Ch. 10: ExternalitiesMonday, October 20, 201412:39 AM -Externality: the uncompensated impact of one person's actions on the well-being of a bystanderoIf the impact on a bystander is adverse, it is called a negative externalityoIf the impact is beneficial, it is called a positive externality-Because buyers and sellers neglect the external effects of their actions when deciding how much to demand or supply,the market equilibrium is not efficient when there are externalities. oThe exhaust from automobiles is a negative externality because it creates smog that other people have to breathe. Government attempts to solve this problem by setting emission standards for cars and taxing gasoline toreduce the amount of drivingoRestored historic building convey a positive externality because people who walk or ride by them can enjoy the beauty and the sense of history that they provide. Since building owners don't get the full benefit of restoration, they tend to discard these old buildings. Governments respond by regulating destruction of historic buildings and providing tax breaks to owners who restore them oBarking dogs create a negative externality because neighbors are disturbed by the noise. Dog owners don't bear the full cost of the noise so they take too few precautions to prevent their dogs from barking. Governments address the problem by making it illegal to disturb the peaceoResearch into new technologies provides positive externality because it creates knowledge others can use. Because inventors can't capture the full benefits of their inventions, they tend to devote too few resources to research. Government addresses the problem through the patent system, which gives inventors exclusive use of their inventions for a limited time. -In each case, some decision maker fails to take account of the external effects of their behavior. The government responds by trying to influence this behavior to protect the interests of bystanders. Externalities and Market Inefficiency-Welfare Economics: A RecapoThe demand curve reflects the value to buyers and the supply curve reflects the cost of sellers. The equilibrium quantity maximizes the total value to buyers minus the total cost of sellers. In the absence of externalities, the market equilibrium is efficient. -Negative ExternalitiesoSuppose that aluminum factories emit pollution, which is a negative externality. oBecause of the externality, the cost to society of producing aluminum exceeds the cost to the producers of aluminum. For each unit of aluminum produced, the social cost includes the private costs of the aluminum producers plus to costs to those bystanders affected by the pollution. Price of aluminumSocial cost (private cost and external cost)-In the presence of a negative externality, such as pollution, the social cost of the good exceed the private cost. The optimal quantity is therefore smaller than the equilibrium quantity (Qmarket)-At Qmarket, the demand curve lies below the social cost curve so reducing the production and consumption below the market equilibrium level raises total economic well-being. -To achieve this optimal outcome, place a tax on producers which would shift the supply curve upward by thesize of the tax. If the tax accurately reflected the external cost, the new supply curve would coincide with the social -cost curve. -This is called internalizing the externality: altering incentives so that people take account of the external effects of their actionsExternal costSupply (private cost) optimum☺equilibriumDemand (private value)Quantity ofaluminumQoptimum Qmarket -Positive ExternalitiesoEducation-More educated people → more informed voters → better government for everyone-More educated population → lower crime rates-More educated population may encourage the development and dissemination of technological advances → higher productivity and wages for everyoneoBecause the social value of education is higher than the private value, the social value curve lies above the demand curve. The optimal quantity is found where the social value curve and the supply curve intersect. Price of educationExternal benefitSupply (private cost)-In the presence of a positive externality, the social value of the good exceeds the private value. The optimal quantity, Qoptimum, is therefore larger than the equilibrium quantity (Qmarket)-To achieve the optimal outcome, a positive externality requires a subsidy (the exact opposite to the case of negative externalities). This is also internalizing the externalities -Education is heavily subsidized through public schools and government scholarshipsoptimumequilibriumSocial value (private value and external benefit)Demand (private value) Quantity of education Qmarket Qoptimum-Negative externalities lead markets to produce a larger quantity than is socially desirable. -Positive externalities lead markets to produce a smaller quantity than is socially desirable. -To remedy the problem, government can internalize the externality by taxing goods that have negative externalities and subsidizing goods that have positive externalitiesTechnology Spillovers, Industrial Policy, and Patent Protection-An important type of positive externality is called a technology spillover - the impact of one firm's research and production efforts on other firms' access to technological advance-Ex: robots. Whenever a firm builds a robot, there is some chance that the firm will discover a new and better design that may benefit society as a whole because that design will enter society's pool of technological knowledge-The government can internalize the externality by subsidizing the production of robots, causing the supply curve to shift down by the amount of the subsidy, which would increase the equilibriumquantity of robots-To ensure that market equilibrium equals the social optimum, the subsidy should equal the valueof the technology spillover-Some economists believe that technology spillovers are pervasive and that the government should encourage those industries that yield the largest spillovers. oGovernment intervention in the economy that aims to promote technology-enhancing industries is sometimes called industrial policy-Other economists are skeptical about industrial policy. Without precise measurements, the political system may end up subsidizing industries with the most political clout rather than those that yield the largest positive externalities-Patent laws protect the rights of