Chapter 10: Externalities Introduction: ! externality- uncompensated impact of one’s actions on the well-being of a bystander ! negative externality- impact of bystander is adverse ! positive externality- impact on bystander is beneficial ! when there are externalities equilibrium fails to maximize total benefits to society Welfare Economics Recap: ! in absence of government intervention, the market allocates resources in a way to maximizes total value to consumers Negative Externalities: ! Private cost- cost of producing an additional unit of a good/service (marginal cost) ! Social cost- cost incurred by the producer and society ! Social cost includes private costs of producers plus cost of bystanders adversely affected by pollution ! social-cost curve is above supply curve because it takes into account external costs imposed on society (difference between curves is cost of pollution) ! producer should produce Q where social cost intersects demand curve (QOptimum) ! internalizing the externality- altering incentives so that people take account of external effect of their actions ! Negative Externalities in Production: when private cost is less than social cost (air pollution, global warming) ! Positives Externalities in Production: when private cost is greater than social cost (fable of the bees) Positive Externalities: ! Private value- benefit from an addt’l unit of a good or service that the consumer receives (willingness to pay) ! Social Value- benefit enjoyed by the consumer and society ! Negative Externalities in Consumption: when private value is greater than social value (loud music, 2nd hand smoke) ! Positive Externalities in Consumption: when private value is less than social value (vaccinations, LoJack) ! Negative externalities lead markets to produce a larger quantity than is socially desirable. ! Positive externalities lead markets to produce a smaller quantity than is socially desirable. ! Gov’t can internalize the externality by taxing goods that have negative externalities and subsidizing goods that have positive externalities Public Policies Toward Externalities: ! Gov’t can respond to externalities in one of two ways: o Command-and-control policies regulate behavior directly o Market-based policies provide incentives so private decision makers will choose to solve the problem on their own ! Gov’t can remedy an externality by making behaviors either required or forbidden o Ex. it is a crime to dump poisonous chemicals into the water supply (command-and-control policy that prohibits this act altogether) ! instead of trying to eradicate pollution entirely, society has to weigh the costs and benefits to decide the kinds and quantities of pollution it will allow Corrective Taxes and Subsidizes: ! gov’t can use market-based policies to align private incentives with social efficiency ! corrective taxes (Pigovian)- tax designed to induce private decision makers to take into account of social costs that arise from a negative externality ! ideal corrective tax would equal the external cost from an activity with negative externalities,! ideal corrective subsidy would equal the external benefit from an activity with positive externalities ! higher the tax, the larger the reduction in pollution; If the tax is high enough, the factories will close down altogether, reducing pollution to zero ! Corrective taxes alter incentives to account for the presence of externalities; while corrective taxes raise revenue for the government, they also enhance economic efficiency Tradable Pollution Permits: ! One firm agrees to sell some of its pollution rights to a firm who needs to increase its pollution o owners of the two factories better off because they are voluntarily agreeing to it o deal does not have any external effects because the total amount of pollution remains the same o social welfare is enhanced by allowing the firm 1 to sell pollution rights to firm 2 ! more costly it is for a firm to cut back on pollution, the more it will be willing to pay for a permit o firms that can reduce pollution at a low cost will sell whatever permits they get o firms that can reduce pollution only at a high cost will buy whatever permits they need o final allocation will be efficient regardless of the initial allocation ! With corrective taxes, polluting firms must pay a tax to the government. With pollution permits, polluting firms must pay to buy the permit ! Both corrective taxes and pollution permits internalize the externality of pollution by making it costly for firms to pollute (a) EPA uses a corrective tax to set a price for pollution supply curve for pollution rights is perfectly elastic (firms can pollute as much as they want by paying the tax) position of the demand curve determines the quantity of pollution (b) EPA sets a quantity of pollution by issuing pollution permits supply curve for pollution rights is perfectly inelastic (quantity of pollution is fixed by the number of permits) position of the demand curve determines the price of pollution Objections to the Economic Analysis of Pollution: ! clean environment is a normal good (positive income elasticity); rich countries can afford a cleaner environment Types of Private Solutions: ! Sometimes the problem of externalities is solved with moral codes and social sanctions (moral injunction tells use to internalize externalities) ! Another private solution to externalities is charities (gov’t allows income tax deduction for charitable donations) ! The private market can often solve the problem of externalities by relying on the self-interest of the relevant parties ! Internalizing externalities is one reason that some firms are involved in different types of businesses ! Another way for the private market to deal with external effects is for the interested parties to enter into a contract ! the contract can solve the inefficiency that normally arises from these externalities and make both parties better off The Coase Theorem: ! coase theorem- if private parties can bargain without cost of the allocation of resources, they can solve the problem of externalities on their own ! Example: o Dick’s dog disturbs Jane; Should Dick get rid of the dog or should Jane suffer sleepless nights because of the dog? o If benefit exceeds cost, Dick should keep the dog o According to Coase Theorem, the private market will reach the efficient outcome on its own:
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