1 In this chapter, look for the answers to these questions: What is an externality?Why do externalities make market outcomes inefficient?How can people sometimes solve the problem of externalities on their own? Why do such private solutions not always work?What public policies aim to solve the problem of externalities?
2 Introduction One type of market failure: externalities. Externality: the uncompensated impact of one person’s actions on the well-being of a bystanderNegative externality: the effect on bystanders is adversePositive externality: the effect on bystanders is beneficial
3 Pollution: A Negative Externality Example of negative externality:Air pollution from a factoryThe firm does not bear the full cost of its production, and so will produce more than the socially efficient quantityHow govt may improve the market outcome:Impose a tax on the firm equal to the external cost of the pollution it generates
4 Other Examples of Negative Externalities the neighbor’s barking doglate-night stereo blasting from the dorm room next to yoursnoise pollution from construction projectstalking on cell phone while driving makes the roads less safe for othershealth risk to others from second-hand smoke
5 Positive Externalities from Education A more educated population benefits society:lower crime rates: educated people have more opportunities, so less likely to rob and stealbetter government: educated people make better-informed votersPeople do not consider these external benefits when deciding how much education to “purchase”Result: market eq’m quantity of education too lowHow govt may improve the market outcome:subsidize cost of education
6 Other Examples of Positive Externalities Being vaccinated against contagious diseases protects not only you, but people who visit the salad bar or produce section after youR&D creates knowledge others can useRenovating your house increases neighboring property valuesThank you for not contaminating the fruit supply!
7 Negative Externalities Private Costs and Social CostsMarginal private costcost of producing an additional unit of a good or service that is borne by the producer of that good or serviceMarginal external costcost of producing an additional unit of a good or service that falls on people other than the producer
8 Negative Externalities Marginal social costThe marginal cost incurred by the entire society—by the producer and by everyone else on whom the cost falls.Marginal social cost (MSC) is the sum of marginal private cost (MC) and marginal external cost.MSC = MC + Marginal external cost
9 Negative Externalities the relationship between cost and outputWhen output is 4,000 tons of chemicals a month:1. Marginal privatecost is $100 a ton.2. Marginal externalcost is $125 a ton.3. Marginal social cost is $225 a ton.
10 Negative Externalities Production and Pollution: How Much?when an industry is unregulated, the amount of pollution it creates depends on the market equilibrium price and the quantity of the good producedif the industry creates an external cost, the market equilibrium is inefficienttoo much of the good is produced
11 Negative Externalities inefficiency with an external cost1. The market is in equilibrium at a price of $100 a ton and 4,000 tons of chemical a month is inefficient.2. Marginal social cost exceeds ...3. Marginal benefit.
12 Negative Externalities 4. The efficient quantity is 2,000 tons of chemical, where marginal social cost equals marginal benefit.5. The gray triangle shows the dead-weight loss created by the pollution externality.
13 Recap of Welfare Economics 12345102030Q (gallons)P$The market for gasolineThe market eq’m maximizes consumer + producer surplus.Supply curve shows private cost, the costs directly incurred by sellers$2.5025Demand curve shows private value, the value to buyers (the prices they are willing to pay)
14 Analysis of a Negative Externality 12345102030Q (gallons)P$The market for gasolineSocial cost = private + external costexternal costSupply (private cost)External cost= value of the negative impact on bystanders= $1 per gallon (value of harm from smog, greenhouse gases)
15 Analysis of a Negative Externality 12345102030Q (gallons)P$The market for gasolineThe socially optimal quantity is 20 gallons.Social costSAt any Q < 20,value of additional gas exceeds social costAt any Q > 20,social cost of the last gallon is greater than its valueD25
16 Analysis of a Negative Externality 12345102030Q (gallons)P$The market for gasolineMarket eq’m (Q = 25)is greater thansocial optimum (Q = 20)Social costSOne solution: tax sellers $1/gallon,would shift supply curve up $1.D25
17 “Internalizing the Externality” Internalizing the externality: altering incentives so that people take account of the external effects of their actionsIn the previous example, the $1/gallon tax on sellers makes sellers’ costs equal to social costs.When market participants must pay social costs, the market eq’m matches the social optimum.(Imposing the tax on buyers would achieve the same outcome; market Q would equal optimal Q.)
18 Positive Externalities In the presence of a positive externality, the social value of a good includesprivate value – the direct value to buyersexternal benefit – the value of the positive impact on bystandersThe socially optimal Q maximizes welfare:At any lower Q, the social value of additional units exceeds their cost.At any higher Q, the cost of the last unit exceeds its social value.
19 Positive Externalities Private Benefits and Social BenefitsMarginal private benefitbenefit of an additional unit of a good or service that the consumer of that good or service receivesMarginal external benefitbenefit of an additional unit of a good or service that people other than the consumer of the good or service enjoy
20 Positive Externalities Marginal social benefitmarginal benefit enjoyed by society -- by the consumers of a good or service and by everyone else who benefits from itMarginal social benefit (MSB) is the sum of marginal private benefit (MB) and marginal external benefitMSB = MB + Marginal external benefit
21 Positive Externalities an external benefitWhen 15 millionstudents attendcollege:1. Marginal private benefit is $10,000 per student.2. Marginal external benefit is $15,000 per student.3. Marginal social benefit is $25,000 per student.
