3 EXTERNALITIESAn 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
5 Negative Externalities Automobile exhaustCigarette smokingBarking dogsLoud stereos in an apartment buildingNoisy StudentsNeighbor’s poorly maintained property
6 Positive Externalities ImmunizationsRestored historic buildingsResearch into new technologiesNeighbor’s well maintained propertyVolunteering
7 Spillover 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
8 Graphing 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
9 Internalizing 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
10 Internalizing 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!