3EXTERNALITIESAn externality is the uncompensated impact of one person or firm’s actions on another person/societyBoth positive externalities & negative externalities existAll externalities are considered market failures (inefficient)That is, markets with externalities do not maximize total surplus (welfare)Governments can correct externalities with taxes or subsidies
5Negative Externalities Automobile exhaustCigarette smokingBarking dogsLoud stereos in an apartment buildingNoisy StudentsNeighbor’s poorly maintained property
6Positive Externalities ImmunizationsRestored historic buildingsResearch into new technologiesNeighbor’s well maintained propertyVolunteering
7Spillover Costs & Spillover Benefits Spillover Costs- external costs not included in supply curve (MC)External costs exist with ALL negative externalitiesMC is understated => which leads to overproductionSpillover Benefits-external benefits not included in demand curve (MB)External benefits exist with ALL positive externalitiesMB is understated => which leads to underproductionMCMB
8Graphing Externalities When graphing negative externalities use MC & MB curvesThen add any spillover cost or benefit to existing curveMarginal Social Cost (MSC) = MC + spillover cost (external cost)Marginal Social Benefit (MSB) = MB + spillover benefit (external benefit)MBMCNegative ExternalityMSCMBMCMSBPositive Externality
9Internalizing Externalities Internalizing an externality involves altering incentives to improve market outcomes (i.e. to increase total welfare)Government SolutionsTaxes or SubsidiesLaws (immunization laws, pollution laws)PatentsFree market Solution:Trading pollution credits => i.e. cap & trade
10Internalizing Negative Externalities Aluminum CansAssume this Factory PollutesMSCImpose Tax = spillover costShifts Supply Curve leftReach social optimal outputMCQ2P2E2MBTotal Cost = Total BenefitTotal Cost = MSC (MCP + MCS)Total Welfare is Maximized!