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 Positive externality impact on bystander is beneficial Negative externality impact on bystander is adverse Market equilibrium is not efficient when there are externalities Externalities and Market Inefficiency Negative externalities aluminum factories pollute o The cost to society of producing aluminum is larger than the cost to the aluminum producers o Social cost includes the private cost of the aluminum producers plus the costs to those bystanders affected by the pollution Social cost curve is above the supply curve Social cost of the good exceeds the private cost optimal quantity is smaller than the equilibrium quantity this inefficiency results b c the market equilibrium only reflects the private costs of production o Produce the level of aluminum where the demand curve crosses the social cost curve Achieve this by taxing aluminum producers which would shift the supply curve upward by the size of the tax hopefully the new supply curve coincides with the social cost curve Internalizing the externality altering incentives so that ppl take account of the external affects of their actions o Negative externalities lead markets to produce a large quantity than is socially desirable therefore gov taxes goods Positive externalities education more educated better voter better gov for everyone o Social value curve lies above the demand curve b c the demand curve does not reflect the value to society of the good the social value is greater than the private value o Optimal quantity is found where the social value curve and the supply curve meet optimal quantity large than equilibrium quantity o Gov uses subsidies to try to get the demand curve to match the social value curve o Positive externalities lead markets to produce a smaller quantity than is socially desirable therefore gov subsidizing goods o Technology spillover the impact of one firm s research and production efforts on the other firms access to technological advance Industrial policy gov intervention in the economy that aims to promote technology enhancing industries Patents give incentive to research Public Policies Toward Externalities Gov can respond to externalities in 2 ways command and control policies regular behavior directly where market based policies provide incentives so that private decision makers will choose to solve the problem on their own Command and control policies regulation o Can make certain behaviors required or forbidden Market based policy 1 corrective taxes and subsidies o Align private incentives with social efficiency o Corrective taxes taxes enacted to deal with the effects of negative externalities induces private decision makers to take account of the social costs that arise from a negative externality aka Pigovian taxes should equal the external cost from a negative externality move allocation of resources toward the social optimum o Tax reduce pollution more efficiently than regulation Market based policy 2 Tradable pollution permits o Firm A can pollute X and firm B can pollute X Firm A wants to pollute more so it asks firm B if it can pollute less Firm A takes some of firm B s pollution rights overall pollution is the same still though o Cost effective way to keep environment clean Private Solutions to Externalities Other than government action ppl can develop solutions to externalities Moral codes don t litter Charities alumni corporations give money to schools b c education is a positive externality Self interest of relevant parties Interested parties enter into a contract 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 o However in the real world bargaining does not always work o May not work b c of transaction costs the costs that parties incur in the process of agreeing to and following through on a bargain o Hard to reach an efficient bargain when the number of interest parties is large
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