Transcript Externalities

Externalities
Externalities
 What is an externality?
 the uncompensated impact of one person's actions on the wellbeing of a bystander (or 3rd party)
 Two Types of Externalities
 Negative Externality


If the impact on the bystander is adverse, it is called a
negative externality.
Positive Externality

If the impact on the bystander is beneficial, it is called a
positive externality.
Examples
 Negative Externalities
 pollution from power plants
 exhaust from automobiles
 noise from airplanes or barking dogs
 Positive Externalities
 restored historic buildings
 new technologies
 inoculations
Examples
 How does an externality create a market failure?
 Supply and demand do not account for the external effects on
3rd parties. If they did, equilibrium would change.
Market for Aluminum
Price
External
Cost
S (social cost: private cost + external cost)
S (private cost)
Note: The market quantity is
above the optimal quantity.
Society produces too much!
(Society over-allocates resources to
this activity)
D
QMARKET
QOPTIMAL
Quantity
Note: When considering the
external costs, the last
consumer at the equilibrium
quantity is not willing to pay
the costs to society for
producing that same
quantity.
Market for Flu Shots
External
Benefit
Price
S
Note: The market quantity is
Below the optimal quantity.
Society produces too little!
(Society under-allocates resources to
this activity)
D (private value + social benefit)
Note: At the market
equilibrium, there are still
more Pareto Improvements
to be made.
D (private value)
QMARKET
Quantity
QOPTIMAL
Correcting Externalities
 Negative Externalities
 Society produces too much
 Positive Externalities
 Society produces too little
 With too much or too little, we have a market failure.
 What can be done?
 Public Solutions


Command & Control Policies, Market Based Solutions
Private Solutions

Moral codes and social sanctions, Charities, Contracts
Correcting Externalities
 Command and Control Policies


In other words, government regulations
Many government regulations attempt to correct negative
externalities by making the activity illegal.

(example: against the law to dump poison into the city’s water
supply)
Correcting Externalities
 Market based solutions
 In other words, government taxes and subsidies
 Usually considered to be a “corrective tax” or “corrective
subsidy”
 Negative Externalities
 Pigovian taxes (ideally a corrective tax would be imposed
exactly equal to the external cost)
 Positive Externalities
 Pigovian subsidy (ideally a corrective subsidy would be
imposed exactly equal to the external benefit)
Market for Aluminum
S (social cost: private cost + social cost)
Price
S (private cost)
$50
$45
How large of a Pigouvian
tax is required to correct this
negative externality?
$40
D
QMARKET
QOPTIMAL
Quantity
Objections to the Economic Analysis of Pollution
 "We cannot give anyone the option of polluting for a
fee.“ -- Senator Edmund Muskie
 Economists have little sympathy for this type of
argument. To economists, good environmental
policy begins by acknowledging the first of the Ten
Principles of Economics in Chapter 1: People face
trade-offs.
 Consider transportation. All forms of transportation
produce pollution, even horses! We should weigh
the benefits and costs in determining policy toward
externalities
Private Solutions to Externalities
 Moral codes and social sanctions
 “Do unto others as you would have them do unto you”
 Charities
 Appalachian Mountain Club, Appalachian Trail Conservancy,
Appalachian Voices, etc…
 Contracts
 The parties involved my enter into a contract in an attempt to make
everyone agree to a situation in which they are all better-off.
Private Solutions to Externalities
 Coase Theorem
 suggests that private market solutions to externalities can be very
effective in some circumstances
 The Coase theorem says that private economic actors can potentially
solve the problem of externalities among themselves. Whatever the
initial distribution of rights, the interested parties can reach a bargain
in which everyone is better off and the outcome is efficient.
 (Note: Coase Theorem generally requires bargaining with zero
opportunity cost, such as not hiring a lawyer at $100 an hour)