ExternalitiesSpillover Costs & Spillover Benefits

Chapter 10 (pages 203-208)

Switzerland & Garbage

35 Liter Swiss Trash Bag

EXTERNALITIES

• An externality is the uncompensated impact of one person or firm’s actions on another person/society – Both positive externalities & negative externalities exist

• All externalities are considered market failures (inefficient)

– That is, markets with externalities do not maximize total surplus (welfare)

– Governments can correct externalities with taxes or subsidies

Factory A Factory B

Negative Externalities

– Automobile exhaust

– Cigarette smoking

– Barking dogs

– Loud stereos in an apartment building

– Noisy Students

– Neighbor’s poorly maintained property

Positive Externalities – Immunizations– Restored historic buildings– Research into new technologies– Neighbor’s well maintained property– Volunteering

Spillover Costs & Spillover Benefits

• Spillover Costs- external costs not included in supply curve (MC)

– External costs exist with ALL negative externalities

– MC is understated => which leads to overproduction

• Spillover Benefits-external benefits not included in demand curve (MB)

– External benefits exist with ALL positive externalities

– MB is understated => which leads to underproduction

MB

MC

Graphing Externalities

• When graphing negative externalities use MC & MB curves– Then add any spillover cost or benefit to existing curve

• Marginal Social Cost (MSC) = MC + spillover cost (external cost)

• Marginal Social Benefit (MSB) = MB + spillover benefit (external benefit)

MB

MC

Negative Externality

MB

MC

MSB

Positive ExternalityMSC

Internalizing Externalities

• Internalizing an externality involves altering incentives to improve market outcomes (i.e. to increase total welfare)

• Government Solutions– Taxes or Subsidies– Laws (immunization laws, pollution laws)

– Patents

• Free market Solution: – Trading pollution credits => i.e. cap & trade

Internalizing Negative Externalities

Impose Tax = spillover cost Shifts Supply Curve left

Reach social optimal output

Total Cost = Total Benefit

Total Cost = MSC (MCP + MCS)

Total Welfare is Maximized!

Assume this Factory PollutesAluminum Cans

Quantity0

Price

MBPMBP

MCPMCP

Q1Q1

P1E1

MSC

-----------------------------------

Q2

P2 E2

MC

MB

Large SUV Production Electric Cars

Quantity0

Price

MBPMBP

MCPMCP

Q1Q1

P1E1

Quantity0

Price

MBPMBP

MCPMCP

Q1Q1

P1E1

WORKSHEET

Subsidizing Positive Externalities

Impose Subsidy = spillover benefit Shifts demand curve right

Reach social optimal output

Total Cost = Total Benefit

Quantity0

Price

MBMB

MCMC

QMARKETQMARKET

External social benefit

External social benefit

EquilibriumEquilibriumOptimumOptimum

QOPTIMUMQOPTIMUM

Spillover BenefitSpillover Benefit

MSB

Electric CarsAssume these cars have external benefits

Bottled WaterWhat is the real cost?

Start 20 minutes in…

Documentary

1) Demand Section 12 min.2) Recycle Section

Only 11 states have recycle deposits lawsOnly 20% of U.S. water bottles are recycled

Internalizing Negative Externalities

Impose Tax = spillover cost This puts a price on “external costs”

Reach socialy optimal output @ Q2

MSC = MCp + MCs (internal & external)

Bottled Water

Quantity0

Price

MBPMBP

MCPMCP

Q1Q1

P1E1

MSC

-----------------------------------

Q2

P2 E2

MC

MB