Chapter 10 Externalities Externality the uncompensated impact of one person s actions on the well being of a bystander An externality 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 If the impact on the bystander is adverse it is called a negative externality If the impact on the bystander is beneficial it is called a positive externality Examples The exhaust from automobiles is negative externality because it creates smog that other people have to breathe As a result drivers tend to pollute too much The fed Government attempts to solve this problem by setting emission standards for cars and taxes gasoline to reduce amount that people drive Research into new technologies provides positive externality because it creates knowledge that other people can use Because inventors cannot capture the full benefits of their inventions they tend to devote too few resources to research The fed Government addresses this problem partially through the patent system which gives inventors exclusive use of their inventions for a limited of times Externalities and Market Inefficiency Welfare Economics A Recap o Consider market for aluminum Demand curve for aluminum reflects value of aluminum to consumers as measured by prices they are willing to pay At any given quantity height of demand curve shows willingness to pay of marginal buyer It shows the value to the consumer of the last unit of aluminum bought Supply curve reflects costs of producing aluminum At any given quantity height of supply curve shows cost of marginal seller It shows the cost to the producer of the last unit of aluminum sold In absence of government intervention price adjusts to balance supply and demand for aluminum Quantity produced and consumed in market equilibrium is efficient because it maximizes sum of producer and consumer surplus Market allocates resources in a may that maximizes total value to consumers who buy and use aluminum minus total costs to producers who make and sell aluminum Negative Externalities o Suppose aluminum factories emit pollution For each unit of aluminum produced a certain amount of smoke enters atmosphere Because the smoke creates health risk for those who breathe the air it s a negative externality o Because of the externality the cost to society of producing aluminum is larger than the cost to aluminum producers o For each unit of aluminum produced the social cost includes the private costs of the aluminum producers plus the costs to those bystanders affected by the pollution o The social cost curve is above supply curve because it takes into account the external costs imposed on society by aluminum producers Difference between the two curves reflects the cost of the pollution emitted o Equilibrium quantity of aluminum Qmarket is larger than social optimal quantity Qoptium This inefficiency occurs because the market equilibrium reflects on the private costs of production In market equilibrium the marginal consumer values aluminum at less than the social cost of producing it That is at Qmarket the demand curve lies below social cost curve Thus reducing aluminum production and consumption below market equilibrium raises total economic well being o Internalizing the externality altering incentives so that people take account of the external effects of their actions o Same as analysis of negative externalities o Negative externalities lead markets to produce a larger quantity than is socially desirable while positive externalities lead markets to produce a smaller quantity than socially desirable Positive Externalities o Government can remedy an externality by making certain behaviors either required or forbidden Market Based Policy 1 Corrective Taxes and Subsidies o Instead of regulating behavior in response to an externality government can use market based policies to align private incentives with social efficiency o Corrective tax a tax designed to induce private decision makers to take account of the social costs that arise from a negative externality Market Based Policy 2 Tradable Pollution Permits o Deals made by producers that emit pollution Ex A mill wants to increase emission of X by 100 tons The other mill has agreed to reduce its emission by the same amount if the first mill pays it 5 million Public Policies Toward Externalities Command and Control Policies Regulation o From standpoint of economic efficiency allowing the deal is good policy Private Solutions to Externalities Types of Private Solutions o The Golden Rule Moral injunction o Charities income tax deduction for charitable donations o Self interest of relevant parties Integrating different types of business o Interested parties enter into contract The Coase Theorem o The proposition that if private parties can bargain without cost over the allocation of resources they can solve the problem of externalities on their own
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