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Externalities Externalitythe behavior of one agent (person or firm) affects another agent in a way that is external to markets. negative externalities,

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Presentation on theme: "Externalities Externalitythe behavior of one agent (person or firm) affects another agent in a way that is external to markets. negative externalities,"— Presentation transcript:

1 Externalities Externalitythe behavior of one agent (person or firm) affects another agent in a way that is external to markets. negative externalities, e.g., chewing tobacco (disease and soiling),alcohol (drunk driving),road salt (car damage),and antibiotics (disease resistant bacteria). positive externalities, e.g., HPV vaccine (disease), and education (better citizens).

2 Founded in th & Early 20th Century Chewing Tobacco The founders of Mail Pouch came up with the idea when they noticed that people liked chewing the clippings of stogie wrappers. Mail Pouch paid barn owners $1 to $2 a year and painted the rest of the barn as well.

3 19th and Early 20 th Century Chewing Tobacco Quotes from Richard Klugers, Ashes to Ashes Chewing Tobacco: Messy: spit aimed at ubiquitous cuspidor(s) hit carpets, walls, draperies, and trousers. Dangerous: spreader of tuberculosis and other contagions. splendidly suited to 19 th Century outdoor life In early 20 th Century:

4 Early 20 th Century Courthouse Cuspidor

5 S P MKT Q MKT D Q CT P CT (private cost) Social Cost Q*Q* Efficient Q external costthe health and cleanup costs imposed on others from tobacco spit. Market for Chewing Tobacco (CT), 1900

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7 The Market for Chewing Tobacco P CT Q MKT > Q * Q CT S MKT Social Cost D external cost Market Failure: Negative externalities cause markets to For each pouch of chewing tobacco produced, the social cost includes the private costs of producing the chewing tobacco plus the cost to those bystanders adversely affected by the spit from that pouch. Q producing Q Social cost of Private cost of producing Q Q * Q MKT produce a larger quantity than is efficient.

8 P MKT P CT Q MKT Q*Q* Q CT Social Cost Correcting the Market Failure Changing incentives so people (or firms) take account of the external effects of their behaviors is called internalizing the externality. S MKT D P MKT P CT Q NT QTQT Q CT S D The government can internalize the externality by imposing a tax on chewing tobacco (assume that tobacco companies pay it). S Tax(T) external cost tax Q T will equal Q* if the tax (per pouch) = the negative externality (per pouch). MKT PTPT

9 S D Q LJ P LJ (private cost) Market for LoJack (LJ) Social value P MKT External benefit (the value of in prob. that other cars will be stolen) Q MKT Q* (private value) Positive externalities cause markets to produce a smaller Q than is efficient. DWL

10 Correcting the Market Failure S D Q LJ P LJ 0 Social P MKT External benefit value S D Q LJ Subsidy S s P LJ P MKT PSPS 0 Q MKT Q* Q MKT QSQS The government can internalize the externality by giving a subsidy to the producer of LoJack. Q S will equal Q* if the subsidy (per LoJack) = the positive externality (per LoJack).

11 Correcting the Market Failure Alteratively, economists Ayres and Nalebuff urge regulators to require insurers to give discounts to LoJack users. Suppose the government requires insurers to give discounts of $200 to people who purchase LoJack. S D Q LJ P LJ 0 Social P MKT External benefit value S D Q LJ $200 P LJ P MKT 0 Q MKT Q* Q MKT D Q P


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