Slide 1Knowledge RecapExternalitiesExternalities and InefficiencyExternalities and InefficiencyPublic Polies Toward ExternalitiesPublic Polies Toward ExternalitiesPrivate Solutions to ExternalitiesECON 203: Principles of MicroeconomicsClass 11: Externalities1Knowledge Recap•In general, free market equilibrium is efficient.–Maximizes total surplus (CS+PS).–Goods are allocated to buyers who value them most and produced by sellers with the lowest possible costs.•Market efficiency relies upon two main assumptions:–Markets are perfectly competitive.–Market outcomes matter only to buyers and sellers in the given market. •Market failure may occur if either or both of these assumptions are violated.–Markets that are not competitive may lead to market power.–People outside a market may be affected by externalities.2Externalities•Externalities occur when an action results in a cost or benefit for a bystander that is not reflected in a cost or benefit for the person taking the action.–Negative externalities occur when the impact on the bystander is adverse, for example pollution.–Positive externalities occur when the impact on the bystander is beneficial, for example vaccination.•Externalities may result in market failure.–The buyers and sellers neglect the external effects of their actions on bystanders. –Maximal social welfare has to consider the well-being of bystanders together with that of the buyers and sellers.3Externalities and Inefficiency•Negative externalities.–Market equilibrium reflects cost of production.–Total cost to society includes the cost for bystanders.–The result is that the market quantity produced and consumed is higher than optimal for society.–Example: •Negative externality of the production of Sriracha sauce. •Including the external cost of the Sriracha factory to the local neighborhood would shift the supply curve to the left.•The shift in the supply curve decreases quantity produced.4Externalities and Inefficiency•Positive externalities.–Market equilibrium reflects value to buyers.–Total value to society includes the value for bystanders.–The result is that the market quantity produced and consumed is lower than optimal for society.–Example: •Positive externality of the consumption of vaccines. •Including the external benefit of disease prevention to society would shift the demand curve to the right.•The shift in the demand curve increases quantity produced.5Public Polies Toward Externalities•Corrective taxes.–Correct negative externalities by increasing cost of production or consumption.–Makes private cost equal to social cost.•Corrective subsidies.–Correct positive externalities by increasing value of production or consumption.–Makes private benefit equal to social benefit.6Public Polies Toward Externalities•Regulation.–Government mandates the quantity produced/consumed.–Hard to implement.–With multiple producers/consumers with different costs and benefits it may not be the most efficient solution.•Tradable Pollution Permits.–Government regulates quantity produced by emitting “pollution permits” that are required for production.–Factories are allowed to trade permits, which assures that only factories with the lowest costs will produce.–The total number of permits sets the total maximum pollution level.7Private Solutions to Externalities•Sometimes private parties can solve the problem of externalities.–Moral codes of conduct, such as the rule not to litter.–Charities and non-profits that subsidize goods with positive externalities, such as education. –Contracts among interested parties.•Coase Theorem.–Assumptions:•Property rights are well-defined.•Parties can negotiate without cost (no transaction costs).–When these conditions are met, private parties can solve the externality on their