Principles of Microeconomics: Chapter 10Externality: 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.If aluminum factories emit pollution, this creates a health risk and a negative externality. The cost to society of producing aluminum is larger than the cost to aluminum producers. The social cost includes private costs of theproducers 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 ofpollution. 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 occursbecause 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 actionsPositive externalities: E.g., education. The benefit of education is mostly private: a workerbecomes more productive and earns a higher wage. But also yields positive externalities (more informed voters, better government, lowercrime 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 producea 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 tosolve the problem.Command-and-Control Policies: Regulationgov.'t can remedy a certain externality by making certain behaviors either required or forbidden. Market-based Policy 1: Corrective Taxes and SubsidiesCorrective taxes (also known as Pigovian taxes): taxes enacted todeal 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 PermitsIf 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 ExternalitiesSometimes private decision makers can solve the problem themselves. • Moral codes and social sanctions (e.g. littering)• CharitiesThe 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 ownPRIVATE 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:•Each party tries to hold out for a better deal• The number of interested parties is large (coordinating everyone is