Slide 0In this chapter, look for the answers to these questions:IntroductionSlide 4Slide 5Pollution: A Negative ExternalityOther Examples of Negative ExternalitiesPositive Externalities from EducationOther Examples of Positive ExternalitiesRecap of Welfare EconomicsAnalysis of a Negative ExternalitySlide 12Slide 13“Internalizing the Externality”Positive ExternalitiesA C T I V E L E A R N I N G 1: Analysis of a positive externalityA C T I V E L E A R N I N G 1: AnswersEffects of Externalities: SummaryPrivate Solutions to ExternalitiesSlide 20The Coase Theorem: An ExampleSlide 22Slide 23Slide 24A C T I V E L E A R N I N G 2: BrainstormingWhy Private Solutions Do Not Always WorkPublic Policies Toward ExternalitiesMarket-Based Policy #1: Corrective Taxes & SubsidiesSlide 29Slide 30Slide 31Slide 32Example of a Corrective Tax: The Gas TaxA C T I V E L E A R N I N G 3: Discussion questionMarket-Based Policy #2: Tradable Pollution PermitsSlide 36Slide 37Slide 38Tradable Pollution Permits in the Real WorldCorrective Taxes vs. Tradable Pollution PermitsObjections to the Economic Analysis of PollutionCHAPTER SUMMARYSlide 43Slide 44© 2007 Thomson South-Western, all rights reservedN. G R E G O R Y M A N K I WPowerPoint® Slidesby Ron Cronovich 10P R I N C I P L E S O FF O U R T H E D I T I O NExternalitiesExternalitiesCHAPTER 10 EXTERNALITIES2In this chapter, look for the answers to these questions:What is an externality?Why do externalities make market outcomes inefficient? How can people sometimes solve the problem of externalities on their own? Why do such private solutions not always work? What public policies aim to solve the problem of externalities?CHAPTER 10 EXTERNALITIES3IntroductionRecall one of the Ten Principles from Chap. 1:Markets are usually a good way to organize economic activity.Lesson from Chapter 7: In the absence of market failures, the competitive market outcome is efficient, maximizes total surplus.CHAPTER 10 EXTERNALITIES4IntroductionOne type of market failure: externalities.Externality: the uncompensated impact of one person’s actions on the well-being of a bystander •Negative externality: the effect on bystanders is adverse•Positive externality: the effect on bystanders is beneficialCHAPTER 10 EXTERNALITIES5IntroductionSelf-interested buyers and sellers neglect the external effects of their actions, so the market outcome is not efficient. Another principle from Chapter 1: Governments can sometimes improve market outcomes.CHAPTER 10 EXTERNALITIES6Pollution: A Negative ExternalityExample of negative externality: Air pollution from a factory. •The firm does not bear the full cost of its production, and so will produce more than the socially efficient quantity. How govt may improve the market outcome:•Impose a tax on the firm equal to the external cost of the pollution it generatesCHAPTER 10 EXTERNALITIES7Other Examples of Negative Externalitiesthe neighbor’s barking doglate-night stereo blasting from the dorm room next to yoursnoise pollution from construction projectstalking on cell phone while driving makes the roads less safe for othershealth risk to others from second-hand smokeCHAPTER 10 EXTERNALITIES8Positive Externalities from EducationA more educated population benefits society:•lower crime rates: educated people have more opportunities, so less likely to rob and steal•better government: educated people make better-informed votersPeople do not consider these external benefits when deciding how much education to “purchase”Result: market eq’m quantity of education too lowHow govt may improve the market outcome:•subsidize cost of educationCHAPTER 10 EXTERNALITIES9Other Examples of Positive ExternalitiesBeing vaccinated against contagious diseases protects not only you, but people who visit the salad bar or produce sectionafter you. R&D creates knowledge others can useRenovating your house increases neighboring property valuesThank you for not contaminating the fruit supply!CHAPTER 10 EXTERNALITIES100123450 10 20 30Q (gallons)P $The market for gasolineRecap of Welfare EconomicsDemand curve shows private value, the value to buyers (the prices they are willing to pay)Supply curve shows private cost, the costs directly incurred by sellersThe market eq’m maximizes consumer + producer surplus.$2.5025CHAPTER 10 EXTERNALITIES110123450 10 20 30Q (gallons)P $The market for gasolineAnalysis of a Negative ExternalitySupply (private cost)External cost = value of the negative impact on bystanders = $1 per gallon(value of harm from smog, greenhouse gases)Social cost = private + external costexternal costCHAPTER 10 EXTERNALITIES120123450 10 20 30Q (gallons)P $The market for gasolineAnalysis of a Negative ExternalityDSSocial costThe socially optimal quantity is 20 gallons.The socially optimal quantity is 20 gallons.At any Q < 20, value of additional gas exceeds social cost At any Q < 20, value of additional gas exceeds social cost At any Q > 20, social cost of the last gallon isgreater than its valueAt any Q > 20, social cost of the last gallon isgreater than its value25CHAPTER 10 EXTERNALITIES130123450 10 20 30Q (gallons)P $The market for gasolineAnalysis of a Negative ExternalityDSSocial costMarket eq’m (Q = 25)is greater than social optimum (Q = 20)25One solution: tax sellers $1/gallon,would shift supply curve up $1.CHAPTER 10 EXTERNALITIES14“Internalizing the Externality”Internalizing the externality: altering incentives so that people take account of the external effects of their actionsIn the previous example, the $1/gallon tax on sellers makes sellers’ costs equal to social costs.When market participants must pay social costs, the market eq’m matches the social optimum. (Imposing the tax on buyers would achieve the same outcome; market Q would equal optimal Q.)CHAPTER 10 EXTERNALITIES15Positive ExternalitiesIn the presence of a positive externality, the social value of a good includes•private value – the direct value to buyers•external benefit – the value of the positive impact on bystandersThe socially optimal Q maximizes welfare:•At any lower Q, the social value of additional units exceeds their cost.•At any higher Q, the cost of the last unit exceeds its social value.AA CC TT II VV E LE L EE AA RR NN II NN G G 11: : Analysis of a positive externalityAnalysis of a positive