Transcript Unit 4 _ ppt 2 _ Externalities

4
THE ECONOMICS OF THE PUBLIC SECTOR
Externalities
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10
The Main Idea…
• Recall: Adam Smith’s “invisible hand”
• Markets allocate scarce resources with forces of S
& D; equilibrium typically maximizes market
welfare
• But market failures can still
happen.
• Outcome of free market differs from socially
optimal outcome
• Gov’t policies can sometimes improve things
• Video Clip: “Episode 31: Market Failures”
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EXTERNALITIES
• Externality = the uncompensated
impact of one person’s actions on
the well-being of a bystander
• For example, I played a terrible song
at the start of class. You were innocent
bystanders – you weren’t involved in
me buying the song off of iTunes, but
you still suffered the noise pollution.
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EXTERNALITIES
• When the impact on the bystander
is adverse, the externality is called
a negative externality
• Exhaust from cars
• Your neighbor’s barking dog
• Rebecca Black’s, “Friday”
• When the impact on the bystander
is beneficial, the externality is
called a positive externality
• Me getting a flu shot
• Education
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EXTERNALITIES CAUSE MARKET
INEFFICIENCY
• In either case, decision maker fails to take into
account the external effect of his or her behavior
• This causes markets to be inefficient, and thus fail to
maximize total surplus
• Negative externalities lead markets to produce a
larger quantity than is socially desirable overproduction
• Positive externalities lead markets to produce a
smaller quantity than is socially desirable underproduction
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Life on Dismal Lake 
• I need five brave volunteers…
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Negative Externality Example: Aluminum
• 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.
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Figure 1 The Market for Aluminum
Price of
Aluminum
Supply
(private cost)
Equilibrium
Demand
(private value)
0
QMARKET
Quantity of
Aluminum
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Negative Externality Example: Aluminum
• The Market for Aluminum
• 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.
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Figure 2 Pollution and the Social Optimum
Price of
Aluminum
Social
cost
Cost of
pollution
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0
QOPTIMUM QMARKET
Quantity of
Aluminum
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Negative Externality Example: Aluminum
• Intersection of the demand curve and the socialcost curve determines optimal output level.
• Socially optimal output level is less than market
equilibrium quantity
• The market produces a larger quantity than is
socially desirable.
• The social cost of the good exceeds the private cost
of the good.
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Adjusting for Externalities
• Internalizing an externality involves altering
incentives so that people take account of the
external effects of their actions
• Negative externality can be internalized by a
tax on producers for each unit of aluminum;
this would reduce equilibrium quantity to
socially optimal level
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Quick Quiz 1: Are You Picking Up
What Was Put Down?
• The government taxes goods like alcohol,
tobacco, and gasoline – you may be familiar
with the term sin tax. Why do you think many
economists support these types of taxes?
Provide a brief written explanation along with a
graph to support your reasoning. For you
graph, pick one market to represent – alcohol,
tobacco, or gas.
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Happy Friday 
• What are your plans for after
graduating high school? For example,
college? job? What are your
reasons?
• Take out your class notes & the
quick quiz handout. (extras are
available in the “Absent” folder if
you can’t find yours…)
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Positive Externality Example: Education
• When an externality benefits the bystanders, a positive
externality exists.
• The social value of the good exceeds the private value.
• For example, education yields positive externalities
• Better-educated voters lead to better government
• Crime rates drop as education level of population rises
• Countries with high levels of education enjoy higher
standard of living
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Figure 3 Education and the Social Optimum
Price of
Education
Supply
(private cost)
Social
value
Demand
(private value)
0
QMARKET
QOPTIMUM
Quantity of
Education
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Positive Externalities
• 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.
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Positive Externalities
• Internalizing Positive Externalities: Subsidies
• Used as the primary method for attempting to
internalize positive externalities
• Education is heavily subsidized through public
schools and gov’t scholarships
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Quick Quiz 2: Are You Picking Up
What Was Put Down?
• Give an example of positive externality.
Explain why market outcomes are inefficient in
the presence of this externality. Provide a
graphical representation and explain how the
government can remedy such a market failure.
• DON’T PEAK AT YOUR NOTES.
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Addressing Externalities: Two Types
of Public Policy
• Command-and-Control Policies –
regulate behavior directly
• Make certain behaviors illegal
• Environmental regulations – limit pollution
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Addressing Externalities: Two
Types of Public Policy
• Market-Based Policies – provide incentives so private
decision makers choose to solve problem on their own
• Policy 1:
• Corrective Taxes: used to counter effects of negative
externalities; ideal tax should equal external costs (a.k.a.
Pigovian Taxes)
• Subsidies: used to counter effects of positive externalities;
ideal subsidy should equal external benefit
• Policy 2:
• Tradable Pollution Permits: Firms allotted certain amount of
pollution per year; a free market for pollution rights develops as
firms can buy and sell unused “units” of pollution
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Figure 4 The Equivalence of Pigovian Taxes and Pollution
Permits
(a) Pigovian Tax
Price of
Pollution
Pigovian
tax
P
1. A Pigovian
tax sets the
price of
pollution . . .
Demand for
pollution rights
0
Q
2. . . . which, together
with the demand curve,
determines the quantity
of pollution.
Quantity of
Pollution
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South-Western
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South-Western
Figure 4 The Equivalence of Pigovian Taxes and Pollution
Permits
(b) Pollution Permits
Price of
Pollution
Supply of
pollution permits
P
Demand for
pollution rights
0
2. . . . which, together
with the demand curve,
determines the price
of pollution.
Q
Quantity of
Pollution
1. Pollution
permits set
the quantity
of pollution . . .
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© 2004
South-Western
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South-Western
Quick Quiz #3
• A glue factory and a steel mill emit smoke
containing a chemical that is harmful if inhaled
in large amounts. Describe three ways the town
government may respond to this externality.
What are the pros and cons of each solution?
• Hint: Creating a chart would make this really
easy for Mrs. K to grade… 
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PRIVATE SOLUTIONS TO
EXTERNALITIES
• Government action is not always needed to
solve the problem of externalities.
•
•
•
•
Moral codes and social sanctions
Charitable organizations
Integrating different types of businesses
Contracting between parties
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The Coase Theorem
• The Coase Theorem is
a proposition that
private parties can
solve the problem of
externalities on their
own by bargaining
without cost over the
allocation of resources
• Example: Mrs. K’s
barking dog
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Private Solutions Don’t Always Work 
• Transaction costs can be so high that private
agreement is not possible
• The costs parties incur in the process of agreeing to
and following through on a bargain
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In Summary…
• Sometimes the “invisible hand” fails to take
into account the well-being of third parties –
when a transaction impacts a third party, it’s
called an externality
• Externalities can be positive or negative
• Those affected by externalities can sometimes
solve the problem privately (Coase Theorem)
• When private parties cannot adequately deal
with externalities, then the government steps in.
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Quick Quiz #4
• Come up with your own externality story.
Apply the Coase Theorem and provide a private
solution. Give a specific scenario where the
transaction costs may get in the way of the
private solution.
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