called Coase Theorem (after Ronald Coase) • Market-based: Can the market figure out its own solution and incorporate it into the cost of the good? Sometimes, although the failure to do so in the first place created the externality. • Command and Control Solutions

10. Private (Coase Theorem) Solutions • Are counterintuitive. When they work, they are the most efficient and least costly solutions. • Three requirements to be effective: • 1) Property rights & interests are clearly identified • 2) Small number of people involved • 3) Low (or no) transaction (bargaining) costs • e.g. trains & wheat fields, barking dogs, loud music

12. Command and Control • Command and control solutions are government-based because they require laws (legislative), enforcement (executive) and the court system (judicial) to implement. • e.g. The Clean Air Act & Clean Water Act • Work best in large-scale externality situations that involve a lot of costs many affected bystanders and poorly defined property rights.

15. Social costs Cost of pollution Optimum Equilibrium Demand (private value) Qoptimum Qmarket Figure 10-2: Pollution and the Social Optimum Price of Aluminium Supply (private costs) 0 Quantity of Aluminium

16. Private vs. Social Costs & Benefits • MPC = MPB • Marginal Private Cost = Marginal PrivateBenefit tells us what the market will produce on its own. • MSC = MSB • Marginal Social Benefit = Marginal Social Cost tells us what should be the optimum level of production.

17. Correcting Negative Externalities • Pigovian tax: A tax that forces the side of the market producing the externality to pay the social cost. It does not limit the quantity of the externality, it just makes it more expensive to continue. • Tradable permits: Sets a quantity limit to pollution, distributes the right to pollute to factories, and allows them to sell their pollution rights to other firms.

18. Positive Externalities • The social benefit is not accounted for in the cost to produce, so the good is under-produced • The socially optimum quantity is greater than the private quantity. (Q optimum)

20. Other Types of Market Failures • Information Failures: Occur when one side of a market transaction has more information than the other side. • “Asymmetrical Information” • e.g. Licensing of surgeons, lawyers, etc., • Adverse Selection Problems: When what you don’t know before you sign a contract (and the other party does know) inflicts major costs on you. e.g. Buying a used car: Is it a lemon?

22. Information Failures • 2. Moral Hazard: When one party alters their behavior, after they have entered into a contract, in ways that will be costly to the other party. • e.g. College failure insurance • Car insurance: less cautious drivers? • Government insurance of banks and mortgages caused banks to make risky loans.