harcourt brace & company chapter 10 externalities (lecture by d. boldt on 10/18/01 in econ...

Harcourt Brace & Company

Chapter 10

Externalities(Lecture by D. Boldt on 10/18/01

in Econ 2105-06


Externality

• Principle #7 (Ch. 1) Governments Can Sometimes Improve Market Outcomes

• Government involvement may be needed in case of a Market Failure.

• One example of a market failure is a side effect of economic activity known as an Externality.


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!


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• Air Pollution from a Power Plant• Cigarette smoking

Positive Externality• Immunizations• Outside Home Improvements

Examples of Negative and Positive Externalities


Externalities and Market Inefficiency - Negative Externalities

• Negative externalities 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. . .



SupplyPrivate Cost

DemandPrivate Value

QMarket

Market output before accounting

for externality.



SupplyPrivate Cost

DemandPrivate Value

QMarket

Cost of

Pollutio

nSocial

Cost



SupplyPrivate Cost

DemandPrivate Value

Cost of

Pollutio

nSocial

Cost

The optimum outputaccounts for the

externality.

QOptimum



The intersection of the demand curve and the social-cost curve determines the optimal output level - less than equilibrium quantity.


Externalities and Market Inefficiency - Positive Externalities

• Positive externalities 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 and Market Inefficiency - Graphical Example

SupplyPrivate Cost

DemandPrivate Value

QMarket


SupplyPrivate Cost

DemandPrivate Value

QMarket

Market output before accounting

for externality.



SupplyPrivate Cost

DemandPrivate Value


Value of TechnologySpillover

QOptimal



• The intersection of the demand curve and the social-cost curve determines the optimal output level - more than equilibrium quantity.


Private Solutions to ExternalitiesCoase Theorem:

– If private parties can bargain to their mutual advantage without cost, then the private market may solve the problem of externalities and allocate resources efficiently.

– Private bargaining can internalize the external effects, resulting in efficient solutions (bargaining with a neighbor)


Failure to Private Solutions Approach

Sometimes the private solution approach will fail because:– The transaction costs (bargaining costs)

can be so high that private agreement is not possible.

– Failure to achieve a private solution may require that the government intervene.


Public Policy Toward Externalities

When externalities are significant and when private solutions are not possible, government may attempt to solve the problem by:– Command-and-Control policies

– Market-Based policies (taxes or tradeable permits)


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

– Requiring certain pollution control devices


Market-Based PoliciesTaxes: In situations where market

failure occurs because of externalities, the government can attempt to internalize the externality by:– imposing a tax on goods with a negative

externality.

– implementing a subsidy on goods with a positive externality.


Market-Based PoliciesTradable 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.

harcourt brace & company chapter 10 externalities (lecture by d. boldt on 10/18/01 in econ...

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