chapter 10 externalities. objectives 1.) learn the concepts of external costs and external benefits....
TRANSCRIPT
Chapter 10
Externalities
Objectives
1.) Learn the concepts of external costs and external benefits.
2.) Understand why the presence of externalities can produce market failures.
3.) Recognize when private agreement can and cannot effectively solve problems associated with externalities.
Market Efficiency: Chapter 7 Under the assumptions of perfect
competition and no externalities, the economic well-being of a society is measured as:
The sum of consumer and producer surplus!
The invisible hand is powerful but not omnipotent, which leads to market failure.
Market Failure
If a market system affects individuals other than buyers and sellers of that market, side-effects are created called Externalities.
– Externalities cause markets to be inefficient, and thus fail.
Externality - Defined The uncompensated
effects that the production or consumption of goods have on third parties.
The impact of one person’s actions on the well-being of a bystander!
Externality - Effect 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 are considered.
External Benefits - 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 others who do not have to pay for them.
External Costs - 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 others who are not paid to endure them.
Negative Externality
Automobile exhaust
Cigarette smoking
Positive Externality
Immunizations
Restored historic buildings
Identify Some Negative and Positive Externalities
Automobile exhaust
Cigarette smoking
Barking dogs (loud pets)
Loud stereos in an apartment building
Examples of Negative Externalities
Immunizations
Restored historic buildings
Research into new technologies
Examples of Positive Externalities
Externalities and Market Inefficiency - Negative Externalities
Negative externalities in production or consumption sometimes lead markets to produce a larger quantity than is socially desirable.
The Social Costs of production or consumption are greater than the private cost or private benefit by producers and consumers.
This leads to market failure.
Negative Externalities and Market Inefficiency - Graphical Example
Assume that the production process emits pollution - negative externality.
The cost to society of production 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.
Reflects in a new Supply Curve. . .
Negative Externalities and Market Inefficiency - Graphical Example
SupplyPrivate Cost
DemandPrivate Value
QMarket
Market output before accounting
for externality.
The Market for Aluminum and Welfare Economics
The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus.
The Market for Aluminum and Welfare Economics
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.
The Market for Aluminum and Welfare Economics
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.
Negative Externalities and Market Inefficiency - Graphical Example
Cost ofPollution
DemandPrivate Value
QMarket
Supply
Private C
ost Social
Cost
Negative Externalities and Market Inefficiency - Graphical Example
Cost ofpollution
DemandPrivate Value
Supply
(priv
ate cost)Social
Cost
The optimum outputaccounts for the
externality.
QOptimum
Internalizing an externality is alteringincentives so that people take account of the extreme effects of their actions
Negative Externalities and Market Inefficiency - Graphical Example
The intersection of the demand curve and the social-cost curve determines the optimal output level - less than equilibrium quantity.
Attainment of the Optimal Output
The government can internalize the externality by imposing a tax on the
producer.
Externalities and Market Inefficiency - Positive Externalities
Positive externalities in production or consumption sometimes lead markets to produce a smaller quantity than is socially desirable.
The Social Costs of production or consumption are less than the private cost or private benefit to producers and consumers.
This leads to market failure.
Positive Externalities in Production
A technology spillover is a type of positive externality that exists when a firm’s innovation or design not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole.
Positive Externalities and Market Inefficiency - Graphical Example
SupplyPrivate Cost
DemandPrivate Value
QMarket
SupplyPrivate Cost
DemandPrivate Value
QMarket
Market output before accounting
for externality.
Positive Externalities and Market Inefficiency - Graphical Example
SupplyPrivate Cost
DemandPrivate Value
Positive Externalities and Market Inefficiency - Graphical Example
Value of TechnologySpillover
QOptimal
Social Cost
Positive Externalities in Production
The intersection of the demand curve and the social-cost 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 costs of production are less than the private cost to producers and consumers.
Internalizing Externalities: Subsidies
Government many times uses subsidies as the primary method for attempting to internalize positive externalities.
Technology Policy
Government intervention in the economy that aims to promote technology-enhancing industries is called technology policy.
Technology Policy
Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention.
The patent is then said to internalize the externality.
Supply(Private Cost)
Demand(Private Value)
Consumption Externalities
QOptimal
Negative Consumption Externality
QMarket
Social value
Price ofAlcohol
0 Quantityof
Alcohol
Supply(Private Cost)
Demand(Private Value)
Consumption Externalities
QOptimal
Positive Consumption Externality
QMarket
Social value
Price ofEducation
0 Quantityof Education
Positive Externalities and Market Inefficiency - Graphical Example
The intersection of the demand curve and the social-cost curve determines the optimal output level - more than equilibrium quantity.
