1. THE ECONOMICS OF THE PUBLIC SECTOR4
THE ECONOMICS OF THE PUBLIC SECTOR

2. 10
Externalities

3. But market failures can still happen.
The Main Idea…
Recall: Adam Smith’s “invisible hand”
Markets allocate scarce resources with forces of S & D; equilibrium typically maximizes market welfare
But market failures can still happen.
Outcome of free market differs from socially optimal outcome
Gov’t policies can sometimes improve things
Video Clip: “Episode 31: Market Failures”

4. EXTERNALITIES
Externality = the uncompensated impact of one person’s actions on the well-being of a bystander
For example, I played a terrible song at the start of class. You were innocent bystanders – you weren’t involved in me buying the song off of iTunes, but you still suffered the noise pollution.

5. EXTERNALITIES
When the impact on the bystander is adverse, the externality is called a negative externality
Exhaust from cars
Your neighbor’s barking dog
Rebecca Black’s, “Friday”
When the impact on the bystander is beneficial, the externality is called a positive externality
Me getting a flu shot
Education

6. EXTERNALITIES CAUSE MARKET INEFFICIENCY
In either case, decision maker fails to take into account the external effect of his or her behavior
This causes markets to be inefficient, and thus fail to maximize total surplus
Negative externalities lead markets to produce a larger quantity than is socially desirable - overproduction
Positive externalities lead markets to produce a smaller quantity than is socially desirable - underproduction

7. I need five brave volunteers…
Life on Dismal Lake 
I need five brave volunteers…

8. Negative Externality Example: Aluminum
The Market for Aluminum
The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus.
If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers.

9. Figure 1 The Market for Aluminum
Price of
Aluminum
Supply
(private cost)
Demand
(private value)
QMARKET
Equilibrium
Quantity of
Aluminum
Copyright © South-Western

10. Negative Externality Example: Aluminum
The Market for Aluminum
For each unit of aluminum produced, the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution.

11. Figure 2 Pollution and the Social Optimum
Price of
Social
cost
Aluminum
Cost of
pollution
Demand
(private value)
Supply
(private cost)
Optimum
QOPTIMUM
Equilibrium
QMARKET
Quantity of
Aluminum
Copyright © South-Western

12. Negative Externality Example: Aluminum
Intersection of the demand curve and the social-cost curve determines optimal output level.
Socially optimal output level is less than market equilibrium quantity
The market produces a larger quantity than is socially desirable.
The social cost of the good exceeds the private cost of the good.

13. Adjusting for Externalities
Internalizing an externality involves altering incentives so that people take account of the external effects of their actions
Negative externality can be internalized by a tax on producers for each unit of aluminum; this would reduce equilibrium quantity to socially optimal level

14. Quick Quiz 1: Are You Picking Up What Was Put Down?
The government taxes goods like alcohol, tobacco, and gasoline – you may be familiar with the term sin tax. Why do you think many economists support these types of taxes? Provide a brief written explanation along with a graph to support your reasoning. For you graph, pick one market to represent – alcohol, tobacco, or gas.

15. Happy Friday 
What are your plans for after graduating high school? For example, college? job? What are your reasons?
Take out your class notes & the quick quiz handout. (extras are available in the “Absent” folder if you can’t find yours…)

16. Positive Externality Example: Education
When an externality benefits the bystanders, a positive externality exists.
The social value of the good exceeds the private value.
For example, education yields positive externalities
Better-educated voters lead to better government
Crime rates drop as education level of population rises
Countries with high levels of education enjoy higher standard of living

17. Figure 3 Education and the Social Optimum
Price of
Education
Social
value
Supply
(private cost)
Demand
(private value)
QOPTIMUM
QMARKET
Quantity of
Education
Copyright © South-Western

18. Positive Externalities
The intersection of the supply curve and the social-value curve determines the optimal output level.
The optimal output level is more than the equilibrium quantity.
The market produces a smaller quantity than is socially desirable.
The social value of the good exceeds the private value of the good.

19. Positive Externalities
Internalizing Positive Externalities: Subsidies
Used as the primary method for attempting to internalize positive externalities
Education is heavily subsidized through public schools and gov’t scholarships

20. Quick Quiz 2: Are You Picking Up What Was Put Down?
Give an example of positive externality. Explain why market outcomes are inefficient in the presence of this externality. Provide a graphical representation and explain how the government can remedy such a market failure.
DON’T PEAK AT YOUR NOTES.

21. Addressing Externalities: Two Types of Public Policy
Command-and-Control Policies – regulate behavior directly
Make certain behaviors illegal
Environmental regulations – limit pollution

22. Addressing Externalities: Two Types of Public Policy
Market-Based Policies – provide incentives so private decision makers choose to solve problem on their own
Policy 1:
Corrective Taxes: used to counter effects of negative externalities; ideal tax should equal external costs (a.k.a. Pigovian Taxes)
Subsidies: used to counter effects of positive externalities; ideal subsidy should equal external benefit
Policy 2:
Tradable Pollution Permits: Firms allotted certain amount of pollution per year; a free market for pollution rights develops as firms can buy and sell unused “units” of pollution

23. Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits
(a) Pigovian Tax
Price of
Pollution
Demand for
pollution rights P
Pigovian
tax Q 1.
A Pigovian
tax sets the
price of
pollution . . .
Quantity of 2.
. . . which, together
with the demand curve,
determines the quantity
of pollution.
Pollution
Copyright © South-Western

24. Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits
(b) Pollution Permits
Price of Q
Supply of
pollution permits
Pollution
Demand for
pollution rights P 2.
. . . which, together
with the demand curve,
determines the price
of pollution.
Quantity of 1.
Pollution
permits set
the quantity
of pollution . . .
Pollution
Copyright © South-Western

25. Quick Quiz #3
A glue factory and a steel mill emit smoke containing a chemical that is harmful if inhaled in large amounts. Describe three ways the town government may respond to this externality. What are the pros and cons of each solution?
Hint: Creating a chart would make this really easy for Mrs. K to grade… 

26. PRIVATE SOLUTIONS TO EXTERNALITIES
Government action is not always needed to solve the problem of externalities.
Moral codes and social sanctions
Charitable organizations
Integrating different types of businesses
Contracting between parties

27. The Coase Theorem
The Coase Theorem is a proposition that private parties can solve the problem of externalities on their own by bargaining without cost over the allocation of resources
Example: Mrs. K’s barking dog

28. Private Solutions Don’t Always Work 
Transaction costs can be so high that private agreement is not possible
The costs parties incur in the process of agreeing to and following through on a bargain

29. In Summary…
Sometimes the “invisible hand” fails to take into account the well-being of third parties – when a transaction impacts a third party, it’s called an externality
Externalities can be positive or negative
Those affected by externalities can sometimes solve the problem privately (Coase Theorem)
When private parties cannot adequately deal with externalities, then the government steps in.

30. Quick Quiz #4
Come up with your own externality story. Apply the Coase Theorem and provide a private solution. Give a specific scenario where the transaction costs may get in the way of the private solution.