Externalities: Problems and SolutionsSlide 2Examples of ExternalitiesSlide 4Slide 5Slide 6Slide 7Slide 8Slide 9Slide 10Slide 11Slide 12Slide 13Slide 14Slide 15Slide 16Slide 17Slide 18Slide 19Slide 20Slide 21Slide 22Slide 23Public Responses to Externalities - TaxesSlide 26Slide 27Slide 28Slide 29Slide 30Slide 31Slide 32Slide 33Slide 34Slide 35Slide 36Slide 37Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers1 of 34Externalities: Problems and Solutions5.1 Externality Theory5.2 Private-Sector Solutions to Negative Externalities5.3 Public-Sector Remedies for Externalities5.4 Distinctions between Price and Quantity Approaches to Addressing Externalities5.5 ConclusionPublic Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth PublishersC H A P T E R 5 ■ E X T E R N A L I T I E S : P R O B L E M S A N D S O L U T I O N S2 of 34externality Externalities arise whenever the actions of one party make another party worse or better off, yet the first party neither bears the costs nor receives the benefits of doing so.market failure A problem that causes the market economy to deliver an outcome that does not maximize efficiency.Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers3 of 343 of 33Examples of Externalities•Negative Externalities–Pollution–Cell phones in a movie theater–Congestion on the internet–Drinking and driving–Student cheating that changes the grade curve–The “Club” anti-theft device for automobiles•Positive Externalities–Research & development–Vaccinations–A neighbor’s nice landscape–Students asking good questions in class–The “LoJack” anti-theft device for automobiles•Not Considered Externalities–Land prices rising in urban area–Known as “pecuniary” externalitiesPublic Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth PublishersC H A P T E R 5 ■ E X T E R N A L I T I E S : P R O B L E M S A N D S O L U T I O N S4 of 34In December 1997, representatives from over 170 nations met in Kyoto, Japan, to attempt one of the most ambitious international negotiations ever: an international pact to limit the emissions of carbon dioxide worldwide because of global warming. The nations faced a daunting task.The cost of reducing the use of fossil fuels, particularly in the major industrialized nations, is enormous. Replacing these fossil fuels with alternatives would significantly raise the costs of living in developed countries. The outcomes included a decision by Parties to adopt a universal legal agreement on climate change as soon as possible, and no later than 2015.The United Nations Climate Change Conference, Durban 2011http://unfccc.int/2860.phpPublic Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth PublishersC H A P T E R 5 ■ E X T E R N A L I T I E S : P R O B L E M S A N D S O L U T I O N S5 of 34Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers6 of 34C H A P T E R 5 ■ E X T E R N A L I T I E S : P R O B L E M S A N D S O L U T I O N SExternality TheoryEconomics of Negative Production Externalities5.1negative production externalityWhen a firm’s production reduces the well-being of others who are not compensated by the firm.Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers7 of 34C H A P T E R 5 ■ E X T E R N A L I T I E S : P R O B L E M S A N D S O L U T I O N SExternality TheoryEconomics of Negative Production Externalities5.1 FIGURE 5-2Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers8 of 34C H A P T E R 5 ■ E X T E R N A L I T I E S : P R O B L E M S A N D S O L U T I O N SExternality Theory5.1Economics of Negative Production Externalitiesprivate marginal cost (PMC) The direct cost to producers of producing an additional unit of a good.social marginal cost (SMC) The private marginal cost to producers plus any costs associated with the production of the good that are imposed on others.Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers9 of 34C H A P T E R 5 ■ E X T E R N A L I T I E S : P R O B L E M S A N D S O L U T I O N SExternality TheoryEconomics of Negative Production Externalities5.1private marginal benefit (PMB) The direct benefit to consumers of consuming an additional unit of a good by the consumer.social marginal benefit (SMB) The private marginal benefit to consumers plus any costs associated with the consumption of the good that are imposed on others.Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers10 of 34C H A P T E R 5 ■ E X T E R N A L I T I E S : P R O B L E M S A N D S O L U T I O N SExternality TheoryNegative Consumption Externalitiesnegative consumption externality When an individual’s consumption reduces the well-being of others who are not compensated by the individual.5.1Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers11 of 34C H A P T E R 5 ■ E X T E R N A L I T I E S : P R O B L E M S A N D S O L U T I O N SExternality Theory5.1Negative Consumption Externalities FIGURE 5-3Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers12 of 34C H A P T E R 5 ■ E X T E R N A L I T I E S : P R O B L E M S A N D S O L U T I O N SExternality Theory5.1APPLICATIONThe Externality of SUVsThe typical driver in 2008 was in a car that weighed about 4,117 pounds. The major culprits in this evolution of car size are sport utility vehicles (SUVs) with an average weight size of 4,742 pounds.The consumption of large cars such as SUVs produces three types of negative externalities:Environmental Externalities:The contribution of driving to global warming is directly proportional to the amount of fossil fuel a vehicle requires to travel a mile. SUV drivers use more gas to go to work or run their errands, increasing fossil fuel emissions.Wear and Tear on Roads:Each year, federal, state, and local governments spend $33.1 billion repairing our roadways. Damage to roadways comes from many sources, but a major culprit is the