22 Positive Externalities inefficiency w/ an external benefit1. Market equilibrium is at a tuition of $15,000 a year and 7.5 million students and is inefficientbecause …2. Marginal social benefit exceeds …3. Marginal cost.
23 Positive Externalities 4. The efficient number of students is 15 million.5. The gray triangle shows the deadweight loss created because too few students enroll in college.
24 Positive Externalities Government Actions In the Face of External BenefitsFour devices that governments can use to achieve a more efficient allocation of resources in the presence of external benefits:Public provisionPrivate subsidiesVouchersPatents and copyrights
25 Positive Externalities Public provisionproduction of a good or service by a public authority that receives the bulk of its revenue from the governmentSubsidypayment that the government makes to private producers to cover part of the costs of productionVouchertoken that the government provides to households that can be used to buy specified goods or services
26 Positive Externalities Public provisionhow public provision can achieve an efficient outcome1. Marginal social benefit equals marginal cost with 15 million students enrolled in college.2. The efficient quantity.3. Tuition is $10,000 per year.4. The taxpayers cover the remaining $15,000 of marginal cost per student.
27 Positive Externalities Private Subsidieshow a subsidy achieves an efficient outcomeefficient number ofstudents is 15 million1. A $15,000 subsidy per student shifts the supply curve toS = MC – subsidy.2. The equilibriumprice is $10,000 astudent.
28 Positive Externalities 3. The market equilibrium is efficient with 15 million students enrolled in college.4. Marginal social benefit equals marginal cost.
29 Positive Externalities Vouchershow voucherscan achieve anefficientoutcomedemand curveis D = MSBbecause…1. With vouchers, buyers are willing to pay MB plus the value of the voucher.
30 Positive Externalities 2. Market equilibrium is efficient with 15 million students enrolled in college.3. Price, marginal social benefit, and marginal cost are equal.4. Tuition equals the dollar price of $10,000 plus the value of the voucher.
31 Positive Externalities Intellectual property rightsproperty rights of the creators of knowledge and other discoveriesPatent or copyrightgovernment-sanctioned exclusive right granted to the inventor of a good, service, or productive process to produce, use, and sell the invention for a given number of years
32 A C T I V E L E A R N I N G 1: Analysis of a positive externality 1020304050PQ$The market for flu shotsExternal benefit = $10/shotDraw the social value curve.Find the socially optimal Q.What policy would internalize this externality?SD
33 A C T I V E L E A R N I N G 1: Answers Socially optimalQ = 25 shotsTo internalize the externality, use subsidy = $10/shot.1020304050PQ$The market for flu shotsexternal benefitS25Social value = private value + external benefitD
34 Effects of Externalities: Summary If negative externalitymarket produces a larger quantity than is socially desirableIf positive externalitymarket produces a smaller quantity than is socially desirableTo remedy the problem, “internalize the externality”tax goods with negative externalitiessubsidize goods with positive externalitiesEffects of Externalities: Summary
35 Private Solutions to Externalities The Coase theoremif private parties can bargain without cost over the allocation of resources, they can solve the externalities problem on their own
36 The Coase Theorem: An Example Dick owns a dog named Spot.Negative externality: Spot’s barking disturbs Jane, Dick’s neighbor.The socially efficient outcome maximizes Dick’s + Jane’s well-being.If Dick values having Spot more than Jane values peace & quiet, the dog should stay.Coase theorem: The private market will reach the efficient outcome on its own…See Spot bark.
37 Application of the Coase Theorem If factories own homes and river, the rent people willingly pay decreases as the amount of pollution increases.If homeowners own the river, factories must pay homeowners for any pollution, and the more they pollute, the more they pay.Regardless of who owns the river, so long as someone owns it, the factories bear the cost of pollution, and the quantity of production and pollution are efficient.
38 Why Private Solutions Do Not Always Work Transaction costs: the costs that parties incur in the process of agreeing to and following through on a bargainSometimes when a beneficial agreement is possible, each party may hold out for a better deal.Coordination problems & costs when the number of parties is very large.
39 Public Policies Toward Externalities Two approachesCommand-and-control policies regulate behavior directly. Examples:limits on quantity of pollution emittedrequirements that firms adopt a particular technology to reduce emissionsMarket-based policies provide incentives so that private decision-makers will choose to solve the problem on their own.
40 Corrective Taxes & Subsidies Corrective tax: a tax designed to induce private decision-makers to take account of the social costs that arise from a negative externalityAlso called PIGOUVIAN TAXES after Arthur Pigou ( ).The ideal corrective tax = external costFor activities with positive externalities, ideal corrective subsidy = external benefit
41 Corrective Taxes & Subsidies effects of apollution tax1. A pollution tax is imposed that is equal to the marginal external cost arising from pollution.
