1. KRUGMAN'S MICROECONOMICS for AP* Externalities and Public Policy Margaret Ray and David Anderson Micro: Econ: 39 75 Module

2. What you will learn in this Module : How external benefits and costs cause inefficiency in markets. Why some government policies to deal with externalities, such as emissions taxes, tradable emissions permits, and Pigouvian subsidies, are efficient, although others, including environmental standards, are not. Arthur Cecil Pigou

3. Policies Toward Pollution Environmental Standards (emissions testing; sewage treatment) Emissions Taxes Tradable Emissions Permits

4. Production, Consumption, and Externalities Private versus social benefits Private versus social costs

5. Externalities A Pigouvian tax is a tax levied on a market activity that generates negative externalities (or a subsidy for a positive externality. The tax or subsidy is intended to correct the market outcome. In the presence of negative externalities, the social cost of a market activity is not covered by the private cost of the activity. In the presence of positive externalities, the social benefit of a market activity is not covered by the private benefit of the activity.

6. Positive Externalities When the production and consumption of a good provides benefits to third parties, that good is said to provide positive externalities to society. Qty home improvements Price, MSB MPB MSB S P opt Q opt Q mkt P mkt Subsidy P cons

7. Positive Externalities We can see that the market under-produces goods that generate positive externalities. In other words, we don’t get enough of a good thing.We can see that the market under-produces goods that generate positive externalities. In other words, we don’t get enough of a good thing. This is inefficient and produces deadweight loss just like price controls and monopoly. This represents benefits that would be enjoyed by society if the socially optimal, not the market, output was produced.This is inefficient and produces deadweight loss just like price controls and monopoly. This represents benefits that would be enjoyed by society if the socially optimal, not the market, output was produced. The area of the deadweight triangle is above the supply curve, with base of (Q opt - Q mkt ), and height of (P msb – P mkt ),The area of the deadweight triangle is above the supply curve, with base of (Q opt - Q mkt ), and height of (P msb – P mkt ), Qty home improvements Price, MSB MPB MSB S P opt Q opt Q mkt P mkt Subsidy P cons

8. Positive Externalities How could policy eliminate the deadweight loss?How could policy eliminate the deadweight loss? We could provide a subsidy (called a Pigouvian subsidy) on each unit of home improvement goods demandedWe could provide a subsidy (called a Pigouvian subsidy) on each unit of home improvement goods demanded Qty home improvements Price, MSB MPB MSB S P opt Q opt Q mkt P mkt Subsidy P cons

9. Negative Externalities When the production and consumption of a good creates costs to third parties, that good is said to create negative externalities to society. Qty electricity Price, MSC MPC D MSC P opt Q opt Q mkt P mkt Tax P firm

10. Negative Externalities We can see that the market over-produces goods that generate negative externalities. In other words, we get too much of a bad thing.We can see that the market over-produces goods that generate negative externalities. In other words, we get too much of a bad thing. This is inefficient and produces deadweight loss just like price controls and monopoly. This represents additional costs that would not be incurred by society if the socially optimal, not the market, output was produced.This is inefficient and produces deadweight loss just like price controls and monopoly. This represents additional costs that would not be incurred by society if the socially optimal, not the market, output was produced. Qty electricity Price, MSC MPC D MSC P opt Q opt Q mkt P mkt Tax P firm

11. Negative Externalities - Examples Smokers ignore the unintended but harmful impact of toxic ‘passive smoking’ on non-smokersSmokers ignore the unintended but harmful impact of toxic ‘passive smoking’ on non-smokerstoxic ‘passive smoking’ on non-smokerstoxic ‘passive smoking’ on non-smokers Acid rain from power stations in the UK can damage the forests of NorwayAcid rain from power stations in the UK can damage the forests of Norway Air pollution from road use and traffic congestionAir pollution from road use and traffic congestionAir pollutionAir pollution The social costs of drug and alcohol abuseThe social costs of drug and alcohol abuse External costs of scraping the seabed for supplies of gravelExternal costs of scraping the seabed for supplies of gravelsupplies of gravelsupplies of gravel

12. Negative Externalities - Examples External costs of traveling by taxiExternal costs of traveling by taxiExternal costs of traveling by taxiExternal costs of traveling by taxi The environment damage caused by the intensive use of fertilizers in agricultureThe environment damage caused by the intensive use of fertilizers in agricultureenvironment damageenvironment damage The external costs of cleaning up from litter and the dropping of chewing gumThe external costs of cleaning up from litter and the dropping of chewing gumcleaning up from litterdropping of chewing gumcleaning up from litterdropping of chewing gum The external costs of the miles that food travels from producer to the final consumerThe external costs of the miles that food travels from producer to the final consumermiles that food travels from producer to the final consumermiles that food travels from producer to the final consumer

13. Network Externalities When more people use Facebook or Twitter, it becomes more valuable to you.When more people use Facebook or Twitter, it becomes more valuable to you. A network externality exists when the value to an individual of a good or service depends on how many other people use the same good or service.

14. Figure 75.1 In Pursuit of the Efficient Quantity of Pollution Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

15. Figure 75.2 Environmental Standards versus Emissions Taxes Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

16. Figure 75.3 Positive Externalities and Consumption Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

17. Figure 75.4 Negative Externalities and Production Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers