Chapter 10 – Externalities-Externality: the uncompensated impact of one person’s actions on the well-being ofa 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 peopledrive-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 timesExternalities and Market Inefficiency- Welfare Economics: A Recapo Consider market for aluminum. Demand curve for aluminum reflects value of aluminumto 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 makeand sell aluminum- Negative Externalitieso 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 producerso 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 pollutiono 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- Positive Externalitieso Same as analysis of negative externalitieso 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.Public Policies Toward Externalities- Command-and-Control Policies: Regulationo Government can remedy an externality by making certain behaviors either required or forbidden- Market-Based Policy 1: Corrective Taxes and Subsidieso 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 Permitso 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.o From standpoint of economic efficiency, allowing the deal is good policy.Private Solutions to Externalities- Types of Private Solutionso The Golden Rule. Moral injunctiono Charities – income tax deduction for charitable donationso Self-interest of relevant parties. Integrating different types of businesso Interested parties enter into contract- The Coase Theoremo The proposition that if private parties can bargain without costover the allocation of resources, they can solve the problem of externalities on their
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