Lecture Outline – ExternalityWhenever a cost or benefit is imposed on a third partyExternal cost = imposed on third party Ex. a firm that expels pollution into the air. Social mar-ginal cost = marginal cost of firm + external cost imposed on third party1. Negative Externalities· What is an external cost? Give an example of an external cost.o External cost = imposed on third party Ex. a firm that expels pollution into theair.· What is a negative externality?o If a negative externality is present, then what is the difference between the so-cial marginal cost and private marginal cost? External cost of the third partyo If a negative externality does not exist, then what is the difference between thesocial marginal cost and private marginal cost?· Draw a supply and demand graph and identify the private marginal cost curve, the so-cial marginal cost curve and the value of the negative externality.·o Social MC curve = Firms MC + External Cost1o Whenever negative externality is present, there is an overproduction of the good.· When an external cost is present, how does the market outcome compare to the effi-cient (i.e. socially optimal) outcome? o Overproductiono Does the market produce too little or too much of the good or service when anexternal cost is present? = too mucho When an external cost is present, is the market price too high or too low rela-tive to the price that will maximize total surplus? Why do the prices differ?o Identify the market equilibrium and the social equilibrium on a graph.o Identify the deadweight loss (DWL) on your graph. Does the DWL represent “unrealized gains from trade” or “wasted or resources?” Explain. wasted resources•Consumers also create negative externalities - Ex. Smoking•External cost = 2nd hand smoke•MB of smoking = $12•MC of smoking = $3•External Cost = $15Total cost = CS+PS - external costsTS = -$62. Positive Externalities· What is an external benefit? Give an example of an external benefit.o External benefit = positive benefit received by a third party2o Ex. Flu shots- people who receive flu shot get it because they don’t want to get the flu. but for those who are around who don’t get the flu shot, theybenefit from you by you not getting the flu and getting them sicko Marginal benefit -marginal cost = total surplus· What is a positive externality?o If a positive externality is present, then what is the difference between the social marginal benefit and the private marginal benefit? External benefit of the third partyo If a positive externality does not exist, then what is the difference between the social marginal benefit and the private marginal benefit?· Draw a supply and demand graph and identify the private marginal benefit curve, the social marginal benefit curve and the value of the positive externality.·· When an external benefit is present, how does the market outcome compare to theefficient (i.e. socially optimal) outcome? o Social marginal benefit curve = shows the true value received by the soci-ety3o Optimal price and quantity of production= intersection of social MB curveand supply curveo Does the market produce too little or too much of the good or service when an external benefit is present? under provision, too little, becauause people only do things for themsleves.o When an external benefit is present, is the market price too high or too lowrelative to the price that will maximize total surplus? Why do the prices differ?o Identify the market equilibrium and the social equilibrium on a graph.o Identify the deadweight loss (DWL) on your graph. Does the DWL repre-sent “unrealized gains from trade” or “wasted or resources?” Explain. Unrealized gains from trade = DWL Market does not allocate resources efficiently3. Solutions to the Externality Problema. Way to reduce consumption/production is to impose a taxb. Difference between supply curves= value of ext. costs.4c. Set tax equal to external cost· What is a Pigouvian tax? o increases total surplus in the market because it eliminated DWLo Pigouvian tax is a way to reduce consumption or production of good to reduceexternal costo When should a Pigouvian tax be employed?  When you need to reduce consumption or productiono Explain why a Pigouvian tax will increase total surplus (i.e. economic wel-fare) and not reduce it. Use a graph to support your answer. Increases total surplus because it eliminates DWLo Is it optimal to reduce the value of the external cost to zero? Explain. No because the only way to reduce External cost to zero is to com-pletely stop production the good which will eliminate all surplus and this would not be efficient.o Command & Control i.e. laws prohibiting smokers among minors or limiting smoking in public places· What is a Pigouvian subsidy?·5o We need to make more of the good because there is an underproduction.o Subsidy = external benefito When should a Pigouvian subsidy be employed? When there is an underproductiono Explain why a Pigouvian subsidy will increase total surplus (i.e. economic welfare) and not reduce it. Use a graph to support your answer. Realize more gains from tradeo Is it optimal to maximize the value of the external benefit? Explain. No because the cost of production is much higher than the demand at the maximum value of external benefit. Waste of resources· What is a command-and-control policy? o Government dictates how much of the externality is allowed.o Give an example of a command-and-control policy that can be used to correct the market failure whenever a negative externality is present? Imposing a law that restricts smoking in public placeso Given an example of a command-and-control policy that can be used to cor-rect the market failure whenever a positive externality is present? Require people to do something i.e. make a rule that you have to get flu shots to go to school· What is the Coase Theorem? What conditions must hold in order to come to a privatesolution to the externality problem?o Private solution can be reached without the government. 1. There should only be a few parties involved.o 2. Needs to be clearly defined who owns the right to whatever the problem is (property must be clearly established). 6o 3. Transaction costs are low (all costs necessary for buyers and sellers to reachan agreement.)o Give an example of how the Coase Theorem is applied to correct the market failure whenever a positive externality is