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Principles of Microeconomics Chapter 10 Externality the uncompensated impact of one person s actions on the well being of a bystander can be negative or positive Ex exhaust from automobiles is a negative externality research into new technologies is a positive externality in each some decision maker fails to take account of the external effects of his or her behavior Market equilibrium is not efficient when there are externalities equilibrium fails to maximize total benefit to society as a whole Negative externalities In examining a market e g aluminum the price will adjust to balance supply and demand in the absence of government intervention This is technically efficient because the market is at equilibrium maximizing the total value to consumers minus the total costs to producers negative externality If aluminum factories emit pollution this creates a health risk and a The cost to society of producing aluminum is larger than the cost to aluminum producers The social cost includes private costs of the producers plus to costs to those bystanders affected by the pollution the social cost curve is above the supply curve because it takes into account the external costs imposed on society by aluminum production The difference between the two curves reflects the cost of pollution To maximize surplus from the market value to consumers cost to producers except cost is higher because it includes external costs the level of aluminum production should be where the demand curve crosses the social cost curve This is the optimal amount of Al produced from the standpoint of society as a whole Original equilibrium Q is larger than the socially optimal Q this occurs because market E reflects only private costs of production and the marginal consumer values Al at less than the social cost curve therefore the market E is inefficient To achieve optimal levels of production one can tax Al producers shifting supply curve upward by the size of the tax ideally coinciding with the social cost curve called internalizing the externality altering incentives so that people take account of the external effects of their actions Positive externalities E g education The benefit of education is mostly private a worker becomes more productive and earns a higher wage But also yields positive externalities more informed voters better government lower crime rates encouragement of technological advances generally higher wages The social value is greater than the private value so the social value curve lies above the demand curve Optimal quantity is found where the supply curve meets the social value curve Here optimal quantity is greater than equilibrium quantity To achieve optimal levels of education the government can internalize the externality by subsidizing market participants In summary negative externalities lead markets to produce a larger than desirable quantity Positive externalities lead markets to produce a smaller than desirable quantity To correct this gov ts can internalize the externality by taxing goods that are negative and subsidizing goods that are positive Public Policies toward Externalities The government can respond to externalities in one of two ways command and control policies regulate behavior directly market based policies provide incentives to nudge private decision makers to solve the problem Command and Control Policies Regulation gov t can remedy a certain externality by making certain behaviors either required or forbidden Market based Policy 1 Corrective Taxes and Subsidies Corrective taxes also known as Pigovian taxes taxes enacted to deal with the effects of negative externalities an ideal corrective tax would equal the external cost from an activity with negative externalities and an ideal corrective tax subsidy would equal the external benefit from an activity with positive externalities Economists usually prefer corrective taxes to regulations because they can reduce issues at a lower cost to society E g pollution Regulation would dictate a level of pollution while the tax would give factory owners an incentive to reduce pollution The corrective tax places a price on the right to pollute Corrective taxes are unlike most other taxes when externalities are present society cares about the well being of bystanders being affected so corrective taxes alter incentives to account for externalities and move allocate of resources towards the social optimum Market based Policy 2 Tradable Pollution Permits If the gov t allows any voluntary transfer of the right to pollute from one to another it will have created a scarce resource pollution permits A market will develop the more costly it is for a firm to cut back on pollution the more it will be willing to pay for a permit Private Solutions to Externalities Sometimes private decision makers can solve the problem themselves Charities Moral codes and social sanctions e g littering The private market can often solve the problem of externalities by relying on the self interest of the relevant parties e g a beekeeper and an apple grower live next to each other They both rely on each other s products to make their own so why not combine firms Internalizing externalities is a reason that some firms are involved in different types of businesses Coase theorem 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 PRIVATE SOLUTIONS DO NOT ALWAYS WORK The Coase theorem applies only when the relevant parties have no trouble reaching and enforcing an agreement Sometimes the interested parties fail to reach an agreement because of transaction costs the costs that parties incur in the process of agreeing to and following through on a bargain Other issues costly Each party tries to hold out for a better deal The number of interested parties is large coordinating everyone is


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NU ECON 1116 - Principles of Microeconomics: Chapter 10

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