42 Corrective Taxes & Subsidies The supply curve becomes the marginal private cost curve, MC, plus the tax -- the curve labeledS = MC + tax.
43 Corrective Taxes & Subsidies 2. Market equilibrium is at a price of $150 a ton and a quantityof 2,000 tons of chemical a month and is efficient because…3. Marginal social cost equals marginal benefit.
44 Corrective Taxes & Subsidies 4. The government collects tax revenue shown by the purple rectangle.
45 Example of a Corrective Tax: The Gas Tax The gas tax targets three negative externalities:congestion the more you drive, the more you contribute to congestionaccidents larger vehicles cause more damage in an accidentpollution burning fossil fuels produces greenhouse gases
46 Corrective Taxes & Subsidies Example: Acme, US Electric run coal-burning power plants. Each emits 40 tons of sulfur dioxide per month. SO2 causes acid rain & other health issues.Policy goal: reducing SO2 emissions 25%Policy optionsregulation: require each plant to cut emissions by 25%corrective tax: Make each plant pay a tax on each ton of SO2 emissions. Set tax at level that achieves goal.
47 Corrective Taxes & Subsidies Suppose cost of reducing emissions is lower for Acme than for US Electric.Socially efficient outcome: Acme reduces emissions more than US Electric.The corrective tax is a price on the right to pollute.Like other prices, the tax allocates this “good” to the firms who value it most highly (US Electric).
48 Corrective Taxes & Subsidies Under regulation, firms have no incentive to reduce emissions beyond the 25% target.A tax on emissions gives firms incentive to continue reducing emissions as long as the cost of doing so is less than the tax.If a cleaner technology becomes available, the tax gives firms an incentive to adopt it.
49 Corrective Taxes & Subsidies Other taxes distort incentives and move economy away from the social optimum.But corrective taxes enhance efficiency by aligning private with social incentives.
50 A C T I V E L E A R N I N G 2: Discussion question Policy goal: Reducing gasoline consumptionTwo approaches:A. Enact regulations requiring automakers to produce more fuel-efficient vehiclesB. Significantly raise the gas taxDiscuss the merits of each approach. Which do you think would achieve the goal at lower cost? Who do you think would support or oppose each approach?
51 Tradable Pollution Permits Recall: Acme, US Electric each emit 40 tons SO2, total of 80 tons.Goal: reduce emissions 25% (to 60 tons/month)Suppose cost of reducing emissions is $100/ton for Acme, $200/ton for US Electric.If regulation requires each firm to reduce 10 tons,cost to Acme: (10 tons) x ($100/ton) = $1,000cost to USE: (10 tons) x ($200/ton) = $2,000total cost of achieving goal = $3,000
52 Tradable Pollution Permits Alternative:issue 60 permits, each allows its bearer one ton of SO2 emissions (so total emissions = 60 tons)give 30 permits to each firmestablish market for trading permitsEach firm can choose among these options:emit 30 tons of SO2, using all its permitsemit < 30 tons, sell unused permitsbuy additional permits so it can emit > 30 tons
53 Tradable Pollution Permits Suppose market price of permit = $150One possible equilibrium:Acmespends $2,000 to cut emissions by 20 tonshas 10 unused permits, sells them for $1,500net cost to Acme: $500US Electricemissions remain at 400 tonsbuys 10 permits from Acme for $1,500net cost to USE: $1,500Total cost of achieving goal: $2,000
54 Tradable Pollution Permits A system of tradable pollution permits achieves goal at lower cost than regulation.Firms with low cost of reducing pollution sell whatever permits they can.Firms with high cost of reducing pollution buy permits.Result: Pollution reduction is concentrated among those firms with lowest costs.
55 Corrective Taxes vs. Tradable Pollution Permits Like most demand curves, firms’ demand for the ability to pollute is a downward-sloping function of the “price” of polluting.A corrective tax raises this price and thus reduces the quantity of pollution firms demand.A tradable permits system restricts the supply of pollution rights, has the same effect as the tax.When policymakers do not know the position of this demand curve, the permits system achieves pollution reduction targets more precisely.
56 Objections to the Economic Analysis of Pollution Some politicians, many environmentalists argue that no one should be able to “buy” the right to pollute, cannot put a price on the environment.However, people face tradeoffs.The value of clean air & water must be compared to their cost.The market-based approach reduces the cost of environmental protection, so it should increase the public’s demand for a clean environment.
57 CHAPTER SUMMARYAn externality occurs when a market transaction affects a third party. If the transaction yields negative externalities (e.g., pollution), the market quantity exceeds the socially optimal quantity. If the externality is positive (e.g., technology spillovers), the market quantity falls short of the social optimum.Sometimes, people can solve externalities on their own. The Coase theorem states that the private market can reach the socially optimal allocation of resources as long as people can bargain without cost. In practice, bargaining is often costly or difficult, and the Coase theorem does not apply.The government can attempt to remedy the problem. It can internalize the externality using corrective taxes. It can issue permits to polluters and establish a market where permits can be traded. Such policies often protect the environment at a lower cost to society than direct regulation.