Attainment of the Optimal Output
The government can internalize the externality by subsidizing the
production - paying the producer to produce more than the equilibrium.
Government Policy Toward Externality
In situations where market failure occurs because of externalities, the government will attempt to internalize the externality by:
– imposing a tax on goods with a negative externality.
– implementing a subsidy on goods with a positive externality.
Quick Quiz Given an example of a
negative externality and a positive externality.
Explain why market outcomes are inefficient in the presence of externalities.
Private Solutions to Externalities
Government action is not always needed to solve a problem of externalities.
Alternative private solutions:
– Moral codes and social sanctions
– Charitable organizations focused on dealing with an externality.
Examples of private solutions. . .
Private Solutions to Externalities
Coase Theorem:
– If private parties can bargain to their mutual advantage without cost, then the private market will always solve the problem of externalities and allocate resources efficiently.
– Private bargaining can internalize the external effects, resulting in efficient solutions.
Failure to Private Solutions Approach
Sometimes the private solution approach will fail because:
– The 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.
Quick Quiz
Give an example of a private solution to an externality.
What is the Coase theorem?
Why does the private solution approach often fail?
Public Policy Toward Externalities
When externalities are significant and when private solutions are not possible or incomplete, government may attempt to solve the problem by:
– Command-and-Control policies
– Market-Based policies
Command-and-Control Policies
Usually in the form of regulations:
– making certain behavior forbidden
– making certain behavior required
Examples:
– All students must be immunized
– Stipulating levels of pollution emissions
Market-Based Policies
Government use of taxes and subsidies to align private incentives with social efficiency.
– Pigovian Taxes: designed to reflect the social costs of a negative externality and internalize the external cost to the offending entity.
Examples of Regulation versus Pigovian tax
If the EPA decides it wants to reduce the amount of pollution coming from a specific plant. The EPA could…
tell the firm to reduce its pollution by a specific amount (i.e. regulation).
levy a tax of a given amount for each unit of pollution the firm emits
(i.e. Pigovian tax).
Market-Based Policies
Tradable Pollution Permits: the voluntary transfer of the right to pollute from one firm to another.
– Pollution permits which results in a new market for these permits.
– Firms that can reduce pollution most easily will be willing to sell their permit, for whatever they can get.
Demand forpollution rights
The Equivalence of Pigovian Taxesand Pollution Permits
Pigovian Tax
Q
Pigoviantax
Price ofPollution
0 Quantityof Pollution
P
Demand forpollution rights
The Equivalence of Pigovian Taxesand Pollution Permits
Pigovian Tax
Q
Pigoviantax
Price ofPollution
0 Quantityof Pollution
P
1. A Pigovian tax1. A Pigovian taxsets the price ofsets the price ofpollutionpollution
1. A Pigovian tax1. A Pigovian taxsets the price ofsets the price ofpollutionpollution
Demand forpollution rights
The Equivalence of Pigovian Taxesand Pollution Permits
Pigovian Tax
Q
Pigoviantax
Price ofPollution
0 Quantityof Pollution
P
2. ... which together2. ... which togetherwith the demand curve,with the demand curve, determines the determines the quantity of pollutionquantity of pollution
2. ... which together2. ... which togetherwith the demand curve,with the demand curve, determines the determines the quantity of pollutionquantity of pollution
Demand forpollution rights
Q
Supply ofpollution permits
Price ofPollution
Quantityof Pollution
P
The Equivalence of Pigovian Taxes and Pollution Permits
Pollution Permits
Demand forpollution rights
Q
Supply ofpollution permits
Price ofPollution
0 Quantityof Pollution
P
1. Pollution permits set1. Pollution permits setthe quantity ofthe quantity ofpollution...pollution...
1. Pollution permits set1. Pollution permits setthe quantity ofthe quantity ofpollution...pollution...
The Equivalence of Pigovian Taxes and Pollution Permits
Pollution Permits
Demand forpollution rights
The Equivalence of Pigovian Taxes and Pollution Permits
Pollution Permits
Q
Supply ofpollution permits
Price ofPollution
0 Quantityof Pollution
P
2. ... which together2. ... which togetherwith the demand curve,with the demand curve, determines the determines the price of pollutionprice of pollution
2. ... which together2. ... which togetherwith the demand curve,with the demand curve, determines the determines the price of pollutionprice of pollution
Externalities - Conclusion
Uncompensated effects that the production or consumption of goods have on third parties are called externalities.
– Negative externalities: results in market equilibrium beyond the social optimum.
– Positive externalities: results in market equilibrium short of social optimum.
Externalities - Conclusion
Solutions to externalities can be accomplished:
– through private agreements or government intervention