invisible hand Recall Adam Smith s of the self interested marketplace leads buyers and maximize sellers in a market to the total benefit that society can derive from a market anything But can still happen EXTERNALITIES AND MARKET INEFFICIENCY externality An refers to the uncompensated impact of one person s actions on the wellbeing of a bystander Externalities cause markets to be and thus total inefficient surplus EXTERNALITIES AND MARKET INEFFICIENCY externality An arises when a person engages in an activity that influences the well being of a bystander and yet neither pays nor receives any compensation for that effect beneficial When the impact on the bystander is positive the externality is called a externality adverse When the impact on the bystander is negative the externality is called a externality 1 EXTERNALITIES AND MARKET INEFFICIENCY Negative externality Automobile exhaust Cigarette smoking Barking dogs loud pets Loud stereos in an apartment building EXTERNALITIES AND MARKET INEFFICIENCY Positive externailties Immunizations Restored historic buildings Research into new technologies The Market for Aluminum Price of Aluminum Supply private cost Equilibrium Demand private value 0 QMARKET Quantity of Aluminum 2 Pollution and the Social Optimum Price of Aluminum Social cost Cost of pollution Supply private cost Optimum Equilibrium Demand private value 0 Quantity of Aluminum QOPTIMUM QMARKET Negative Externalities The intersection of the curve and the curve determines the output level The socially optimal output level the market equilibrium quantity involves altering incentives so that people take account of the external effects of their actions Education and the Social Optimum Price of Education Supply private cost Social value Demand private value 0 QMARKET QOPTIMUM Quantity of Education 3 Positive Externalities The intersection of the curve and the curve determines the output level The optimal output level the equilibrium quantity The market produces a quantity than is socially desirable The social value of the good the private value of the good Positive Externalities Internalizing Externalities Used as the primary method for attempting to internalize positive externalities Industrial Policy Government intervention in the economy that aims to promote technology enhancing industries are a form of technology policy that give the individual or firm with patent protection a over its invention The is then said to internalize the externality TO EXTERNALITIES Government action is not always needed to solve the problem of externalities Moral codes and social sanctions Charitable organizations Integrating different types of businesses Contracting between parties 4 The The is a proposition that if private parties can bargain without cost over the allocation of resources they can solve the problem of externalities are the costs that parties incur in the process of agreeing to and following through on a bargain Why Private Solutions Do Not Always Work Sometimes the private solution approach fails because can be so high that private agreement is not possible TOWARD EXTERNALITIES When externalities are significant and private solutions are not found government may attempt to solve the problem through 5 PUBLIC POLICY TOWARD EXTERNALITIES Policies Usually take the form of Forbid certain behaviors Require certain behaviors Examples Requirements that all students be immunized Stipulations on pollution emission levels set by the Environmental Protection Agency EPA PUBLIC POLICY TOWARD EXTERNALITIES Policies Government uses and to align private incentives with social efficiency are taxes enacted to correct the effects of a negative externality PUBLIC POLICY TOWARD EXTERNALITIES Examples of Regulation versus Pigovian Tax If the EPA decides it wants to reduce the amount of pollution coming from a specific plant The EPA could tell the firm to reduce its pollution by a specific amount i e levy a tax of a given amount for each unit of pollution the firm emits i e 6 PUBLIC POLICY TOWARD EXTERNALITIES Market Based Policies allow the voluntary transfer of the right to pollute from one firm to another A market for these permits will eventually develop A firm that can reduce pollution at may prefer to its permit to a firm that can reduce pollution only at The Equivalence of Pigovian Taxes and Pollution Permits a Pigovian Tax Price of Pollution Pigovian tax P 1 A Pigovian tax sets the price of pollution Demand for pollution rights 0 Q 2 which together with the demand curve determines the quantity of pollution Quantity of Pollution The Equivalence of Pigovian Taxes and Pollution Permits b Pollution Permits Price of Pollution Supply of pollution permits P Demand for pollution rights 0 2 which together with the demand curve determines the price of pollution Q Quantity of Pollution 1 Pollution permits set the quantity of pollution 7