Chapter 10 Externalities Externality arises when a person engages in an activity that influences the well being of a bystander but neither pays nor receives any compensation for that effect o Negative externality is if the impact on the bystander is adverse o Positive externality If the impact is beneficial o In the presence of externalities society s interest in a market outcome extends beyond the well being of buyers and sellers who participate in the market to include the well being of bystanders who are affected indirectly The market equilibrium is not efficient when there are externalities because buyers and sellers neglect the external effects of their actions when deciding how much to demand or supply o SO the equilibrium fails to maximize the total benefit to society as a whole o Example of a negative externality Is the release of dioxin into the environment Self interested paper firms will not consider the full cost of the pollution they create in their production process and consumers of paper will not consider the full cost of the pollution they contribute from their purchasing decisions Therefore the firms will emit too much pollution unless the government prevents of discourages them from doing so Externalities come in many varieties as do the policy responses that try to deal with the market failure o The exhaust from automobiles is a negative externality because it creates smog that other people have to breathe As a result of this externality drivers tend to pollute too much The federal government attempts to solve this problem by setting emission standards for cars It also taxes gasoline to reduce the amount that people drive o Restored historic buildings convey a positive externality because people who walk or ride by them can enjoy the beauty and the sense of history that these buildings provide Building owners do not get the full benefit of restoration and therefore tend to discard older building too quickly Many local governments respond to this problem by regulating the destruction of historic buildings and by providing tax breaks to owners who restore them o Barking dogs crate a negative externality because neighbors are disturbed by the noise Dog owners do not bear the full cost of the noise and therefore tend to take too few precautions to prevent their dogs from barking Local government addresses this problem by making it illegal to disturb the peace o In each of these cases some decision maker fails to take account of the external effects of his or her behavior The government responds by trying to influence this behavior to protect the interests of bystanders Negative externalities o If aluminum factories emit pollution For each unit of aluminum produced a certain amount of smoke enters the atmosphere Because this smoke creates a health risk for those who breathe the air it is a negative externality This externality affects the efficiency of the market outcome since because of the externality the cost to society of producing aluminum is larger than the cost to the aluminum producers For each unit of aluminum produced the social cost includes the private costs of the aluminum producers plus the costs to those bystanders affected adversely by the pollution So the social cost curve is above the supply because it takes into account the external costs imposed on society by aluminum production The difference between these two curves reflects the cost of pollution emitted Internalizing the externality altering incentives so that people take account of the external affects of their actions o Imposing a tax would be called internalizing the externality because it gives buyers and sellers in the market an incentive to take into account the external effects of their actions o Aluminum from above example would in essence take the costs of pollution into account when deciding how much aluminum to supply because the tax would make them pay for these external costs And because the market price would reflect the tax on producers consumers of aluminum would have an incentive to use a smaller quantity Positive externalities o The government can also correct the market failure by inducing market participants to internalize the externality when responding to cases of positive externalities o To move the market equilibrium closer to the social optimum a positive externality requires a subsidy Opposite of negative externality which requires a tax Summary thus far When a transaction between a buyer and seller directly affects a third party the effect is called an externality Negative externalities lead the market to produce a larger quantity than is socially desirable socially desirable Positive externalities lead markets to produce a smaller quantity than is To remedy this problem the government can internalize the externality by taxing goods that have negative externalities and subsidizing goods that have positive externalities Both public and policymakers and private individuals respond to externalities in various ways All of the remedies share the goal of moving the allocation of resources closer to the social optimum The government can respond to externalities in one of two ways o Command and control policies which regulate behavior directly o Market based policies which provide incentives so that private decision makers will choose to solve the problem on their own Command and control policies regulations o The government can remedy an externality by making certain behaviors either required or forbidden For example it is a crime to dump poisonous chemicals into the water supply In this case the external costs to society far exceed the benefits to the polluter The government therefore institutes a command and control policy that prohibits this act altogether o It would be impossible to prohibit all polluting activity so instead of trying to completely get rid of pollution society has to weigh the costs and benefits to decide the kinds and quantities of pollution it will allow o In the US the Environmental Protection Agency EPA is the government agency with the task of developing and enforcing regulations aimed at protecting the environment Environmental regulations have many different forms The EPA can dictate a maximum level of pollution that a factory may emit or can require that firms adopt a particular technology to reduce emissions In all cases the government regulators need to know the details about specific industries and about the alternative technologies that
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