Slide 1Slide 2Slide 3Slide 4Slide 5Slide 6Slide 7Slide 8Slide 9Slide 10Slide 11Slide 12Slide 13Slide 14Slide 15Slide 16Slide 17Slide 18Slide 19Slide 20Slide 21Slide 221Externalities•When a private action has side effects that affect other people in important ways, we have the problem of externalities–By-product of a good or activity that affects someone not immediately involved in transaction2The Private Solution to a Negative Externality•Under certain conditions, inefficiency that would be caused by a negative externality will automatically be resolved by the parties themselves–The outcome is the efficient outcome•Achieves maximization of total net benefits possible in the situation3The Coase Theorem•What if building a theater would create $100,000 of benefits for some but $70,000 worth of harm for others?•Whether the theater will or will not be built depends entirely on whether it is the efficient or inefficient outcome–Regardless of who holds the legal rights–Negative externality is solved by market–No government intervention is required, other than the initial assignment of legal rights4The Coase Theorem•The Coase Theorem—named after economist Ronald Coase–States that private market will solve externality problem on its own, always arriving at the efficient outcome•When side payments can be negotiated and arranged without cost–While initial distribution of legal rights will determine allocation of gains and losses among the parties, it will not affect action taken5The Coase Theorem•Requires that side payments can be arranged without cost—or, in practice, that cost is so low relative to gains or losses at stake that it doesn’t matter–This requirement is most likely to be satisfied when all of the following conditions are present•Legal rights are clearly established•Legal rights can be easily transferred•The number of people involved is very small•Unfortunately, many real world situations do not satisfy these conditions•Biggest problem is applying Coase theorem to many real-world externalities is the third condition–Often, a large number of people are involved•When many people are involved, achieving efficiency with side payments is plagued by an often insoluble problem–Free rider problem6The Free Rider Problem•Occurs when efficient outcome requires a side payment but individual gainers—each obligated to pay a small share of the side payment—will not contribute•If extensive enough—can shrink the side payment until it isn’t large enough to compensate losers and still leave gainers better off•Stands in the way of many Pareto improvements–One of the main reasons why we typically turn to government to deal with important externalities that affect many people7Market Externalities and Government Solutions•A competitive market has many buyers and sellers–When a negative externality affects a market, the private solution is unlikely to work•A market with a negative externality associated with producing or consuming a good will produce more than the efficient quantity–Creating a welfare loss•Unfortunately, with so many people involved, it would take too much time and trouble for individual producers and consumers to arrange appropriate side payments and production cutbacks–In any case, free rider problem would effectively destroy the arrangement–Efficient outcome requires government intervention in the market8Figure 11a: A Tax on Producers to Correct a Negative Externality100 125DS$1.00AMSCC$0.50B(a)Millions of Gallons per PeriodDollars2. The efficient quantity is here . . .3. but the equilibrium quantity is here.4. In equilibrium, the welfare loss is triangle ABC.1. This market has a negative externality of $0.50 per unit.9Figure 11b: A Tax on Producers to Correct a Negative Externality100 125D$1.00$0.50B(b)Millions of Gallons per PeriodDollars$1.30$0.80SBefore TaxSAfter Tax6. shifts the supply curve upward . . .7. and moves the equilibrium to the efficient quantity.5. A tax per unit on producers, equal to the negative externality per unit,A10Taxing a Negative Externality•Government could use a tax on producers to move gasoline market to point B•Payment of the externality tax is shared between consumers and producers, as is the payment of any tax, and will depend on elasticities of supply and demand–A tax on each unit of a good, equal to the external harm it causes, can correct a negative externality and bring market to an efficient output level•Consider the logic of this result–Tax cures the inefficiency because it forces market to internalize the externality•To take account of the harm caused by gasoline•Suggests that a tax on consumers of gasoline would work just as well as a tax on producers•Taxes to correct negative externalities have been used in countries around the world–In United States, however, taxes designed to correct negative externalities are less common11Regulation and Tradable Permits•A tax is not only way to correct a negative externality–Government can also use regulation to move a market closer to the efficient point•In last two decades, U.S. government has relied increasingly on an innovative technique to reduce several types of pollution –Tradable permits •License that allows a company to release a unit of pollution into the environment over some period of time–Firms can trade their permits in an organized market•Left to itself, a market with a negative externality will produce too much output–Taxes, regulation, and tradable permits are examples of government intervention to decrease output toward efficient level12Dealing with a Positive Externality•What about the case of a positive externality?–By-product of an activity or a service benefits other parties, rather than harms them•A market with a positive externality associated with producing or consuming a good will produce less than the efficient quantity, creating a welfare loss•A subsidy on each unit of a good, equal to the external benefits it creates, can correct a positive externality and bring the market to an efficient output level13Figure 12a: A Subsidy for Consumers to Correct a Positive Externality800,000 1,000,000DS$100,000MSBCA$30,0002. The equilibrium quantity is here . . .3. but the efficient quantity is here.4. In equilibrium, the welfare loss is triangle ABC.(a)Number of Degrees per YearDollars1.This market has a positive externality of $30,000 per college
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