EXTERNALITIES

1. EXTERNALITIES Chapter 10

2. Market Efficiency: A Recap Assuming perfect competition and no externalities . . . . . . the economic well-being of a society is measured as the sum of consumer and producer surplus.

3. Market Efficiency: A Recap The �invisible hand� of the marketplace helps to maximize total benefits to society. . . but market failures can still happen.

4. Market Failure When a market outcome affects parties other than the buyers and sellers in the market, side-effects are created called externalities. Externalities cause markets to be inefficient, and thus fail.

5. An externality is . . . the impact of one person�s actions on the well-being of a bystander.

6. The Effect of Externalities on Society In the presence of externalities, society�s interest in a market outcome extends beyond the well-being of buyers and sellers in the market. The well-being of bystanders and society as a whole is also considered.

7. Negative Externalities The uncompensated costs that are imposed upon individuals who are not directly involved in the production or consumption of goods. � The act of producing or consuming goods sometimes generates costs to those who are not paid for them.

8. Positive Externalities The uncompensated benefits that are received by individuals who are not directly involved in the production or consumption of goods. � The act of producing or consuming goods sometimes generates benefits to those who do not have to pay for them.

9. Automobile exhaust Cigarette smoking Examples of Negative Externalities

10. Immunizations Restored historic buildings Examples of Positive Externalities

11. Externalities and Market Inefficiency Negative externalities lead to market failure. � Negative externalities can occur when production or consumption lead markets to produce larger quantities than are socially desirable. � The social costs of production become greater than the the private costs to producers and consumers.

12. Negative Externalities in Production A negative externality like pollution results in a new supply curve. � The cost to society is larger than the cost to the producer. � The social cost includes the private costs plus the costs to those bystanders adversely affected by the pollution.

13. Negative Externalities in Production

14. Negative Externalities in Production

15. Negative Externalities in Production

16. Negative Externalities in Production

17. Negative Externalities in Production The intersection of the demand curve and the social-cost curve determines the optimal output level. � That optimal output level is less than the equilibrium quantity.

18. Attainment of the Optimal Output Internalizing an externality involves altering incentives so that people take into account the external effects of their actions.

19. Attainment of the 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.

20. Externalities and Market Inefficiency Positive externalities in production or consumption lead to market failure. � The market produces a smaller quantity than is socially desirable. � The social costs of production are less than the private cost to producers and consumers.

21. Positive Externalities in Production The intersection of the demand curve and the social-cost curve determines the optimal output level. � That optimal output level is more than the equilibrium quantity.

22. Positive Externalities in Production

23. Positive Externalities in Production

24. Positive Externalities in Production

25. Positive Externalities in Production

26. Attainment of the Optimal Output The government can internalize the externality by subsidizing production�paying the producer to produce more than the equilibrium quantity so that the socially desirable quantity is met.

27. Government Policy Toward Externalities The government may attempt to internalize the externalities by . . . . . . imposing a tax on goods with negative externalities. . . . subsidizing goods with positive externalities.

28. Quick Quiz! Give an example of a negative externality and a positive externality.

29. Quick Quiz! Explain why market outcomes are inefficient in the presence of externalities.

30. Private Solutions to Externalities Government action is not always needed to solve the problem of externalities.

31. Types of Private Solutions to Externalities Moral codes and social sanctions Charitable organizations Integrating different types of businesses Contracting between parties

32. Coase Theorem The Coase theorem states that if private parties can bargain without cost over the allocation of resources, then the private market will always solve the problem of externalities on its own.

33. Coase Theorem Private bargaining can internalize the external effects, resulting in efficient solutions.

34. Private Solutions Approach Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible. � Transaction costs are the costs that parties must incur to agree and follow through on a bargain.

35. Quick Quiz! Give an example of a private solution to an externality.

36. Quick Quiz! What is the Coase theorem?

37. Quick Quiz! Why does the private solution approach often fail?

38. Public Policy Toward Externalities When externalities are significant and private solutions are not found, government may attempt to solve the problem through . . . . . . command-and-control policies. . . . market-based policies.

39. Command-and-Control Policies Usually take the form of regulations: � Forbid certain behaviors. � Require certain behaviors. Examples: � Requirements that all students be immunized. � Stipulations on pollution emission levels.

40. Market-Based Policies Government uses taxes and subsidies to align private incentives with social efficiency. Pigovian taxes are taxes enacted to correct the effects of a negative externality.

41. Market-Based Policies 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.

42. Conclusion Uncompensated effects that the production or consumption of goods have on third parties are called externalities.

43. Conclusion Negative externalities result in a market equilibrium beyond the social optimum.

44. Conclusion Positive externalities result in a market equilibrium short of social optimum.

45. Conclusion Solutions to externalities can be accomplished through private agreements or government intervention.

46. EXTERNALITIES End of Chapter 10