ExternalitiesExternalities

Part IPart I

ExternalitiesExternalities

Part IPart I

• Learn the nature of an externality.• See why externalities can make market

outcomes inefficient.• Examine how people can sometimes solve

the problem of externalities on their own.• Consider why private solutions to

externalities sometimes do not work.• Examine the various government policies

aimed at solving the problem of externalities.

• Learn the nature of an externality.• See why externalities can make market

outcomes inefficient.• Examine how people can sometimes solve

the problem of externalities on their own.• Consider why private solutions to

externalities sometimes do not work.• Examine the various government policies

aimed at solving the problem of externalities.

In this Topic you will…In this Topic you will…In this Topic you will…In this Topic you will…

• Recall: Adam Smith’s “invisible hand” of the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society can derive from a market.

But market failures can still

happen!

• Recall: Adam Smith’s “invisible hand” of the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society can derive from a market.

But market failures can still

happen!

EXTERNALITIESEXTERNALITIESEXTERNALITIESEXTERNALITIES

• 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.

• 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.

EXTERNALITIESEXTERNALITIESEXTERNALITIESEXTERNALITIES

• An externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander.

• Externalities cause markets to be inefficient, and thus fail to maximize total surplus.

• An externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander.

• Externalities cause markets to be inefficient, and thus fail to maximize total surplus.

EXTERNALITIESEXTERNALITIESEXTERNALITIESEXTERNALITIES

• 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 third parties are considered.

• 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 third parties are considered.

EXTERNALITIESEXTERNALITIESEXTERNALITIESEXTERNALITIES

• Positive Externality• 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.

• Positive Externality• 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.

EXTERNALITIESEXTERNALITIESEXTERNALITIESEXTERNALITIES

• Negative Externality• 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• 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.

EXTERNALITIESEXTERNALITIESEXTERNALITIESEXTERNALITIES

Negative Externality• Automobile exhaust• Cigarette smoking

Positive Externality• Immunizations• Restored historic buildings

Negative Externality• Automobile exhaust• Cigarette smoking

Positive Externality• Immunizations• Restored historic buildings

EXTERNALITIESEXTERNALITIESEXTERNALITIESEXTERNALITIES

• The Market for Aluminum – The demand curve for aluminum

reflects the value to consumers of aluminum as measured by the prices they are willing to pay.

– The supply curve for aluminum reflects the costs of producing aluminum.

– Qmarket: 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 – The demand curve for aluminum

reflects the value to consumers of aluminum as measured by the prices they are willing to pay.

– The supply curve for aluminum reflects the costs of producing aluminum.

– Qmarket: the quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus.

Welfare Economics: A RecapWelfare Economics: A RecapWelfare Economics: A RecapWelfare Economics: A Recap

Demand (private value)

Supply (private costs)

0

Equilibrium

QmarketQuantity of Aluminium

Price of Aluminium

Figure 10-1: The Market for AluminiumFigure 10-1: The Market for AluminiumFigure 10-1: The Market for AluminiumFigure 10-1: The Market for Aluminium

• The Market for Aluminum (cont’d)

– 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 (cont’d)

– 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.

Welfare Economics: A RecapWelfare Economics: A RecapWelfare Economics: A RecapWelfare Economics: A Recap

• The Market for Aluminum (cont’d)– 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.

• The Market for Aluminum (cont’d)– 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 in Negative Externalities in ProductionProduction

Negative Externalities in Negative Externalities in ProductionProduction